Professor Edward Kane:

I thank the Chairman. I appreciate being invited here today and I congratulate the committee for trying to get to the bottom of what made this financial crisis so severe, in Ireland in particular, but also in other countries. It is an honour to have a chance to help the committee in this work.

My testimony is built around the idea that financial markets resemble roads. These roads are used simultaneously by individuals and businesses and their purpose is to allow ordinary citizens and corporations to create wealth and divide it up. Banking is regulated for the same reason as road traffic, which is where the power of this metaphor comes from. One issue is to co-ordinate potentially chaotic activity. Members can imagine how hard it would be to cross a city like Dublin if we did not have street lights and stop signs. There is also the need to make all drivers behave more safely.

In banking supervision, norms that foster deception and abuse of the public trust have become embedded in banks' and regulators' organisational structures. It might help if I take a minute to explain how people think about organisational culture in sociology. The most widely cited model suggests that every organisation has a mission and set of goals and then has a set of visible procedures, buildings, staff and equipment that are presumably devoted to those goals. However, the third thing an organisation has is a bunch of unobserved norms of behaviour regarding what one has to do to get ahead in the organisation and what is expected of those within it. These norms often conflict seriously with the goals and mission. I will try to develop that idea as I go along.

The banking crisis occurred because bankers routinely abused the financial rules of the road without suffering meaningful personal penalties. Why is that? It is because of these norms. The heart of the problem is professional ethics in banking and in regulatory agencies.

If systems for supervising traffic flows were as distorted and as elitist and slow to respond as those for supervising banks in Europe and the US, ordinary citizens would be afraid to venture out of their homes.

The central problem is straightforward. Safety nets encourage unhealthy relationships between banks and their regulators and distort the incentives of both groups. In good times and in bad, regulatory and banking cultures encourage their countries' largest banks to take on too high a risk of ruin. We call this "tail risk", thinking of the probability of the distribution of outcomes. People take risks in banking all the time, but to risk the ruin of their firm is something one would think they would not ordinarily be eager to do. The way the safety net subsidises risk-taking, it only pays off if we are taking tail risks.

Financial accounting systems fail to identify and record the economic value these incentives transfer from taxpayers to stockholders and banks. I propose two straightforward solutions. First, regulators must explicitly measure and manage the cost of safety net guarantees. Currently, they do not calculate it and certainly do not manage it. Second, regulators should impose a series of graduated penalties on individuals who violate important rules of the road. In the United States and in Europe, most of the penalties have been focused on the corporations. Fines have been charged, which penalise shareholders, but not much has been done about the individuals who put the bank at risk. These two steps would help force too big to fail, TBTF, banks to internalise the costs of safety net guarantees and would negate the elitist norms that continue to corrupt the culture of regulation in the US and Europe. These solutions come from a handful of propositions from lessons we have learned from the most recent crises around the world.

The first point is that safety nets can and often do cause financial instability. To stop this, society needs to make the extraction of these subsidies to risk taking a source of disdain rather than pride. Currently, bankers pride themselves on this kind of abuse of the safety net. However, this will not happen until regulators and supervisors strip out from reported profit flows the embedded value of the taxpayer credit support a too big to fail bank receives. So, if one is a manager of a too big to fail bank and one increases the tail risk, when one takes that risk, the increasing value of the stock price will increase one's compensation and make one appear a wonderful manager. However, when one takes long shot risks, the odds are that some of them will turn sour.

Although analysts agree that regulators should control systemic risk, most definitions of systemic risk leave out the role that regulators' propensity to assist troubled and insolvent firms rather than to resolve their insolvency plays in generating it. One of the norms that conflict with the goal of financial stability is the norm of helpfulness. It leads policy makers to act as cheerleaders for innovative forms of contracting. There is also a norm of mercy, where if an institution gets in trouble, there is a presumption that it happened through bad luck, rather than through deliberate and aggressive risk taking. Banks are given the benefit of the doubt about their solvency, until it is too amply demonstrated. The deference these norms create encourages incentive conflict within the supervisory culture.That is to say, an examiner may find a lot of problems with a bank, but as this is reported up the line, the regulatory officials will often ask the examiners to use softer words and to find ways of painting the thing. This ties to the norm of "non-escalation". Regulators are very afraid they will be accused of escalating a bad situation and instead try to cover it up. This essentially leads to the idea that it is alright to deceive, as long as one's heart is in the right place. This kind of deception allows more of this tail risk to be taken and increases the bill that ultimately must be paid.

Fragility is rooted in conflicted incentives. Dangerous incentives could be reduced if safety net subsidies were measured conscientiously and compensation schemes paid managers and taxpayers in better ways. Although officials claim otherwise, it is no accident that they repeatedly fail to foresee the emergence of crisis pressures and that they respond to them in elitist fashion, helping the banks at the expense of taxpayers. These conflicts lead to regulatory capture and that expands implicit and explicit government guarantees that become part of the equity funding structure of any bank that is too big to fail.

It is important to rethink this point, and I will mention this again and again in my testimony. It is wrong to think of bailout funds as loans or insurance payments. I will say this again and again. They are loss absorbing equity, but they are very badly structured. The taxpayer cannot sell his position. He cannot hedge it. The taxpayer is coerced into this position. It is not a voluntary action and his position has unlimited losses. If the regulators never close these firms, there are unlimited losses, whereas ordinary stockholders have limited liability. There are several other issues, but we do not need to go into them as the committee can already see how bad it is the way we have structured the incentives for government to protect. What I think is that we should think of it as a trust fund for taxpayers that is invested in this barely structured equity contracts in banking organisations. Contingent taxpayer support deserves to be recognised as an equity claim. I am not saying it is recognised as an equity claim, but it deserves to be recognised as such. Parliaments around Europe and Congress of the United States ought to address this so that in company law and in financial accounting, we recognise taxpayers as having an ongoing position in any firm that is de factotoo big to fail.

The rest of my statement develops this point. Financial safety nets coerce taxpayers into these positions and taxpayers should receive legal protections parallel to those that explicit shareholders enjoy, particularly minority shareholders. Essentially, we as taxpayers are minority shareholders in too big to fail banking organisations in our country and we are being abused. The formal establishment of this position, of owners' equity, leads to thinking of the too big to fail institutions as creating a portfolio of trust funds in which taxpayers are forced to invest. This casts regulators as trustees and creates, automatically, a different view of what their goals should be. The formal establishment of such trusteeships would lead officials to judge regulatory performance in terms of effects on the value of taxpayers' equity position. These positions can be valued using what we call "contingent claim analysis". This would also require regulators in protected institutions to rework their norms, information systems and incentive frameworks to support this effort. This is a big change in the duties of regulators and of top managers and officials of too big to fail firms.

The lesson is clear on these conflicts of interest. Governments need to do two things. They need to rethink the informational obligations that insured financial institutions and their regulators owe to taxpayers as de factoequity investors and change the way that information and industry balance sheets and risk exposures are reported, verified and used by supervisors. Lots of information is collected on industry balance sheets, but not enough on risk exposures. It is not reported publicly or verified, or it is only verified by periodic examination, and is not used by supervisors in the most effective way for taxpayers. Without these reforms of the practical duties imposed on industry and government officials and the way these duties are enforced, financial safety nets will continue to expand and their expansion will undermine financial stability.

The last lesson I want to get across concerns the nature of guarantees. Guarantees are misunderstood, even by some of the top economists in the world. They have a two-part structure. The main idea of a guarantee is to allow the guaranteed party to put responsibility for covering losses that exceed the value of the assets the bank owns to the government that guarantees it. However, the put is not the whole contract. No guarantor wants to voluntarily expose itself to unlimited losses, which happens if one writes only the put. For this reason, all guaranteed contracts incorporate a stop loss provision that gives the guarantor a call on the assets of the firm. When we talk about closing an insolvent bank, it is a call on the assets of the firm. Ordinarily, the stop loss kicks in just as insolvency is approached or breached. However in the US, efforts to exercise the Government's call are termed "prompt corrective action". In the US and Europe, we did not see much timely corrective action for “too big to fail”, TBTF, institutions during the great financial crisis. The policy actions we did see have helped the world's TBTF banks to become bigger and more politically powerful than before. It is a perverse result.

With the helpfulness and mercy norms, the Government's call on the assets could not be exercised. Guarantees then shift risk losses away from creditors and stockholders. It is as if these TBTF banks have a flow of profits that goes through a pipeline with a Y junction in it. Insolvency exists when the institution is unable to cover its debts from its own resources, but when a TBTF firm such as AIB becomes insolvent, a political switch is thrown that channels further losses to the taxpayers until and unless the firm manages to recover solvency. Deeply insolvent institutions are zombie institutions. They can operate only because they are backed by the black magic of implicit government guarantees. A government does not need to come forward and announce that it guarantees the bank. The fact that it leaves the bank open, that the bank has a safety net and political power, leads creditors in this and other countries to lend to the bank. This passive policy of forbearance allows the institutions to roll over and even expand their debts, which the private markets without the guarantees would never allow.

In the US, the American Insurance Group, AIG, case closely parallels what has happened with AIB here, except that it was never nationalised. In the lead up to the crisis moments, the company underwent a long-term decline on the stock market but bounced around depending on whether or not there was serious consideration being given to nationalising the institution. A graph included in my presentation shows that the stock price never got to zero. Much of the value of the firm during the crisis months of 2008 and 2009 came from the Government guarantee. The equity claim from the taxpayers had very little upside but continued to have a great deal of downside.

Another figure from some work I have done with Armen Hovakimian and Luc Laeven shows the value of the quarterly dividend the US taxpayer ought to have been paid by large banking firms between 1974 and 2010. While the value of this dividend shows a cyclical pattern, it is most instructive to look across cycles. With each cycle from 1974 onwards the value of this unpaid dividend to taxpayers increased. My fear is that this is still going on, that people are still figuring out how better to fleece taxpayers, unless we do something to reverse it. I have already sketched my solutions and will sketch them further. We should be able to see the same patterns in the Irish scene and I fear that greater and more dangerous subsidy flows will reveal themselves in the next crisis. We will have crises, and while I hope we will have a few years of respite, a lot of clouds are gathering in Europe today.

It is important to understand the difference between guarantees, insurance and loan contracts because each of them imposes different ethical duties. Insurance around the world does not protect so much the insurance company but the insured. It allows the insured to take additional risks because they have insurance. This is called moral hazard. In a loan contract, one expects to be repaid and this is the difference between insurance and the bailout. An insurance company does not redouble the coverage of drivers who have revealed themselves to act as recklessly as the TBTF firms did during the last economic boom, especially after they have had the losses. Similarly, lifelines provided to an underwater firm cannot be thought of as low-interest loans because nobody will lend even a nickel to firms that are in zombie condition.

To solve this problem, something must be done to sanction the reckless pursuit of subsidies by TBTF firms. Exhortations and promises are not enough. The type of sanctions I would propose are outlined in the last part of my statement. The key point is to recognise the deliberate exploitation of TBTF guarantees as a form of criminal theft and develop ways to punish individuals who engage in it directly and higher officials who encourage it without pulling the trigger.

The way we frame problems is critically important in policy making. Although it is not true today, in the future legal systems must make it crystal clear that recklessly increasing a guaranteed firm's risk of ruin is a form of theft. I am not saying it is a form of theft de jurebut de facto. Whether it is de jure theft depends on the laws of a country. The theft is from what I call the taxpayer trust fund. The taxpayer has stocks that should be managed by government officials as trustees. Rules of the financial game must acknowledge that it is wrong for individual managers to adopt these ruinous risks and wilfully conceal and abuse taxpayers' equity stake. Such behaviour deserves to be sanctioned explicitly by corporate and criminal law and not excused by insurance law as if it were inevitable moral hazard.

Banking supervisors have let society down in two ways. First, they did not set up the equivalent of the most modern radar systems and helicopter surveillance to track excessive speed and aggressive driving. Second, they did not develop a penalty structure to punish unruly behaviour in a meaningful and timely fashion. Effective regulation and supervision must establish disincentives that can dissuade bankers who are tempted to drive at perilous speeds and undertake dangerous manoeuvres. While we have incentives, we also need disincentives so they know they will be punished. Today, they are very confident they will not be punished. The analogy between regulating banks and regulating vehicular traffic suggests that, country by country, the penalty structure and burdens of proof in cases of safety net theft could be designed to parallel those used in traffic courts. Here and in the US, we already have administrative procedures for enforcing regulatory findings whose jurisdictions resemble those of traffic courts.

Most of these schemes combine fines for minor violations, a points system which hikes the penalty for repeated and more serious violations and procedures for transferring particularly consequential cases such as vehicular homicide or extreme drunken driving to ordinary criminal and civil courts. No matter what regulators finally do with their traditional tools, such as capital and liquidity requirements, if they do not set up sanctions which punish individuals for acts of wilful or complicit safety net theft, we are bound to get more wrongdoing in the future. There is great value in prosecuting violators in open court. The public needs to understand how much managers benefit when the burdens of the corporate fines and admissions they negotiate serve principally to punish shareholders instead of naming and sanctioning individual managers.

I thank those present for listening and look forward to any questions.