The Fraud Recipe for CEO’s, Why Banks Hate Free Markets and Love Crony Capitalism, and the Dysmal Legacy of Mainstream Economists

Jaime writes the blog Capitalism without Failure


Bill Black: The Fraud Recipe for CEO’s, Why Banks Hate Free Markets and Love Crony Capitalism, and the Dysmal Legacy of Mainstream Economists


The selected notes below are from William K. Black’s presentation at the Modern Monetary Theory Summit in Rimini, Italy, in Febuary of this year.  The audio is embedded in this post following the text. 

On the “technocrats” running the show in Europe: There are no ‘technocrats,’ especially ‘genius’ technocrats.  I suggest a new rule of thumb for judging a ‘genius technocrat.’  They have to be right at least two out of ten times.  There is not a single economist in Europe, who calls himself a technocrat, that could do the equivalent of making two penalty kicks out of ten.

What we learned from the Savings & Loan crisis: George Santayana famously said that, “those who cannot remember the past are condemned to repeat it.” But, even if we remember the mistakes we have made, the new policy we pick could be another mistake.  Here is what we learned about the incidence of fraud leading up to the savings and loan crisis, according to the national commission that investigated the causes of that crisis:

“‘The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures… [E]very accounting trick available was used… Evidence of fraud was invariably present, as was the ability of the operators to ‘milk’ the organisation.’
On Control Fraud: Control fraud occurs when the person who controls a seemingly legitimate entity uses it as a weapon to defraud.  In finance, accounting is the weapon of choice.  These accounting frauds cause greater losses than all other property crimes combined, yet economists never talk about it.

On the danger Control Frauds pose to society: When many of these frauds occur in the same area, they hyperinflate financial bubbles, which is what causes financial crises and mass unemployment.  It makes the CEOs wealthy, produces Balzac scandals, and destroys democracy.

On how perverse incentives encourage fraud: Perverse incentives produce criminogenic environments that encourage fraud. When people are able to steal a lot of money, with no threat of imprisonment, nor having to live in disgrace, an environment conducive to fraud is established.  Establishing such an environment in practice requires the 3 D’s: Deregultation, Desupervision, and de facto Decriminalization. Deregulation: you get rid of the rules.  Desupervision: any rules that remain, you do not enforce.  Decriminalisation: even if you sometimes sue the perpetrators and get a fine, you do not put them in prison.  

On the ideal perverse incentives for accounting fraud: Accounting fraud thrives most with really high pay based on short-term reported income with no way to claw it back -even when it proves to be a lie.  Also helpful is for assets to not have a readily verifiable market-value; this makes it easy to inflate the asset prices and easy to hide real losses.  For a true epidemic of fraud, it is also helpful to have easy entry into the industry.

Bill Black’s Recipe for Bankers to become Billionaires:  1. Grow massively, 2. By making very poor quality loans at high rates of interest, 3. Use extreme leverage (high corporate debt), and 4. Set aside virtually no loss reserves for the massive losses that will be coming. If you do these four things, you are mathematically guaranteed to report record short-term income. Akerlof and Romer referred to it as a sure thing – it is guaranteed.

What the Recipe for Fraud will Guarantee: 1. The bank will report record profits (fictional profits), 2. The CEO will promptly become wealthy, and 3. Down the road, the bank will suffer catastrophic losses. As a bonus, if many banks do this simultaneously, a bubble will be hyperinflated.

Why bankers hate free markets and effective market competition, and adore crony capitalism: If you are a banker and wish to grow your bank (lending) at 50% per year – as was happening in Iceland, Ireland and much of Europe, for example – you would have to beat your competition – as in charge a lower interest rate. But if markets are working properly, your competition will try to match your rates – and you wouldn’t end up making more loans, and your income would fall. All bankers would lose. That’s why banks are the biggest proponents of crony capitalism – and are the world leaders in crony capitalism.

Why bad loans are perfect for bank fraud: When loans are made to people who cannot afford to repay them, banks that do basic underwriting are no longer an issue in terms of competition. And,when you lend to people with no intention to pay back a loan, you can charge very high interest and very high fees – thus maximizing short-term paper gains. And if enough banks get into the business, the bubble is hyperinflated, the bad loans can be rolled over into new bad loans, and the losses can be hidden for years. The bottom line is that mediocre bankers cannot make money in a competitive market, but they are guaranteed to make enormous money by using the fraud recipe. Here is a quote from the economist who led the national investigation of the Savings and Loan crisis, James Pierce: “‘Accounting abuses also provided the ultimate perverse incentive:  it paid to seek out bad loans because only those who had no intention of repaying would be willing to pay the high loan fees and interest required for the best looting.  It was rational for operators’—that’s CEOs—‘to drive their banks ever deeper into insolvency, as they looted them.’

So the best and surest way to become wealthy, as a bank CEO, is to make the worst possible loans.  In order to make so many bad loans, they have to gut the underwriting process.  Underwriting is what an honest bank does to make sure that it’s going to get repaid.  
How Adverse Selection and Gresham’s Dynamics permeate an industry: Imagine you run a Competent Honest Bank and you do underwriting.  And you can tell can tell high-risk and low-risk borrowers.  Low risk borrowers you charge 10%.   High-risk borrowers you charge 20%.  I run Bill’s Incompetent Bank, I can’t tell risk.  So, I charge everybody 15%.  Which borrowers come to me?  Only the absolute worst borrowers.  No good borrower would come because they could borrow at your bank at 10%.  In economics, we call this adverse selection.  And it means that a bank that makes loans this way must lose vast amounts of money.  No honest banker would operate this way.  And the banks that engage in these frauds also create criminogenic environments themselves to recruit fraud allies.  For example, when it comes to the people that value homes, if they won’t inflate the value, the dishonest banks won’t use them.  Do they need to corrupt every person that values homes?  No, five percent of the profession is sufficient.  They just send all their business to the corrupt appraisers.  This is called a Gresham’s Dynamic; and it means that cheaters prosper and bad ethics drives good ethics out of the marketplace.
On how to battle fraud: We need a coast guard for our banks.  We can no longer allow CEOs to desert their posts after running their banks aground and causing such great destruction.  The elite bank CEOs that destroyed the global economy remain wealthy, powerful, and famous because they looted.  They were bailed out.  They did not leave in a lifeboat in the dark of night.  They left in their yachts – yachts that the governments paid for.
On the disaster known as contemporary Economists: The dominant economists are truly terrible at one thing; They are terrible at economics.  Occasionally they go beyond economics and they are abysmal on ethics.  They are the leading opponents and dangers to democracy throughout the EU, in particular, but in America as well.On Economists’ awful predictive abilities and lack of morality – including three individual examples: Economists tell us they want to be judged on their predictive ability.  We welcome their admission because their record in prediction is pitiful.  But, of course, it is precisely the fact that they have been wrong about everything important for three decades that makes them unwilling to admit their error and evermore insistent on continuing their worst policy advice. Economics is particularly awful when it gets into the concept of morality.   

Black provides examples of three individuals who wield(ed) enormous influence but got everything wrong:

1. Greg Mankiw
Recall the quotation above from the economist who conducted the investigation of the Savings and Loan crisis.  He pointed out that it was ‘rational’ for looters to make bad loans.  Here is the reaction of one economist, Greg Mankiw, to hearing the work of that national commission and of that Nobel Prize winner-to-be, George Akerlof.  Keep in mind that Mankiw was the official discussant; he had the paper a week in advance; he thought about these remarks. He said:
“‘[…] it would be irrational for savings and loans [CEOs] not to loot.’
Mankiw takes a statement about how fraud is maximized by making bad loans, to the ethical proposition that it must be the appropriate action, even though the rational action is to defraud.
Greg Mankiw was not a random economist. President Bush made him Chairman of the President’s Council of Economic Advisers, the most prominent economic position in the U.S.A., after he had said these things.
2. Daniel Fischel
The next two gentlemen are the leading law and economics scholars on corporate law: Daniel Fischel and Judge Frank H. Easterbrook.  The following is a quote from their treatise in 1991 – so, an entire generation of U.S. lawyers have been taught this next phrase:
“‘A rule against fraud is not an essential or […] an important ingredient of securities markets.’
The key economist there—who is not really an economist, he’s a lawyer—is Daniel Fischel.  He worked for three of the worst control frauds, including the absolute worst savings and loan control fraud, praised them as the best firms in the USA, and then wrote this two years later without ever admitting in his book that he had tried his theories in the real world and they had led him to praise the worst frauds.  So, this is rank academic dishonesty on top of getting everything wrong.  And what happened to Fischel after he got everything wrong?  He was made Dean of the University of Chicago Law School, one of the most prominent academic positions in the USA.
3. Alan Greenspan
Alan Greenspan also worked for the worst fraud in the savings and loan crisis:  Charles Keating’s Lincoln Savings.  Greenspan personally recruited, as a lobbyist for this worst fraud, the five U.S. Senators who would intervene with us [regulators] to try and prevent us from taking enforcement action against the largest violation in the history of our agency because that violation was by Charles Keating and Lincoln Savings.  And those five senators became known and ridiculed as the Keating Five.
Alan Greenspan then wrote a letter saying we should allow Lincoln Savings to do these terrible investments because ‘they posed no foreseeable risk of loss to the federal insurance fund.’  Lincoln Savings’ failed investments proved to be the largest cost to the insurance fund.  After he had gotten it as wrong as it is possible to get something wrong, we made him Chairman of the Federal Reserve.  So, here you have a record of – we promote and honor the people who get it spectacularly wrong, as long as they get it wrong for powerful banks that are frauds.

On the predictions that Neoclassical (theoclassical) Economists got wrongThis is the short list.  Neoclassical economists predicted that because markets were efficient they were self-correcting, fraud was automatically excluded, and financial bubbles could not occurThey assured us that because of bankers’ interest in their reputations and auditors and appraisers, that they would never commit a fraud and never assist a fraudThey predicted that massive financial derivatives would stabilize the economic system.  They told us, even when the bubble had reached proportions larger than any in the history of the world, that there was no housing bubble in the United States, that there was no housing bubble in Ireland, that there was no housing bubble in Japan, that there was no housing bubble in SpainThey told us that if we paid CEOs massive amounts of money based on short-term performance, it would align the interests of the CEO with the shareholders and the public and be the best possible thing.

Every one of these predictions proved to be utterly false.  Actually, every single one of these predictions had been falsified before the economists ever said them; and they did not change their message.
The Cato Institute‘s contribution: In 2007, Cato released the following statement: Iceland’s economic renaissance is an impressive story. Supply-side reforms’—ie tax cuts—‘along with policies, such as privatisation and deregulation, have yielded predictable results; Incomes are rising, unemployment is almost non-existent, and the government is collecting more revenue from a larger tax base.’ 
They cut taxes but overall tax revenue grew because the country was growing at a massive rate.  Why?  Because the big three banks in Iceland were all accounting control frauds.  They were growing at an average rate of 50% every year.  And by the time they collapsed in 2008, they were ten times the GDP of Iceland.  And they suffered 60% losses on their assets. That was Cato’s prediction; proof-positive that deregulation, low taxes, and privatisation produce economic booms.
They said something very similar about Ireland in an article entitled ‘It’s Not Luck‘:
Ireland […] boasts the fourth highest gross domestic product per capita in the world. In the mid-1980s, Ireland was a backwater with an average income level 30% below that of the European Union. Today, Irish incomes are 40% above the EU average. Was this dramatic change the luck of the Irish?  Not at all.  It resulted from a series of hard-headed decisions that shifted Ireland from big government stagnation to free market growth.’ 
They wrote this in 2007, a year after the Irish bubble had popped and Ireland was going into freefall.  And what are we being told now is the answer?  Hard-headed decisions that shift the economies from big government stagnation to free market growth.  They have learned absolutely nothing from their past failed ‘predictions.’
On the role of banks in the Enron fiasco, and the state of relevant law in the USA:  Most of the world’s largest banks eagerly aided and abetted Enron’s frauds.  They knew Enron was engaged in fraud; and they thought that was a good thing because they would get more deal flow, more volume.  These frauds were documented extensively by investigations – hundreds of pages about it.  Not a single one of the large conventional bankers was prosecuted.  There was a prosecution about Merrill Lynch, which the courts obstructed.  Indeed, the U.S. Supreme Court ruled that only the government could bring civil suits against banks that aided and abetted fraud.  Think of that!  You could have indisputable proof that the bank had aided Enron, knowingly done so, caused you billions in losses, and you could not sue the bank.  That’s how bad the law has become in the United States.
On the reaction to the Fed’s Head of Supervision when he voiced concern that banks had aided in the Enron fraud:  The Fed leadership actively resisted bringing any action against the banks – not even a slap on the wrist.  It was only when the Securities and Exchange Commission took a slap on the wrist that the Federal Reserve was embarrassed into taking any action.  The long-time head of supervision at the Federal Reserve was deeply disturbed by the fact that most of the largest banks in the world had aided Enron’s fraud.  He put together a comprehensive briefing for the leadership of the Federal Reserve.  At that meeting, the senior officials of the Federal Reserve and the senior Economists of the Federal Reserve did not criticise Enron and they did not criticise the banks that aided Enron’s frauds.  They were enraged.. at the Supervisor.  How dare he criticise banks?  This illustrates the current state of thinking in the United States; this is the era of Reinventing Government, which pursues is a neoclassical, neoliberalbe soft on bankers agenda. 
On the Fed reaction to the fact that big American banks aided and abetted in the Parmalat fraud: Italy entered the control fraud picture in a big way in 2004 – well into the bankers-can-do-no-evil era – with Parmalat.  Parmalat turned out to be a massive accounting control fraud where the CEO was looting the company and taking the money out of Italy to tax havens where he could hide it in a wave of special complex corporate forms designed for that purpose.  And what did the Federal Reserve say about all of this?  First they bragged about their ‘enforcement’ action.  Note that they would not name the large institutions:
“‘In these enforcement actions, certain large institutions were required to revise their risk management practices where examiners found failures by these institutions to identify those transactions that presented heightened legal and reputational risk, particularly, in cases where transactions were used to facilitate a customer’s accounting or tax objective that resulted in misrepresenting the company’s true financial condition to the public and regulators.’
This passage requires translation because it’s in gobbledygook.  First, they are bragging about an enforcement action that they tried very hard not to bring and which was utterly useless.  Second, their concern is heightened legal and reputational risk.  They are worried that when a bank aids Enron or Parmalat’s frauds they will get caught and then their reputations will suffer.  They are not worried about Enron’s shareholders.  They are not worried about the 12,000 Enron employees who lose their jobs.  They are not worried about Parma’s economy.  None of that matters.  They don’t even discuss it.  And they are not worried about morality.  Call me old school, but I thought, when I was a regulator, if the banks I was regulating were engaged in fraud, first, my job was to stop it.  Second, my job was to remove the CEO from office.  Third, my job was to help prosecute him and put him in prison.  And, fourth, my job was to sue him, so that he walked away with not a lira or a euro or a dollar.  But all of that is gone.On what permitted the crisis to occur in Europe and the USA:  The National Commission Report on the US crisis stated

“‘We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets.  The sentries were not at their posts […] due to the widely-accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves.’
The Report goes on to specifically blame Greenspan and his deregulatory ideology. What was the regulatory common denominator in the USA and Europe? The common-causal mechanism that resulted in crisis was deregulation, desupervision and the absurd executive compensation that swept Europe and the USA. In the end, Economists got what they wanted, and they predicted that it would be wonderful. It produced a catastrophe.

Audio of William K. Black’s presentation:
William K. Black is Associate Professor of Law and Economics at the University of Missouri, Kansas City.  He is a lawyer, former bank regulator, and author of The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.
William K. Black’s presentations took place on Saturday, February 25th in Rimini, Italy at the first Italian grassroots economic Summit on Modern Money Theory produced by Italian Journalist Paolo Barnard.I thank Bonnie Faulkner for making the material in this presentation available through her show, Guns and Butter. If you missed Bonnie Faulkner’s excellent February interview with Bill Black, I highly recommend a listen.


Please visit the University of Missouri, Kansas City New Economic Perspectives blog at  Visit the website for the first Italian Summit on Modern Money Theory at
Portons of the above notes were taken from the transcript prepared by Felipe Messina for Media Roots and Guns and Butter

~~~ is my attempt to ensure both that we do not lose sight of what has happened to us, and that we pursue policy that stops rewarding the irresponsible, the reckless, and the criminal. Accounting tricks, socializing losses, providing public guarantees for private lending, and debasing our currency are not long term solutions. But they have resulted in a temporary, and priceless, respite.

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