Out-of-court settlements with errant banks: Is financial services industry on a dying path?
Monday, 25 August 2014 00:00
Banks are at the receiving end
The reports coming from global financial markets are not good for banks at all. Banking regulators have renewed their war against whom they perceive as errant banks. The law enforcement agencies in their respective countries too have joined them as allies in this onslaught. This time it is not small banks which they have captured in their nets. It is big banks they have netted proclaiming ‘no bank is too big to jail’, the alternative version of the popular dictum ‘some banks are too big to fail’.
This sudden onslaught of banks by both regulators and prosecutors has shattered the foundation, long believed to be firm and strong, of the banking industry. Banks too admitting their guilt have started to arrange for ‘out-of-court settlements’ to avoid eventual bigger losses. One by one, all leaders in the industry have added to their collection of fines, compensatory payments and lump sum customer protection charges. In the process, banks have got out of a messy situation. But, no amount of compensatory payments can restore them with lost credibility, trust and reputation which are the core pillars of a sound banking industry.
An out-of-court settlement with a price tag of $ 25 b
According to National Association of Attorneys General or NAAG – an association of US Prosecutors set up in 1907 – the latest out-of-court settlement has forced five leading banks to pay as much as $ 25 billion (available at: http://naag.org/state-attorneys-general-feds-reach-25-billion-settlement-with-five-largest-mortgage-servicers-on-foreclosure-wrongs.php). The five banks under attack by US Prosecutors have been the largest in the world: Bank of America, J P Morgan Chase, Wells Fargo, Citigroup and Ally Financial. These banks for wrongs done to homeowners by taking over their homes when they were unable to repay their loans – known in industry as ‘foreclosure’ – have agreed to set aside $ 25 billion as compensation as follows:
nA minimum of $ 17 billion which can go up to $ 32 billion by way of direct relief to borrowers including the reduction of the principal sum of the loan;
nAnother $ 3 billion to refinance the borrowers who have been forced to sell their homes below the borrowed cost at a penny due to the adverse market changes – a situation known as ‘underwater mortgage sale’, earning its name from a property which has gone under water and therefore no value to a buyer;
nA payment of a fine of $ 5 billion to state and federal governments in USA.
The objective of being tough on five leading banks has been to protect the consumers – the goal of a bank regulatory method known as micro-prudential regulation. As explained by Iowa Attorney General Tom Miller the “goal has been to hold banks accountable while providing urgently needed relief to homeowners and transform a badly broken system into one that protects borrowers”. It is now clear that the country prosecutors are more concerned about consumer protection than upholding the banking system stability. In this scenario, banks have to undertake a critical balancing job between consumer protection and long term profitability just like an acrobat performs a tight rope walk. If they tilt to either side unnecessarily, they will fall off the rope to their own peril.
Heavy punishments imposed on banks
This is just one settlement among many which the industry has reached with respective country regulators. Since the global financial crisis of 2007/8, bank regulators have been tough on banks and have imposed penalties for a variety of misdeeds they are alleged to have committed. These misdeeds cover a wide range: fixing interest rates – especially the benchmark interest rate in the financial markets called London Inter-Bank Offered Rate or LIBOR, helping money laundering, risky trading in derivatives and fixing of markets for commodities. In this long list of sins attributed to banks, fixing of LIBOR and its counterparts in Yen and Euro has caused big banks to pay fines or out-of-court compensations up to $ 6 billion from end 2012 to mid 2014 (available at: http://www.valuewalk.com/2014/05/large-bank-libor-liabilities/ ).
Mishandling of mortgages to the detriment of homeowners and refinancing agencies has resulted in paying fines and out-of-court settlements, in addition to the above mentioned US $ 25 billion, amounting to $ 39 billion (available at: http://blogs.wsj.com/moneybeat/2014/06/23/a-list-of-the-biggest-bank-settlements/ ). The total so far imposed on banks over the last three years has amounted to $ 70 billion, well over Sri Lanka’s GDP of $ 67 billion. These are huge sums about which many in civil society bent on punishing errant banks would take relish at. However, the punishments have been imposed on a leading industry in the globe which has long been praised for its innovativeness, creativity and support for global economic growth. Hence, somewhere something has gone wrong and it lies beyond the fines imposed on and out-of-court settlements arranged with those supposed to be errant banks.
Need for looking beyond punishments
How could an industry so vital to a healthy global economy emerge as culprits in the eyes of the public, regulators and country prosecutors? What was the contribution made by banks themselves to their current predicament? What was the contribution made by the bank regulators for the errant banks to misbehave and eventually come clean by paying thumping compensatory payments? These are interesting issues to be sorted out since the current wave of cleaning bank balance sheets through forced settlements does not cure the ailments from which the industry is suffering.
At least two reasons could be adduced to the current malady. One is the regulatory forbearance on the part of the regulators. The other is the regulatory capture by those supposed to be regulated by regulators.
Banking regulators failing to act in time
Regulatory forbearance is the failure of regulators to take timely action on an errant bank when they come to know of wrong things happening in it. In the case of banks, the regulator is usually the central bank of the country or in some cases, an independent financial services authority. They gather a large amount of information from banks themselves through regular reports – known as offsite surveillance – and by making on the spot examinations – known as onsite supervision. In both cases, information is provided by banks themselves and it is in the interest of the information provider, in the absence of any penalty for supplying false information, to supply only partial information or information beneficial to him. In economics, this is known as asymmetric information where a bank knows everything about itself while the central bank knows only what is supplied to it.
If central banks are not tough on banks which supply partial, wrong or only favourable information, there are all the incentives for banks to keep on supplying wrong information to the regulator. However, there are two other valuable sources of information which central banks cannot ignore. One is the market rumours about nasty things happening in banks. The other is the anonymous informer – known as the ‘whistleblower’ – who keeps on sending a flow of information to the regulator. The whistleblowers would have been guided by ill-wills in blowing the whistle. Yet, the pieces of information they supply are very vital for a central bank to quickly act on an errant bank after due investigations.
When central banks come under political pressure not to act
The reasons for practising regulatory forbearance by central banks are numerous. They may be under political pressure not to act on errant banks which are related to top politicians or which have successfully captured the politicians. Even if a central bank does not come under political pressure, it may still refrain from taking action due to its own inefficiency or inefficacy or sometimes due to prestige reasons. Third, central banks may be concerned about the large social costs that may be imposed on society by allowing a big bank to close its doors. A situation where depositors form themselves into associations and threaten to commit suicide in front of a central bank is nasty and should be avoided.
Whatever the reason, regulatory forbearance contributes errant banks to thrive and once the system is plagued by such banks, a massive operation has to be launched in order to protect the banking system. This is what the Iowa Attorney General has referred to as the ‘broken system’ though he has failed to mention who had contributed to break the system in the first instance.
Regulatory capture: The worst public enemy
Regulations are imposed by governments – banking regulations are one such form – to correct the market failures and protect the consumers. However, every instance of regulation is marred by desires of interested parties to capture the regulators and get them to work for them, instead of working for society. This writer in a previous article under the title ‘Regulatory Capture: The worst public enemy imaginable’ in this series analysed the malady of regulatory capture (available at: http://www.ft.lk/2013/02/04/regulatory-capture-the-worst-public-enemy-imaginable/).
Incentives for capturing regulators
It was the Harvard University’s political scientist Samuel P. Huntington who first came up with the idea that interest groups have incentives to influence regulatory agencies in a paper published in 1952. But the formal development of the concept in terms of economics was done by Chicago University economist and Nobel Laureate, George J. Stigler, in 1971in a paper published in the Bell Journal of Economics and Management Science under the title ‘The Theory of Economic Regulation’.
The term regulatory capture was not coined by Stigler, but by another political scientist, Marver H. Bernstein, formerly at Princeton University and at that time President of the Brandeis University, in a paper published in 1972. In this paper titled ‘Independent Regulatory Agencies: A Perspective on Their Reform,’ Bernstein said that “most familiar charge against independent commissions is that they develop an orientation toward the views and interests of their clientele and become ripe for capture,” thereby giving birth to the term regulatory capture.
Today, the regulatory capture theory in public policy is a well established proposition and it represents the main arguments presented for establishing the failure of the government. Hence, the need for eliminating the same in the public policy system is as important as eliminating bribery and corruption – another important source of the government’s failure.
Bank regulators and politicians above the regulators are captured by big banks in order to dilute the regulatory mechanism for their benefit. While politicians are cultivated for capture through rewards, bank regulators fall prey to their crafty schemes due to deficiencies in their knowledge base.
It is usual in many countries, the resource persons for central banking training courses are provided by big commercial banks. With this knowledge superiority, when commercial banks come for discussions, the central bank officials are at their mercy. The result is that banking regulators act not for the protection of the system, but for the benefit of banks with which they have developed close relationships.
Gullible public believes that regulations are good
Banking regulations are introduced with so much of hopes at the time of introduction. But they become perverse to the society over the natural life span of a regulatory agency.
This happens when the regulatory agency allows itself to be captured by interest groups.
Though this is a well known fact, the demand by politicians and the public is for more and more public policies and regulations. The politicians do so because they stand to gain.
The public does so because they are made to believe that regulations are for their benefit through effective propaganda work that arouses patriotic, nationalistic or religious feelings.
How to limit the regulatory capture?
After the bad experience with regulatory capture in the last century, an independent think-tank called The Tobin Project based in Massachusetts in USA implemented a special project on regulatory capture in 2009. Its report titled ‘Preventing Regulatory Capture: Special Interest Influence and How to Limit It’ has been released in 2013 by the Cambridge University Press.
The papers in the volume have been released to the web for free use by the interested scholars (available at: http://tobinproject.org/books-papers/preventing-capture).
These papers have argued that to limit the regulatory capture, consumer groups have to be empowered to check on the influence of the industry on regulators, the court system should be strengthened to review the regulatory action and declare whether it is legal or illegal and a central review system of the regulatory action should be established with powers to look at the regulatory work from both prospective and retrospective points of view.
Preventing regulatory capture
Since the consumer groups, judiciary and central review agencies can also be manipulated by the special interest groups, especially all powerful political authorities, the whole issue boils down to three basic requirements to be put in place. They are the observance of the Rule of Law, the preservation of the independence of the judiciary and respecting the work done by both formal and informal institutions that have dedicated themselves to eliminate the possible regulatory capture by interest groups.
Act in time to prevent misdeeds of banks
Banks are being punished today partly for the ills of banking regulators and partly for the sins committed by them. Paying high compensatory payments weaken the banking system and the taxpayers will be eventually called upon to rescue them at a greater cost. Timely action by banking regulators is therefore more important than imposing fines on the errant banks.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com.)