'Too big to jail'

U.S. Assistant Attorney General Lanny Breuer seemed to hit hard in December 2012 when he announced that global banking giant HSBC would pay the government a fine of $1.9 billion. HSBC, he said, permitted “narcotics traffickers and others [to] launder millions of dollars through HSBC subsidiaries, and to facilitate hundreds of millions more in transactions with sanctioned countries,” including Cuba, Iran, Libya, Syria, and Myanmar.

Breuer said HSBC had a multiyear “record of dysfunction” and was guilty of a “stunning failure of oversight.” But he did not mention that the settlement allowed HSBC to avoid a criminal conviction that would have blocked the global bank from the U.S. banking system—what court watchers call a “death sentence.” In his triumphal announcement, Breuer also failed to mention that HSBC had earned more than $21 billion in 2011, and more than $20 billion in 2012. The fines amounted to less than 10 percent of its profit for a single year.

In March 2013 Breuer’s boss, Attorney General Eric Holder, went before the Senate Finance Committee to explain why HSBC wasn’t indicted for these crimes. He said some banks may be too large to prosecute without wrecking the economy. Holder’s “too big to jail” comments caused an immediate uproar. Sen. Charles Grassley, R-Iowa, the ranking Republican member of the Senate Judiciary Committee, said “big bankers know that if they commit financial crimes, they can expect a passive response from the Justice Department.”

The one-year anniversary of Holder’s remarks has created new interest in the questions: Have banks become too big to fail, and too big to jail? According to Mark Calabria of the Cato Institute, “Banks are not too big to fail, but the bailouts created an impression they are. The notion of ‘too big to fail’ is a problem created by a perception the government will intervene, and that prevents market forces from working.”

Tony Plath, a professor of finance at the University of North Carolina-Charlotte, not far from the headquarters of Charlotte-based Bank of America, takes a slightly different view. “The Big Four banks [JPMorgan Chase, Bank of America, CitiGroup, and Wells Fargo] are too big to fail in the sense that I don’t think there’s anything the government can do to them.” He says the government has tremendous resources, “but so does Bank of America. It’s a $2 trillion bank.”

Plath and Calabria both say that legislation enacted in the wake of the financial crisis—particularly the Dodd-Frank Wall Street Reform and Consumer Protection Act—has made matters worse. “To begin with,” Plath said, “Title 1 and Title 2 of Dodd-Frank are in direct contradiction.” Title 1 created the Financial Stability Oversight Council (FSOC) that can designate financial institutions as creating “systemic risk” if they fail. This is the so-called “too big to fail” list. Title 2 provides for the orderly distribution of assets of those financial institutions not on that list that do fail. Critics of Dodd-Frank say these provisions send mixed messages to the markets.

Calabria and Plath also criticize the FSOC’s broad authority to keep adding banks to the “too big to fail” list. They say the risk to the banking system of letting a big bank fail has been dramatically overstated. If a lot of big banks failed simultaneously, that would be a problem. But Calabria believes government bailouts and excessive government intervention—not bank failures—are the real threat to the banking system. “The current system of securities law is broken,” Calabria said. “It undermines market discipline.” That’s why House Financial Services Committee Chairman Jeb Hensarling, R-Texas, told Treasury Secretary Jacob Lew that the FSOC should “cease and desist” designating more financial firms “too big to fail” during a hearing on May 9.

“There is increasingly bipartisan concern about the immense discretionary power that FSOC has and how little transparency there is,” Hensarling said.

The answer to the second question—are banks too big to jail?—is a bit more complicated. “Banks don’t do things. People do things,” Calabria said. Even if the failure of some large institutions poses systemic risks to the financial system, “it doesn’t threaten the institution to convict a person who behaves illegally, so there should be no reason not to pursue individuals guilty of wrongdoing.” But, while banks tend to settle and move on, individuals tend to fight. “If you’re a bank executive, you don’t want to go to jail, so you will defend yourself vigorously,” Calabria said. That’s why so few individuals get convicted. In the aftermath of the 2008 financial crash related to mortgage-backed securities, authorities arrested two Bear Stearns officials, Matthew Tannin and Ralph Cioffi. Bear Stearns ultimately went out of business after JPMorgan Chase bought the firm—with a $29 billion loan from the U.S. government—but Tannin and Cioffi were ultimately found not guilty of misleading investors.

Nonetheless, Calabria believes regulators already have “tremendous authority” to pursue individuals. That’s why he thinks additional regulation is not the answer. In fact, he says evidence shows the banking system is overregulated in ways that “pervert justice.” Rich and powerful bank executives may have to pay a lot of money to defend themselves, but they usually get off—whether guilty or not. Large banks pay civil penalties as a “cost of doing business”—again, whether guilty or not.

“There was a time when penalties and fines meant something,” Calabria said. “It was a way to tell the good guys from the bad guys. But today that’s not the case. All the big institutions have paid something, sometimes just to avoid the trouble of a protracted investigation or litigation. Today, it’s hard to tell if punishment relates to guilt at all.”

To counter this trend, Mary Jo White, who became chairwoman of the Securities and Exchange Commission in 2013, promised to get more wrongdoers into court. But Calabria is dismissive of her efforts. “What she said was good,” he said, “but she’s doing it mostly on the small guys. She’s trying to look tough without actually being tough on the big guys. All that does is reinforce ‘too big to jail.’”

Peter Wallison of the American Enterprise Institute believes there’s a simpler reason so few bankers have gone to jail in the aftermath of the financial crisis: In order to prove criminal activity, you have to prove criminal intent.

“Why did the banks lose so much money?” he asks. “It was because they kept the mortgage-backed securities themselves. If they were trying to defraud someone, if they knew these mortgages were bad, why did they keep them? I’m no defender of the banks, but we’ve been told the banks must have known, and I see no evidence of that.”

Wallison blames government intervention beginning in the 1990s to increase “affordable housing”—not criminal activity—for the financial collapse. By Wallison’s definition, as many as 58 percent of new loans were subprime at the height of the housing bubble. In the aftermath of the financial crisis, the Obama administration set up the Financial Crisis Inquiry Commission, on which Wallison served. He co-authored a report arguing that these high-risk loans, and a bungled government response in 2008, bear most of the responsibility for the crisis.

Tony Plath agrees that “it’s tremendously difficult to establish the burden of proof necessary to identify personal responsibility.” But he doesn’t think the banks were innocent victims.

“Goldman Sachs wasn’t long on the securitizations,” Plath said. “They were on the short side.” By that, he means that Goldman Sachs essentially bet the mortgage-backed securities would collapse in value. When that happened, Goldman Sachs made more than $4 billion. They ultimately paid about $550 million in penalties for their activities, but that was just a fraction of the profits they realized. Michael Swenson and Josh Birnbaum, the two Goldman Sachs executives who masterminded the deals, escaped criminal prosecution. (Swenson continues to work at Goldman Sachs. Birnbaum has since left Goldman Sachs and started his own investment firm. Neither responded by deadline to a request for an interview.)

In recent months, Attorney General Holder has encountered criticism of his inaction from both the left and the right. The Cato Institute’s Calabria recently published an article with Lisa Gilbert from the liberal group Public Citizen. They wrote: “A libertarian from The Cato Institute and a progressive from Public Citizen may not often agree on politics or what the proper role of government should be, but we agree the public has been kept in the dark on the ‘too big to jail’ issue for too long.”

In part as a response to such criticism, Holder and his team at the Justice Department have announced a few criminal prosecutions. On May 19, Credit Suisse pleaded guilty to criminal charges of helping Americans evade income taxes. As part of the deal, the bank will pay $2.6 billion in penalties, and must hire an independent monitor. Credit Suisse’s profits last year were less than $2 billion, so this penalty may actually be punitive and affect the behavior of the bank. Another global bank, BNP Paribas, is accused of doing business with countries sanctioned by the United States. A plea arrangement with that bank should come any day.

But none of the experts I consulted think these plea deals will end “too big to jail” because they do not address the systemic problems. Plath called for greater transparency and stronger “firewalls between the regulatory side and the risk-taking side.” In other words, Plath said, “we need regulators with a career interest in going after the bad guys, and not in getting a job with the financial institutions they are supposed to be policing.” Now, Plath said, there’s a “revolving door between the regulators and the industry they regulate. They come and go at will. It renders the regulatory structure toothless.”

A case in point: Remember Lanny Breuer, the prosecutor we met at the beginning of this story? Just three weeks after delivering his tough speech announcing HSBC’s $1.9 billion penalty, he left the Justice Department to take a job with legal heavyweight Covington and Burling. Through a spokesman, Breuer declined to comment for this story, but according to the firm’s official biography of Breuer, the former prosecutor is now “the firm’s Vice Chairman and one of the leading trial and white collar defense attorneys in the United States.”