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Former financial regulator Bill Black says 863-page Volcker rule will allow banks to continue their risky financial derivative bets by claiming speculation is mere hedging.

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JESSICA DESVARIEUX, TRNN PRODUCER: Welcome to The Real News Network. I’m Jessica Desvarieux in Baltimore. And welcome to this edition of the Bill Black report.

Now joining us is Bill Black. He’s an associate professor of economics and law at the University of Missouri-Kansas City. He’s a white-collar criminologist and a former financial regulator. And, of course, he’s a regular contributor to The Real News.

Thanks for joining us, Bill.


DESVARIEUX: So, Bill, what’s going on in the world of finance and fraud this week?

BLACK: Well, the first thing that’s going on is that they’re leaking to The New York Times that they’re allegedly going to bring a criminal action against JPMorgan, finally, but not for anything involving the crisis–involving Bernie Madoff, except, when you read beyond the headline, it turns out they mean by prosecuting that they will not be prosecuting JPMorgan and they will not be prosecuting any JPMorgan officer and such. So that’s the newest thing in fraud as we speak.

The broader thing that everybody is talking about in the financial world is that the five federal regulatory agencies, the three banking agencies, plus the Commodity Futures Trading Commission and the SEC, have gotten together and proposed a final rule, the so-called Volcker rule. And the Volcker rule is supposed to prevent the banks from speculating in financial derivatives. And it got the name Volcker because Volcker is the one who pushed for this bill, over the intense opposition of much of the Obama administration, in particular Larry Summers and Timothy Geithner and virtually all the Republicans, to get this provision.

And the reason they needed this provision is that Congress lacked–and the administration lacked the courage to have the kind of bold reforms that we instituted after the Great Depression that worked so well, particularly the Glass-Steagall bill that separated what we call commerce from banking. So banking, the bank could make loans to all kinds of entities, but it couldn’t own things. In other words, it couldn’t go and buy GM or something like that or buy stock in GM because, the argument went, wait a minute, we’re giving federal deposit insurance to folks, and that means, first, that you have an explicit federal subsidy that lets you borrow money more cheaply than other competitors. So why–you know, it will just distort competition if we allow banks to get involved in commerce. And second, we’ll put the U.S. government, the Treasury on the hook if you lose money running a bad auto company or steel company or whatever else that’s much riskier. And that doesn’t make any sense either. So Glass-Steagall is one of those rules that worked brilliantly for 50-plus years, and then we violated the central tenet, which, of course, you hear all the time from conservatives that if it ain’t broke, don’t fix it. Well, this one, A) it wasn’t broke. It was working brilliantly. And B) they didn’t fix it. They destroyed it. So that was completely insane, helped lead to this crisis.

And you might think, since it was proven to be a terrible policy and Glass-Steagall was proven to be a very good policy, that they would adopt Glass-Steagall. After all, Congress and the administration, FDR, Franklin Delano Roosevelt, back in the early ’30s, mid ’30s, didn’t have the advantage of the experience of 50 years with Glass-Steagall. They couldn’t be sure that the rule would work. But we had that experience. We knew what worked. And even after the crisis, we lack the courage to do it.

Okay. So that creates a central problem. If you’re going to allow banks to own things in the modern era, the things they’re likely to own, the biggest banks, are financial derivatives. And we’ve just seen in the last crisis how dangerous banks owning these financial derivatives are. These were the collateralized debt obligations and the credit default swaps that blew up a big chunk in the financial world, rendered most of the largest banks in the world insolvent, required the largest bailout in history, caused a great recession, etc., etc., etc. So it’s particularly nuts to continue to allow banks to speculate in financial derivatives. Naturally, that’s what both the administration and the Republicans thought was an excellent idea–continue that. But Volcker prevailed.

You know, here’s the problem. If you’re going–first thing is you’ve got to remember when we talk about the banks, that’s a misnomer in terms of the Volcker rule, and it’s a misnomer in two different ways that combine. First, because banks don’t make decisions, bank officers make decisions, and bank officers have incredibly perverse incentives when it comes to trading and speculating and gambling in financial derivatives, as we have just seen in this crisis. And the second thing is this has to do not with banks in general but the four largest banks in America that do derivatives, because they do, depending on which source you believe, 93 to 95 percent of all the U.S. derivative trades. And we are talking about $300 trillion, over $300 trillion annually in derivatives trades, which is massively greater than the GDP, massively greater than the real economy. And it’s complete insanity to have this world of derivatives where we’re on the hook as Treasury. Okay?

But if you’re going to allow the banks to own things, then the argument is always going to be–and any neoclassical economist is going to tend to noh his or her head and say, yes, yes, we must allow this–you must allow hedging. Hedging is an investment that is designed to offset the risk, if it’s a real hedge, in owning something. Alright? And the way you hedge, overwhelmingly, is through financial derivatives. So if you don’t bring back Glass-Steagall and you allow these four banks, each of which is basically $1 trillion in assets–a trillion is 1,000 billion. So these are mega, mega, mega institutions. And you allow them to own anything they want. They can always claim that any financial derivative they want to buy or sell in order to speculate to try to make the officer money is actually a hedge. And why would they do that? Because the accounting rules say that if the financial derivative is a hedge towards something else, then if you suffer–the bank suffers a loss on that hedge, it doesn’t have to recognize it for accounting purposes, which means that the income is reduced. The banks’ reported income isn’t produced, which means that the officers’ bonuses are massively increased by gaming the system.

And we have known that hedge accounting gaming, this kind of frauds involving hedge accounting, have been common for 50 years. Indeed, we know it in Fannie Mae, which did it through the late ’90s and the early parts of the 2000s and was eventually caught by the SEC hiding over $10 billion in losses where the SEC complaint says explicitly that they did so so that the officers could get larger bonuses. Right? So that’s the crazy world that we have that cannot work.

And as a result of creating a system that is so inherently subject to gaming, there was a war first within the banking regulatory agencies, with the SEC and the Fed, Federal Reserve, hating the Volcker rule and wanting to weaken it. And, you know, the way this was all shaking out, according to the rumors, is that the banks were about to have a big win when JPMorgan Chase had to admit that they had suffered what eventually they admitted was a six-plus billion dollar loss in gambling on financial derivatives, and that changed the political dynamic. So this new rule is tougher and tries to deal with some of these methods of evasion.

But that’s actually the bad news, because that has made this rule somewhere around 863 pages–in other words, four books. Now, there is no way you can enforce such a rule, and trying to train 1,000 examiners about four books’ worth of new rules, which is on top of thousands of pages of additional new rules required by Dodd-Frank is purely insane.

So it’s the worst of all worlds. It inherently cannot work. They can always evade it by simply claiming that something is a hedge instead of what it really is, speculation designed to make the officer Rich–often, by the way, at the expense of the banks. And any honest folks actually trying to comply with the rule will be driven crazy and it’ll be very expensive. And our very already understrength examination staff will be horribly weakened by, again, having to divert them into trying to learn what will literally be thousands of pages of additional rules, all of which will be largely unenforceable.

Alright. Bill Black, thank you so much for joining us.

BLACK: Thank you.

DESVARIEUX: And thank you for joining us on The Real News Network.


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William K. Black, author of The Best Way to Rob a Bank is to Own One, teaches economics and law at the University of Missouri Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.

Black was litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and general counsel of the Federal Home Loan Bank of San Francisco, and senior deputy chief counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.

Black developed the concept of "control fraud" frauds in which the CEO or head of state uses the entity as a "weapon." Control frauds cause greater financial losses than all other forms of property crime combined. He recently helped the World Bank develop anti-corruption initiatives and served as an expert for OFHEO in its enforcement action against Fannie Mae's former senior management.