Penalties and Corporate America's Shenanigans (10/1/14)

Michael Lewis continues to amaze.  See Michael Lewis, The Secret Goldman Sachs Tapes (BloombergView 9/16/14), here.  He is not the story.  He is the story-teller.  One who hears stories from others and says something meaningful about their story.  The story here is from a bureaucrat, Carmen Segarra, the hero of the piece.  The big issue here could be characterized as capture of the regulators, but that may be a bit too facile as the articles cite.  See also Nolan McCarthy, Five things the Goldman tapes teach us about financial regulation (Washington Post Monkey Cage 9/03/14), here.

The story here is about how Goldman Sachs, the larger than life financial institution, works its will with the regulators who are supposed to restrain its will.  It is probably not a story about the evil giant, GS.  GS is not evil (in my opinion).  It is big, it is powerful, it has friends in the right places.  The regulators know that.  That is the evil.  But that is life.  The job of Government is to mitigate that evil by diligence of the type that, allegedly, did not happen with GS.

I won't try to summarize the story.  I can't do that as well as Michael Lewis or Carmen Sagarra in the This American Life episode.  536: The Secret Recordings of Carmen Segarra (This American Life 9/26/14), here.  (For those who prefer reading, the transcript is here.)

The story is about regulators with the Federal Reserve regulating GS.  In reading this story, I could not help but think about this episode in the context of IRS audits.  I have spoken often about bullshit tax shelters.  Basically, fraudulent shelters playing on complexity to discourage regulators (IRS agents) from having the will to get to the bottom of the bullshit.  Many of those shelters were implemented by the titans and exemplars of corporate America.  Those who knew better.  Some of the bullshit shelters were caught and splayed before the public when the taxpayers were so brazen as to litigate in a public forum.  But the GS episode makes me wonder how many were not caught or may have received a pass for some of the reasons laid out in the saga of the Federal Reserve and GS.

In this regard, here are some excerpts from the WP Monkey Cage article summarizing the PRI Sagarra episode.

2.  Complexity may be an important source of capture 

While the tapes don’t conclusively resolve why the Fed was so soft on Goldman, it does offer several clues that suggest the importance of the complexity of the financial sector.  At various junctures in the tapes, Segarra is encouraged by her bosses to cultivate a more cooperative relationship with Goldman.  Their rationale was that her more aggressive posture would ultimately lead Goldman to be less transparent and forthcoming with regulators about its activities.  There is undoubtedly something to this argument.  Goldman is a large and complex firm that makes large and complex deals and investments in a large number of complex markets.  Goldman management itself has a hard time keeping track of all that is going on.  There is no way that a small examination staff, even one co-located at the bank, can do its job without the active cooperation of the bank. So it is quite possible in such a setting that aggressive regulation will be ineffective regulation. 

A partial solution to this problem is to increase the number of examiners and pay the premium needed to attract talent and expertise to the Fed.  But the better solution is to make banks smaller and less complex.  The increase in transparency will lead to better regulation all around. 

 3. Our rules-based regulatory system tilts in favor of Wall Street 

To vastly over-simplify, there are two approaches to regulation:  rules-based and principles-based regulation.  In a rules-based system such as ours, regulators promulgate very specific rules based on the authority that has been delegated to them by Congress.  Ultimately, whatever is not explicitly forbidden is allowed.  In a principles-based system, regulators establish broad principles of behavior and then have a fair amount of leeway in determining whether the regulated firm is complying with the underlying principle. 

There are good arguments for and against both approaches.  But the Goldman tapes show a clear liability of the rules-based system.  As discussed in the broadcast, Goldman was working on a deal with Banco Santander to accept a temporary transfer of some of Santander’s assets so that the Spanish bank would appear to be better capitalized.  The whole purpose of the transaction was to help Santander evade its regulators’ capital requirements.  While the Fed supervisors felt the deal was “shady,” they felt they had no explicit legal authority to block the specific type of transaction.  Perhaps under a regime that enforced a principle against regulatory arbitrage and the subversion of the banking regulations, the Fed could have acted.

To leap from there.  These corporate taxpayers used complexity -- complexity driven in part by little more than increasing obscurity and the chance of winning the audit lottery -- to achieve their raid on the fisc.  While, at least from the raids that were caught, the taxes, some penalties and interest were ultimately collected, many were not caught and, even the ones that were caught, got off lightly in terms of the civil and criminal penalties that could have applied to their shenanigans.  Is there some notion harbored in the IRS and perhaps even in the courts that the exemplars of corporate American do not behave in this fashion (a notion that, in my view, is disproved by the anecdotal cases where they were caught) and thus cannot be subject to the penalties that ordinary U.S. citizens and taxpayers would draw if they undertook this type of behavior?  Why not more penalties?

Instead of focusing the fire where far more revenue is involved and apply penalties in a way that will discourage misbehavior, the IRS goes after the small fish when there are bigger fish to fry.