Too Big to Punish

Big and Small Banks
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Big and Small BanksThe Federal government sees itself leading the fight against discrimination, and has even fallen in love with the notion of “disparate impact,” a concept that suggests businesses should be held liable for actions that have a disproportionate effect on a particular class even if there was no demonstrable intent to discriminate.  Yet since the financial crisis of 2008–09, the Federal government has itself engaged in quite deliberate discrimination in the commercial banking sector.

In this post, I’ll examine how the Federal government has handled the alleged misconduct of large banks differently from the alleged misconduct of small banks.  In doing so, I’ll explain who actually bears the cost of resolving misconduct in large banks versus in small banks.  And as you’ll see, the Federal government’s actions in the world of “too-big-to-fail” and “too-small-to-save” have discrimination written all over them.

Let’s start with the large banks.  In an internal JP Morgan Chase memo written before the onset of the 2008 financial crisis, an employee reported to her bosses that very low quality mortgage loans were being included in the mortgage-backed securities (MBS) created by the bank.  These securities were then sold to a variety of investors around the world.  The U.S. Attorney’s Office found this memo during their preliminary investigation of alleged misrepresentation of the quality of MBS created from pools of mortgage loans.  Subsequent searches, both at JP Morgan Chase and elsewhere, led to lawsuits being filed by the U.S. Attorney’s Office against a number of large banks.  After several years of back and forth between the banks’ attorneys and the U.S. Attorney’s Office, the cases were ultimately concluded by monetary settlements with each bank, adding up to a total of approximately $37 billion.

Many saw this and concluded that the Federal government “won.”  But there is a completely different side to the story.  No individual officer or director of a large bank was ever personally cited as a party to these lawsuits under a claim of breach of fiduciary duties, let alone found guilty of fraudulent activity or required to personally pay some of the settlement costs.  At worst, an officer or executive’s bonus might have been reduced; the directors likely benefited from director fees generated by extra meetings to discuss the suits against their bank.

So who actually bore the cost of the lawsuits and the dollar amount of the settlement?  The mainstream media merrily reported that “the banks” paid.   In reality, however, the shareholders of the banks bore the cost even though no outside shareholder ever contributed to the bank behavior that led to the lawsuit.  Every decision-maker in the bank, from top management to directors, skated away freely.  What’s more, when a bank arrives at a settlement price, some of the settlement costs may actually be deductible as a business expense, thereby reducing taxable income and tax liability.  In short, some of the settlement costs were shifted to the taxpayer.

Contrast this with how the Federal Deposit Insurance Corporation (FDIC) typically handles the cases of failed smaller banks.  Assume for the moment that the FDIC discovered an internal memo from a junior loan officer to his or her boss stating that loans being made by the bank were of exceptionally low quality and very likely to default.  And assume the FDIC also discovered that neither the senior management of the bank nor the directors took any action.  In other words, imagine a memo similar to the one described above, which was found at JP Morgan Chase.  Clearly, this would be a very incriminating piece of evidence.  Upon such a discovery, the FDIC would almost immediately file a lawsuit against the officers and directors of the bank, most likely alleging a breach of fiduciary duties under an ordinary negligence standard in the hope of penetrating the directors’ and officers’ liability insurance and getting to them individually and personally.

In fact, even without such evidence, the FDIC has filed numerous lawsuits against officers and directors of failed small banks on precisely these grounds, alleging they knew at the time of origination that the loans were bad and that borrowers were likely to default.  Furthermore, the FDIC has often contended that the officers and directors should have known financial collapse was coming and therefore discontinued the bank’s lending activity.  That is, the FDIC has argued that directors and officers in smaller banks should have had better economic forecasting ability in anticipating the onset of the financial crisis than the FDIC itself, as well as the Federal Reserve and a host of other economic experts.

Note the extreme difference between how officers and directors are treated in large banks versus in smaller banks.  In the large banks, the lawsuits were simply turned over to lawyers (another cost ultimately borne by shareholders and taxpayers), and settled at zero personal cost to officers and directors.  The contrast with the case of a failed smaller bank couldn’t be clearer: by definition, shareholder equity has been extinguished, so the lawsuit is not filed against the bank itself but rather against its officers and directors, each of whom is named explicitly and personally in the filing.  For months, and in some cases years, after the failure of the bank, the officers and directors may hear nothing from the FDIC, but the threat of the lawsuit is always there.  Finally, when a lawsuit is filed and the allegations are laid out, additional months, or even several years, will be consumed by discovery, depositions of individuals, expert witness reports, settlement discussions, and perhaps a jury trial.  Lives are disrupted as the final outcome remains uncertain.

None of this is an accident.  The Federal government, through its various agencies, has deliberately set out to treat the officers and directors of failed smaller banks much more harshly than their counterparts at large ones.  Why?  Well, the too-big-to-fail doctrine, which protects the largest financial institutions from failure, is one obvious reason.  Another is that large banks have greater political clout than smaller ones, and can therefore defend the interests of their officers and directors much more effectively in Washington.  A third reason might be that large banks have virtually unlimited resources to hire lawyers to fight their corner, whereas failed smaller banks have to rely on liability insurance policies—or the personal wealth of their officers and directors—to fund their defense.

That’s not to say that the officers and directors of failed small banks are always defeated when their case makes it to court.  In fact, a striking statement on the discrimination inherent in Federal government policy towards commercial banks is contained in the conclusion of an order handed down by Judge Terence W. Boyle in the matter of FDIC as Receiver of Cooperative Bank, NC, which granted summary judgment in favor of a failed small bank’s officer and director defendants:

In short, the FDIC claims that defendants were not only more prescient than the nation’s most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans.  Such an assertion is wholly implausible.  The surrounding facts and public statements of economists and leaders such as Henry Paulson and Ben Bernanke belie FDIC’s position here.  It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered “too big to fail.” . . . Taking the position that a big bank’s directors and officers should be forgiven for failure due to its size and an unpredictable economic catastrophe while aggressively pursuing monetary compensation from a small bank’s directors and officers is unfortunate if not outright unjust.

“Unfortunate if not outright unjust” is a good way of describing the Federal government’s approach to commercial banking in the wake of the financial crisis.   And for now, at least, that approach looks set to continue.  The FDIC has appealed Judge Boyle’s decision.