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The Failures of "Too Big to Fail"
The phrase "Too Big to Fail" first found its way into common financial lingo at the time of the 2008 financial crisis. Initially, the term referred to all those corporations that required the support of the government because their sheer size meant that if they collapsed the impact on the economy would be disastrous. Now, used as a throwaway term to describe any financial institution that imposes its obnoxious presence on the economy, it highlights a systemic flaw in the way we view large banks. Over the years, big banks have leveraged this status in order to get away with some of the most nauseating crimes in white collar history.
The British banking behemoth, HSBC (Hong Kong and Shanghai Banking Corporation) has become the poster child of white-collar crime after it laundered approximately $900 million for Mexican drug cartels and processed transactions for many countries facing US sanctions including Sudan, Iran and Cuba. The "World's Local Bank" came to be known as the official banking destination for drug lords and terrorists alike. According to a 2018 Congressional Research Service report, since 2006 about 1,50,000 homicides in Mexico were related to organised crime. Every dollar laundered by HSBC was instrumental in claiming the lives of innocent people in Mexico. In every essence, HSBC was funding murder.
HSBC had for long been looking to expand its operations in Mexico and hence they merged with Banco Bital, a bank with considerable Mexican presence especially in drug production areas like Sinaloa. HSBC made a conscious decision to overlook a multitude of suspicious transactions and the dodgy banking culture of Banco Bital. The result was the inflow of thousands of dollars of questionable money into the legal banking system.
In 2010, the Office of the Comptroller of the Currency (OCC) of the United States issued a 31-page order mandating several changes in HSBC's banking procedure. The document painted a condemning image of a bank unable and unwilling to police itself and its clients. In order to save face and prevent intervention from the authorities, HSBC hired a bunch of people whom they called 'Anti Money Laundering Compliance Officers'. However, these measures were as phoney as the legality of their transactions. In actuality, HSBC hired this herd of employees to basically sit at cubicles and clear the large backlog of alerts that the system would generate each time a rule was broken.
Investigations by the US Senate began once authorities got wind of the shameless negligence with which HSBC was conducting business despite prior warnings. Internal documents that emerged during these investigations revealed that several high ranking HSBC executives knew exactly what was going on. If there was a case in which you could indict a bank for money laundering then this was it. However, to the surprise of many, a deal was worked out. Under this settlement, HSBC and HSBC Bank USA were granted a deferred prosecution agreement and were required to pay a fine of $2 billion dollars. Under such deals, the government agrees to defer or forgo prosecution if the organization agrees to change its behaviour. This leads us to ask that if the Sinaloa Cartel had promised to change its behaviour, would the American Government have granted it a deferred prosecution agreement also?
On paper, the fine seems a mammoth amount, however, it accounts for not more than 5 weeks of profit for HSBC, an institution that by its own admission was the preferred banking destination for drug cartels. This supposedly huge fine was a matter of speeding ticket for them. Ultimately, no arrests were made despite decades of dealings with drug lords and terrorists. To add to that in a statement released by HSBC as a part of their deferred prosecution agreement, it admitted to the fact that the HSBC group knowingly and willfully engaged in conduct and practices outside the USA, which caused HSBC bank and other financial institutions in the United States to process payments in violation of US sanctions. Even the admission of guilt did not prove to be a reason enough for US Justice Department to take action against HSBC.
The case had adequate charges and commensurate evidence to indict HSBC, but with the 2008 financial crisis still fresh in the minds of Americans, Justice Department didn't want to take the risk of potentially causing an economic calamity by indicting a bank that was too big to fail. CBS News called it "a case that had everything, everything except an arrest."
In the same year that HSBC avoided indictment, over 90,000 individuals were sentenced to imprisonment on account of drug offences in the USA, while on the other hand, in 2017 the US Justice Department announced its plans to dismiss all charges against HSBC. In America, the chances of going to jail if you're caught with an ounce of cocaine are extremely high, but apparently if you launder billions of dollars of drug money you're let off scot-free. HSBC is just one of the many examples that show the damage that can be inflicted by allowing an institution to become so large to the point that prosecuting even the individuals in them is not an option.
This pattern, however, had emerged long before HSBC started laundering money. At the cusp of the 2008 Financial Crisis banks offered, as investments, what they called Collateralized Debt Obligations (CDOs). Banks would bundle debt such as auto loans or mortgages in a security which was essentially a package of pooled assets. Value of these CDOs would be derived from the promised repayment of these loans i.e, debt obligations hence making them collateralized. During the housing boom, CDOs were sold like hotcakes in the financial markets as mortgages were generally exposed to a very low risk of default. These financial tools created an insatiable demand for mortgages. However, the fact of the matter was that there were only so many potential homeowners with good credit. Fueled by greed, banks now started to give out high risk loans to borrowers with bad credit scores, also called subprime lending. Subprime lending was accompanied by the fact that traditional insurance companies also started insuring these securities. This meant that a lot of people were betting money on the ability of risky borrowers to pay back their large loans. With falling real estate prices, defaulting owners had no incentive to pay off dues for their houses that they could no longer sell. When the inevitable financial crisis happened and people started defaulting on their loans the value of these CDOs dropped drastically. The insurance companies that had insured these derivatives did not have the cash flow to back their commitments. Banks went into a frenzy when they learnt that they would have to absorb the losses. Share prices dropped faster than ever before. Wall Street was left in shambles.
Often the financial jargon of the Great Recession distracts us from the primary cause of the economic collapse – greed. The corporate greed of large banks and their executives who had no sense of accountability and chased profits blindly is what led to the loss of 5.5 million American jobs, $3.4 trillion in real estate wealth from July 2008 to March 2009 and $7.4 trillion dollars in stock wealth in the same period. With the exception of the Lehman Brothers, almost all other banks received a hefty bailout package which cost every US household $2050 on average. While we agree that the failure of such large institutions would've prolonged the crisis, the fact that only one Wall Street executive was prosecuted is in our opinion, deplorable.
In the wake of the Financial Crisis, it seems not a week has gone by without a global bank being fined for unethical behavior. By the end of 2016, the costs associated with these fine settlements for some sixteen large banks amounted to more than $320 billion. At first glance, one would think that big banks are finally beginning to pay for their crimes. However, these deals are very carefully structured in order to ensure minimum hindrance to the bank's operations due to their systemic importance. For these banks, no fine is large enough and in essence they have been granted immunity from (and by) the justice system. It is a possibility that if these banks weren't sheltered by the American government they would've been a lot more careful about who they were lending to thereby circumventing the crisis altogether.
At present, the RBI has included three Indian banks including SBI, HDFC and scandal-ridden ICICI Bank on its "too big to fail" list. These Systemically Important Banks or SIBs are subject to stricter norms and requirements as mandated by the RBI. Despite ICICI having been given the status of a domestic systemically important bank, the CBI and SEBI had launched enquiries into the involvement of Chanda Kochhar, former Managing Director and CEO of ICICI bank in a nepotism scandal. In June of 2018, Kochhar went on a "planned leave" and further stepped down from her post. This just goes to show that no matter how important a bank might be to a country's financial system it is never too large to be held accountable. Nevertheless, Kochhar's exit came at a time when tensions were already building in the Indian banking sector due to a torrent of consecutive banking scams.
In the aftermath of the PNB-Nirav Modi scam, the government infused in the bank approximately 20 billion rupees to keep it from failing. PNB might not be on RBI's "too big to fail" list nevertheless its irresponsible behaviour has been subsidized by the government. By protecting these lenders from market discipline we are incentivising risky and in some cases illegal behaviour. By setting this precedent, the government has made risky behaviour the new rational behaviour and now banks have all the reason to lend recklessly and chase profits blindly. If this pattern persists then these banks will continue to divert money away from deserving industries which in turn will have chronic effects on the economy.
Failure is indeed necessary in a free market and the financial sector should be no exception to this principle. When an institution fails, a more successful firm can purchase the former's good assets, releasing them from the clutches of incompetent management and thereby increasing market efficiency. What we suggest is a two-pronged strategy to re-establish credibility in the financial sector.
Let banks fear the possibility of failure and their executives the possibility of jail time. Another alternative to the "too big to fail" doctrine could be to break up large banks into smaller entities as soon as their impact on the national economy reaches gargantuan levels. Apart from these strategies, we also believe that bringing back the provision of a bail-in instead of a bail-out could provide a partial solution, despite it being a controversial idea at the time of its introduction. If depositors believe that their money could be at risk they will choose to lend to those banks that make sustainable decisions. Merely fining banks will only deplete the entity's capital and reduce its margins temporarily. It will not change the culture of exploitation that rings within an organisation which has become too big to fail and as a result too big to jail.
By Shreya Roy and Manan Surana
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