Banking crises occur because banks routinely abuse the financial rules of the road without suffering meaningful personal penalties, the Oireachtas Banking Inquiry has heard.
"During good times, supervisors ignore the banks' new and dangerous risky financial behaviour," Professor Edward Kane of Boston College said. "Then, in times of deep trouble, supervisors extend the safety net to promote the needs of distressed institutions and their creditors (even foreign ones) over the welfare of ordinary citizens."
Mr Kane said regulators must explicitly measure and manage the cost of safety net guarantees and should impose a series of graduated penalties on individuals that violate important rules.
“These solutions would help force too-big-to-fail (TBTF) banks to internalise the costs of safety net guarantees, and would greatly lessen incentive distortions that corrupt the culture of regulation in the US and Europe.”
He said the result of regulatory capture meant that implicit and explicit government guarantees have become part of the equity funding structure of TBTF banking organisations and deserve to be recognised as equity claims both in company law and in financial accounting.
“For firms whose insolvency cannot be established and resolved in timely fashion, financial safety nets turn taxpayers into disadvantaged suppliers of loss-absorbing equity funding,” Mr Kane added.
He said taxpayers’ position in TBTF firms had, for many years, been exploited with impunity by managers and shareholders.
“Legislation is needed to clarify that managers of TBTF firms owe enforceable fiduciary duties of loyalty, competence, and care to taxpayers and to criminalise aggressive and wilful efforts to transfer value from taxpayers to shareholders and managers.”
He said limitless guarantees shift the risk of the deepest possible losses away from creditors and stockholders. “It is as if large banks’ profit flow moves through a pipeline with a Y junction in it. Once a TBTF institution becomes effectively insolvent [unable to cover its debts from its own resources], a switch is thrown that channels further losses to taxpayers until and unless the firm manages to recover its solvency again.
“Deeply insolvent banks ... can only operate because they are backed by the black magic of government implicit guarantees. The most important part of zombification is a passive policy of regulatory forbearance, which allows institutions that are insolvent to continue to roll over - and even to expand- their debt.”
Mr Kane urged the committee not to “fall into the trap of thinking of bailout expenditures as either loans or insurance”.
“An insurance company does not double and redouble the coverage of drivers it knows to be as reckless as TBTF firms proved themselves to be during the last economic boom,” he said.
“Similarly, lifelines provided to an underwater firm cannot be thought of as low-interest loans. Loans are simply not available to firms that are in zombie condition.”
During questions from committee members, Mr Kane conceded that he was “only a little bit” familiar with the Irish financial crash post 2008. “I’m not a student of the banking crisis in Ireland,” he said.
He also confused the committee members by referring to Anglo Irish Bank as AIB, which is shorthand in Ireland for Allied Irish Banks. When asked if he meant Anglo when referencing AIB, he said: "Yes, I think so. I thought that was the institution."
Mr Kane said that in the case of a bank collapse, bankers are often treated as “some kind of high priests” where it is considered that they have been “punished enough by being embarrassed by leading the firm to failure”.
Yet, in many cases they walk away with good pensions and financial compensation and so it shouldn’t be just a matter of shame, “it’s a matter of redress”.
In response to a question about the closure of Lehman Brothers in 2008, Mr Kane said it involved a double u-turn by federal policy makers in the United States given that Fannie Mae and Freddie Mac were bailed out beforehand while insurer AIG was rescued afterwards.