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Untouchables - the logic and history of "Too Big To Jail"

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February 19, 2013 – Comments (1) | RELATED TICKERS: C , HSBC

Over the weekend, I ran into a video of Senator Elizabeth Warren's questioning of a handful of SEC employees responsible for the oversight of banks in the United States. The Senator posed a very simple question that caused a humorous level  awkward discomfort for the SEC panel before her. She wanted to find out when was the last time that the SEC had taken a Wall Street bank to trial? The SEC and the Department of Justice have extracted billions of dollars from Banks through settlements over matters such as illegal dealings with drug cartels, manipulation of Libor, mortgage fraud and the creation of dubious investment vehicles  but they rarely take the cases all the way to court. These cases have almost always been handled by reaching an out-of-court settlement, usually in the billions of dollars, that allows the banks to avoid the harsh light of public trial, while allowing the SEC and DOJ to avoid a lengthly and costly trial in which they will almost surely be outgunned (in terms of legal teams and money).

Perhaps one of the most striking examples of these types of settlements is the recent deal the DOJ made with HSBC over the bank's shady business dealings with Mexican Drug cartels, suspected terrorists, rogue states and common criminals. The bank agreed to pay $1.9 billion dollars (roughly equivalent to 5 weeks worth of profits) to settle the matter outside of court. None of HSBC's executives were arrested, no one was personally held accountable in any way and the bank held on to all of it's banking licenses and privileges that it has.

You have to understand that this kind of settlement is par for the course when it comes to going after Banks, and HSBC is not a unique outlier when it comes to sketchy business practices. Citigroup, for example, has a rather checkered past as well  Here are some of the latest settlements for Citigroup (taken from this great article)

- 2001 - Citigroup paid $120 million over its role in the Enron Scandal

- 2002 - $2.7 Billion settlement over Worldcom scandal

- 2002 - $215 fine for predatory lending practices

- 2004 - $400 million settlement over its role in the internet bubble of the late 1990s (Eliot Spitzer went after them for this)

- 2004 - $70 million settlement over predator lending

- 2005 - $208 million for defrauding mutual fund investors

- 2006 - $1.5 million over bond manipulation 

- 2011 - $285 million settlement for it's role in the Housing crisis and the CDO market

If you think about it, it is a pretty good business model. Do whatever illegal, imoral and dubious thing you can to make a a huge profit until the authorities come after you, then pay a small fine (relative to the profits you have reaped), and then go find another opportunity. 

Justice, deterrence and perverse incentives

The structure of the current enforcement system is such that the banks have very little incentive to actually change. The major banks are so big that they can get away with murder because prosecutors are unable or unwilling to go after them in any substancial way. First of all, the banks have so much money and such great legal teams that a drawn-out court case would take years (if not decades) and cost untold millions in legal fees and expenses for the government to prosecute, with no guarantee of victory in the end. The reason why settlements are so popular is because they yield large payments, are presented to the public as huge victories and can be accomplished in a reasonable amount of time.

The second aspect is that governments  especially in times of financial panic, do not want to destabilize the financial system by doing something dramatic like pulling the banking license of a entity with millions of customers, countless counter-party risks and trillions in daily transactions. If Citigroup ever lost it's license, panic would ensue in the financial system since Citi has a complex, and completely opaque, web of financial contracts with almost every major bank in the world. If Citi goes down, it will take the whole system with it. 

But the obvious problem is that the current situation creates perverse incentives and glaring moral hazards. Why should Citi, or any other bank for that matter, worry about the legality (or morality  of a profitable venture if they know that any trouble will be dealt with in the distant future, and at a cost that dwarfs the potential profit right at their fingertips? Bank executives and traders get paid for short-term performance, so the risk of your company facing an often measly fine many years down the road is of little consequence for bankers. To add insult to injury, the fines often end up being tax-deductible!

One solution would be to hold individual executives accountable for the actions of their banks and department. Citi could take down the whole system, but a few millionaire executives in prison would send a message to the banking system and would serve as an deterrent for the rest of the banking community. But banks have been notoriously skilled at keeping cases out of court and lawyering up their executives to avoid criminal charges. A hand full of low-level traders and managers sometimes receive a slap on the wrist, though they are often labeled as "Rogue Traders", but that does little to disuade dubious practices throughout the entire financial system. 

Senator Warren raised a point which really resonated with me, she pointed out that the DOJ often goes after private citizens for rather petty crimes and with relatively little evidence. Low-level drug dealers and petty thieves are prosecuted with the full force of the law, but when it comes to going after the Goliaths of Wall Street, the DOJ and SEC appear to be intimidated by these institutions. The best the authorities seem capable of is doing is to parade executives in front of a committee where politicians ask angry questions, engage in their traditional grand-standing, but achieve very little in any practical sense. Then, many months later, a settlement is reached, an impressive-sounding fine in announced, and justice has been served. 

Originally found at Flurish Financial Analytics 

1 Comments – Post Your Own

#1) On February 19, 2013 at 8:09 PM, awallejr (83.86) wrote:

One solution would be to hold individual executives accountable for the actions of their banks and department.

I have been arguing for this here for years now.  The usual answer is "it is too hard to get conviction's."  But there is a remedy for that, change the laws and make them simpler and easier to prove.

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