By William K. Black. This article was first published on New Economic Perspectives.

This is the second installment of a series arising from my recent participation in CIFA’s XIIth Annual International Forum in Monaco.  The series was prompted by Dr. Hans Geiger’s rage at financial regulation in Europe – not at its pathetic weakness that produced the criminogenic environments through much of the Eurozone, but at the proposal that Swiss banks be required to make criminal referrals when they found evidence of likely criminality by their customers.  This inspired me to wonder why a requirement that has existed in the U.S. for over 30 years would lead to such raw animus against “bureaucrats” serving “big brother” (i.e., the democratically elected Swiss government).

Geiger is a member of the European Shadow Financial Regulation Commission, which I will call the “EU Shadow” for the sake of brevity.  I am familiar with the US Shadow.  There are interesting (if you are a fellow wonk) articles by members of the EU Shadow about its creation and its conception of what it intends to achieve and how it will do so.  I will refer to the 2004 article by the EU Shadow’s chairman, Harald A. Benink.

The “Radically” Anti-Regulator Genesis of the Shadows

Benink is candid about the anti-regulator, anti-government, and anti-regulatory nature of the US Shadow and the fact that it spawned the other Shadows.

“The idea to set up a European Shadow Financial Regulatory Committee was strongly promoted by George Kaufman, one of the initiators and most prominent spokesmen of the US Shadow Financial Regulatory Committee….

[T]he US SFRC advocates a very specific point of view regarding regulatory issues.  Its statements very often embody a radically “liberal” position – in the sense of the word as it is generally used outside the US – which implies a deep-seated scepticism concerning government-imposed regulation, and indeed concerning government intervention in the economy in general.”

The EU Shadow claims that it rejects the US Shadow’s anti-governmental dogmas and animus.

Under no circumstances should the committee engage in gratuitous or glib criticism of regulators or adopt a patronizing attitude towards them.”

Geiger must not have gotten the memo.  His insults of regulators are constant, gratuitous, glib, and patronizing.

The Shadows’ Crown Jewel: Prompt Corrective Action (PCA)

This article deals with the Shadows’ core regulatory idea – “prompt corrective action” (PCA).  The EU Shadow’s faux independence from the US Shadow is exemplified by the fact that their first policy statement proposed PCA.  The Shadows have rebranded PCA as “structured early intervention and restructuring” (SEIR), but I’ll stick with the shorter “PCA.”  Kaufman’s principal argument for PCA mandates is that financial regulators refuse to resolve banks’ problems promptly.  Delay is resolving problem banks increases losses.

Kaufman’s Obsession: His Rage at Ed Gray’s Successful PCA v. S&L Frauds

Benink called Kaufman the effective leader of the US Shadow.  He founded the US Shadow and a number of other groups designed to limit financial regulation and regulators.  Kaufman’s pride and joy is PCA.  Benink also admits that the US Shadow is “radically” hostile to regulation and regulators.  Kaufman’s all-consuming passion when I (eventually) talked with him was his rage at Edwin Gray, the great reregulator who falsified Kaufman’s dogmas.  Kaufman arranged a panel at the annual meeting of economists for the stated purpose of getting the 1993 Report of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) greater attention among economists.  He invited NCFIRRE’s Executive Director, James Pierce (a U.C. Berkeley economist) to be a member of the panel.  Kaufman praised the NCFIRRE Report, but his fervor was reserved for attacking two aspects of the Report.  He denounced the Report for its support of the actions of Edwin Gray, Chairman of the Federal Home Loan Bank Board (Bank Board) from mid-1983 to mid-1987.  Gray was appointed by President Reagan, but began reregulating the savings and loan (S&L) industry in 1983 – the year after the Garn-St Germain Act of 1982 set off the regulatory “competition in laxity” that produced the criminogenic environment that led to the accounting control fraud epidemic that drove the debacle.  (Kaufman and the Shadows are strong supporters of the regulatory race to the bottom.)

Kaufman blamed the Report’s favorable view of reregulation on me.  I was “detailed” to NCFIRRE as Pierce’s deputy (at his request).  Gray had me lead the reregulation of the industry at the staff level.  I was not invited by Kaufman to present on the panel and did not know about it.  Pierce walked out of the panel when Kaufman began his tirade against Gray and blamed me for purportedly misleading Pierce about Gray’s actions.  Kaufman later contacted me urge me to write a paper on the subject responding to his critique.  Pierce told me not to do so.

Gray Remains the Exemplar of Successful PCA

In a sane world Kaufman would have made Gray the poster child for PCA.  First, Gray prioritized for takeover the S&L accounting control frauds while they were still reporting high profits.  Our ability to identify these frauds at such at early juncture arose from our “autopsies” of every failed S&L that disclosed the distinctive fraud pattern.   This led to the most interesting letter of the entire debacle.  It was sent by the most notorious leader of an S&L control fraud, Charles Keating, to a large number of powerful members of the Reagan administration and Congress.  As the text indicates, it was prompted by a memorandum by the leading law firm specializing in S&Ls.  The firm’s memorandum explained the fact that we were making our top priority for closure S&Ls that were still reporting high profits and substantial capital.

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Yes, to Keating, following the precepts of PCA meant we were “Nazi,” “police state,” and “like Jupiter eating his children.”

Second, we adopted rule changes designed to cause the collapse of hundreds of fraudulent S&Ls.  We realized from our “autopsies” of every S&L failure that the Achilles’ “heel” of accounting control frauds was their need for extremely rapid growth.  We adopted a rule restricting growth in order to minimize losses.  The S&L frauds failed much more quickly and they were smaller to when they failed.  Both aspects reduced losses as we intended.

Third, Gray spent virtually every dollar in the FSLIC fund to resolve failed S&Ls promptly.  This was a complete change from the practices of his predecessor, the theoclassical economist Richard (Dick) Pratt.  Gray spent the fund down to $500 million – to insure an industry of over $1 trillion in assets.

Fourth, Gray devised a plan (because the Reagan administration refused to admit that public funds were needed to resolve the crisis) to “recapitalize” the FSLIC insurance fund so that we could close hundreds of additional S&Ls.  The S&Ls, led by the control frauds, used their political power in Congress to delay passage of FSLIC Recap until after Gray left office.

Fifth, Gray adopted reregulation and prioritized the closure of the control frauds over the vitriolic opposition of the frauds, the industry’s powerful trade association, the congressional leadership of both parties, Speaker Wright, the “Keating Five,” and the Reagan administration.  To give only two examples illustrating the insane lengths of that opposition, the OMB threatened to make a criminal referral against Gray on the “grounds” that he was closing too many failed S&Ls and the Reagan administration tried to give Keating control over the Bank Board by appointing two members to the Bank Board chosen by Keating.  (The Bank Board only had three members, so this would have given Keating, the Nation’s most notorious fraud, control over the agency.  Think how many trillions of dollars that would have cost!)  The administration succeeded in making one of Keating’s choices, Lee Henkel, a recess appointment, in which capacity he served as Keating’s “mole” at the agency.  I blew the whistle on him and he eventually resigned in disgrace.

Gray’s adoption of PCA proved the validity of the concept.  He saved the Nation many trillions of dollars, as we can now understand by watching the opposite, anti-regulatory, approach taken from 1993-2009.  So, Gray should be Kaufman’s patron saint of PCA.  Instead, Kaufman tries to pillory Gray.  Why?

The problem is that Kaufman despises regulation and regulators more than he despises elite CEO frauds that cause catastrophic losses and make a mockery of the Shadow’s fatally flawed verion of PCA.  As the EU Shadow emphasizes, he is “radically” anti-governmental.  PCA, for Kaufman, is a means of arguing for minimal regulation.  It is supposed to leave the banks “free” to invest in almost any asset and to make loans and sell products to consumers with minimal restrictions.  Gray’s unforgivable sin was succeeding by actually regulating – and demonstrating that Kaufman’s version of PCA was intensely criminogenic.  Worse, Gray eventually became a hero to the public and even public officials such as Housing banking Chairman Henry B. Gonzalez.

But worst of all, it turned out that Kaufman and his closest allies were strong supporters of Keating.  Indeed, Kaufman’s closest comrade-in-arms on PCA was George Benston.  George Benston was Keating’s leading “expert” in opposing Gray’s reregulation of the industry.  Keating teamed him with Alan Greenspan because of Greenspan’s fame, but Benston did the real work.  It was Benston who conducted the study that praised the 33 S&Ls that invested more than 10% of their assets in “direct investments” (as opposed to loans).  One of Gray’s significant acts of reregulation was to restrict such direct investments to no more than 10% of total assets.  Benston, who was a CPA in addition to an economist, reported that the 33 S&L reported far greater profits than most S&Ls and stated that they should be the model for the industry.  Within two years, all 33 had failed.  They were, overwhelmingly, accounting control frauds.  Keating considered Benston to be so reliably supportive of Keating that he induced the Reagan administration to make him (with Henkel) a recess appointment as Bank Board member.  Fortunately, Benston’s positions on other issues were so extreme that random political forces (in the form of Kansas S&Ls and Bob Dole) arose and blocked his appointment.  After most of the fraudulent S&Ls that Benston had praised had failed Kaufman and Benston wrote to claim that we should not use federal regulation to block activities (such as direct investments) allowed by the states (particularly California, where Keating’s Lincoln Savings was chartered) as part of the “competition in regulatory laxity” unless sufficient time had gone by to establish that the state powers caused large scale failures.  This was the opposite of PCA and had we followed their advice it would have cost the Nation trillions of dollars in losses.

One can now see why Gray is anathema to Kaufman.  Gray’s actions proved the validity of (real) PCA and the catastrophic losses that would have been caused had we instead adopted the anti-regulatory dogmas that Kaufman and Benston had freighted on their version of PCA.  Gray also proved that the Kaufman and Benston version’s fatal flaw was implicitly assuming out of existence the primary cause of the most costly bank failures – accounting control fraud.  I will develop that point in greater detail in a future article in this series.  The PCA paradox is that the leaders of the U.S. Shadow aided the opposition to Gray’s demonstration that real PCA can be spectacularly successful.  Had they succeeded in blocking Gray’s reregulation they would have demonstrated the folly of their proposal’s implicit assumptions that accounting control fraud did not exist.  Gray saved Kaufman and Benston from themselves during the S&L debacle.

Gray also falsified Kaufman’s favorite motif that regulators hated PCA and therefore it was essential that Congress remove any regulatory discretion and mandate Kaufman and Benston’s version of PCA with its fatal ideological anti-regulatory freight.  But thanks to the constant attacks on Gray and effective regulation and regulators Gray was not reappointed to a second term by President Reagan.  This was in some ways remarkable because Gray was a personal friend of Mr. and Mrs. Reagan and by the end of his first term he was recognized as having been proven correct about the epidemic of frauds and the vital need to reregulate and prioritize the frauds for the earliest closure.  He was also praised as heroic for taking these stands in the face of opposition by powerful politicians and economists.  George Akerlof and Paul Romer would later write in their 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit” this implicit ode to Gray and his agency.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

Sadly, by the time Akerlof and Romer were writing it was already clear that the “we” that actually “knew better” did not include the Shadow.  The Shadow led what became a global effort to discredit vital components of regulation and to claim that as long as there was a PCA requirement banks should be allowed to make nearly any loan or investment.  The anti-regulatory dogmas were exceptionally criminogenic for accounting control fraud – and the Achilles’ “heel” of the Shadow’s version of PCA was an epidemic of accounting control fraud.  But as I will develop in future columns in this series, the Shadow compounded this inherent weakness through complacency.  They sold PCA as the elixir that made material losses from bank failures a thing of the past.  As the current crisis has proven (again), when economists “assume the can opener” they unknowingly open up a can of pestilence that would appall Pandora.