Why the financial reform bill won't prevent another crisis

By William K. Black, contributor


FORTUNE -- Financial regulators, white-collar criminologists, and economists all agree that perverse incentive structures cause crises and they agree that the finance industry's incentive structures have long been perverse.

The Obama administration asserts that the financial reform bill the President will sign into law this week will prevent future crises. In fact, it will fail to do so because it does not effectively address those perverse incentives. Indeed, it increases the likelihood of the accounting scams that are the very reason why perverse incentives pay.

Over time, crises have gotten more severe because many reform policies have the unintended consequence of encouraging these types of incentive structures. Executive and professional compensation create the motives, while deregulation, desupervison, and regulatory "black holes" create the opportunity.

Accounting is the CEO's "weapon of choice" that transforms the perverse incentive into what economists, regulators, and criminologists agree is a "sure thing" in crises (means). That's the classic recipe for disaster: motive, means, and opportunity.

The reform bill falls short

The bill does not address the problematic nature of modern executive and professional compensation even though the data shows that these are leading causes of the Great Recession. The percentage of executive compensation tied to short-term reported income has increased since the crisis, according to an independent study by James F. Reda & Associates. Accounting is a "sure thing" when it comes to creating whatever short-term income the CFO and CEO desire to report.

Professional compensation is an endemic disaster, and no one who is honest denies it. Have a CDO backed by "liar's loans" that doesn't warrant even a single "C" rating? You could get any of the top rating agencies to give you an "AAA." Your lawyer would structure the CDO for you, and the internal and outside auditors would bless it. The underlying mortgages rested on multiple scams by professionals. The loan brokers and officers' bonuses led them to advise to file fraudulent applications and caused them to ensure that appraisers were picked that would inflate "market values." "Independent professionals" were suborned in this manner well over a million times.

Studies show that college students are frequently willing to cheat on tests and to refuse to report cheating by others. Why are economists unwilling to understand that these same people often continue to cheat as VPs and CEOs? They prosper because they cheat. Andrew Fastow became Enron's CFO, and was given an "Excellence Award" by CFO Magazine around the same time he was secretly helping Lay and Skilling loot Enron via accounting fraud. (See editor's note.) The title of George Akerlof and Paul Romer's classic 1993 article says it all - "Looting: Bankruptcy for Profit." (Akerlof was awarded the Nobel Prize in Economics in 2001.)

The Basel II international bank capital rules encouraged the biggest banks to use proprietary models to value their own assets. The quants got bigger bonuses if the models produced larger asset values. It tells you something when the trade calls these scams "mark to myth" and "liar's loans." It tells you even more when the reform bill does not make ending these perverse incentives its primary task.

The reform bill fails to address the role of accounting in providing the "sure thing" means for senior officers to exploit and profit personally from these perverse incentives. The financial industry used its lobbying power to induce Congress to extort FASB to change the accounting rules to hide mortgage losses. This is the (early) S&L and the Japanese strategy of the cover up. It leads to disaster (S&Ls) or lost decades (Japan).

Without honest valuations, markets do not clear and the economic recovery will continue to be weak and fragile. It is vital that this cover-up ends immediately. The reform bill, however, permits greater accounting abuses to encourage a cover up.

Reform bill proponents cite the resolution authority as the key advantage of the bill, but that is disingenuous. The regulatory hole in resolution authority was filled over 18 months ago when investment banks became regulated as commercial banks. Presidents George W. Bush and Barack Obama had adequate authority to close the major insolvent banks, a statutory duty to do so (under the Prompt Corrective Action Law of 1991), and the factual basis (insolvency) for appointing receivers.

But the administrations lacked the will, political courage, and the integrity to close the major insolvent banks. They evaded the mandates of the Prompt Corrective Action Law by encouraging the largest banks not to recognize their massive losses on bad loans and CDOs.

-- Editor's note: An earlier version of this post said that Andrew Fastow received a "CFO of the Year" award from CFO Magazine. He was actually one of 11 CFOs to receive an Excellence Award in 1999.

-- William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is also a white-collar criminologist and a former senior financial regulator and the author of "The Best Way to Rob a Bank is to Own One." To top of page