We conclude with this Essay surveying the corporate corruption landscape in 2017 and the conditions supporting or impeding those who would “resist.”

To carry out this survey, we begin with three questions. Answering these questions should give us perspective on how far we have come since the Enron era and what remains to be done:

1. What does the corporate corruption record since the Financial Crisis tell us about the current state of play and the effectiveness of corrective law/regulation?
2. Where will the new impetus for corporate corruption originate and will such corruption likely be contained better than was the case in the Financial Crisis?
3. How much have resistance conditions improved over the last two decades and is the improvement adequate to the need?

The recent corporate corruption record offers a mixed-bag ledger. On the plus side, there has been a conspicuous absence of industrial company accounting scandals. Said differently, in terms of bad accounting we have seen nothing like a WorldCom or an Enron. Many factors have contributed to this improvement. SOX made a positive impact. This happened on many fronts, the two most important of which concern Board Audit Committees and the Public Accounting firms. In recent times, the quiet word in industrial America has been that the Chairman of the Board of the Audit Committee has a very hot seat. This seat is now challenging in terms of content, prone to liability and hard to fill with competent directors. This last point would not be the case if Boards were not taking their job of scrutinizing accounting results much more seriously than before 2001.

As for the CPA firms, they gained back some autonomy once SOX forced them to stop “racing to the bottom” on accounting in pursuit of consulting revenues. The fact that their hiring now lies in the hands of the Audit Committee rather than the CEO is an added plus. So too is the considerable liability that attaches to audit firms which miss material misstatements or omissions. CPA firms hate this, but it reinforces their focus and resolve. The fact that they must communicate in writing with the Audit Committee on major accounting issues also strengthens their hand. Information on hot issues cannot be kept away from the Directors by a management eager to avoid scrutiny.

The Financial Crisis provided a huge, negative counterpoint to these improvements. Once again a raft of abuses became apparent. Once again the accounting firms proved malleable or supine in the face of managements determined to hide distressing facts from the public. The lead up to the Financial Crisis was launched by accounting scandals at both Freddie Mac and Fannie Mae. These scandals cost CEOs like Franklin Raines their jobs and forced changes in CPA firms. As the crisis clouds rolled in, so too did the cases of fraudulent reporting. Two Bear Stearns “carry” funds blatantly misrepresented their subprime mortgage exposure before going bankrupt. Citigroup also misrepresented its exposure when reporting 3Q’07 results. The restatement cost CEO Charles Prince III his job. Only a couple of months later, Citi was forced to take over $100 billion in subprime mortgage instruments back onto its balance sheet. The Structured Investment Vehicles (SIVs) warehousing these instruments could no longer roll over their commercial paper funding. How KPMG, Citi’s auditor, allowed the firm to distort its reporting and wire its way around FASB’s Variable Interest Entity rules has never been fully explained. Ernst & Young’s embarrassment came in allowing Lehman Brothers to manipulate its balance sheet via Repo 105 transactions that no U.S. law firm would approve. Even PWC, which garnered favorable press for outing AIG’s weaknesses in controls, allowed that firm’s Financial Products group to write subprime credit default swaps without any reserves for potential losses or the need to post collateral. Critics accused PWC of being late in calling AIG to account. One can only imagine the beneficial consequences of PWC forcing AIG-FP in 2006 to have prepared for a down SCDO market.

Clearly the recent record on Finance industry financial reporting deviates from that of industrial America. Cases since the Crisis, notably the P/L reporting at MF Global and the accounting scandal at Citi’s Banamex, show the CPA firms either not finding big problems or not forcing the firm to disclose them.

How should we interpret this Industrial/Financial divergence? We would suggest the record shows that when the firm is big/complex enough and/or the stakes are big enough, a determined CEO can still face down the auditors. So far, those conditions have characterized the financial industry more than industrial firms. There is no guarantee that this will continue. Indeed, there is reason to believe that the industrial sector is getting more risky even as the financial sector heads in the opposite direction.

Assessing the current state of the Financial Industry requires a revisit to the causes of the Crisis and to the post-Crisis remediation efforts. Many diagnostics of the Crisis proceed chronologically. They begin with events in the 1990s and move into the origins of the subprime mortgage bubble, its dissemination via Wall Street and the final reckoning when banks woke up to their insolvent circumstances. There is nothing wrong with this standard approach. However, more insight may be gained if we work backwards. If we start with the immediate cause of the 2008 “run on the banks” and work back to how the potential for this run was created, we may discern more clearly what was critical and what was ancillary.

The immediate cause of the Crisis was the freeze-up in interbank lending. Said differently, by September 2008 lenders did not want to roll over their funding of Lehman Brothers, and increasingly that of Merrill Lynch, Citigroup, Bank of America, Morgan Stanley and Goldman Sachs. How was it possible that lenders would “cut off” such premier counterparties, all of whom remained investment-grade rated at that point in time?

The first answer is that they had become both huge and very highly leveraged. Lehman’s balance sheet was levered 40:1 or more. All the investment banks were in the same neighborhood. Balance sheets routinely topped $300 billion and some approached $1 trillion in assets. This combination of size and leverage meant one thing—if a sizeable asset class got into trouble, the associated losses could materially impair firm equity. Mark-to-Market accounting would also force this news into the market place at least every 90 days.

Picture a firm with $500 billion in assets and $15 billion in equity capital. It is levered ~33x. Assume it contains a $100 billion class of questionable assets. This asset class now loses 15% of its value, a figure not at all out of line with what happened in the Crisis. The firm’s equity would be wiped out, and every one of its lenders knows this math.

Thus, the key questions are how did the firms get so levered and how did this dodgy asset class come into being?

Like most issues of this magnitude, the answers are complex. However, they boil down to this: a “race to the bottom” took place among financial firms abetted by staggeringly poor performance by the industry’s gatekeepers—the regulators and the Rating Agencies. Financial institutions found they could generate historically high Returns on Equity and huge compensation packages for management by combining high leverage, securitization of subprime mortgages and active trading of these instruments. As the cases show, Goldman was generating over 30% ROE before the crisis and Morgan Stanley almost 27%; annual pay packages for their CEOs reached $45 M and $41 M respectively. Intoxicated by these incentives, self-disciple eroded and ethical interest in the details of securitization evaporated at most firms.

On leverage, the crazy quilt of bank regulators did little to rein in the institutions they supervised. Even after the Fannie/Freddie accounting scandals, the GSE’s regulator was unable to stop the firms from re-levering to stratospheric levels. Commercial banks like Citi used structured approaches to disguise their true leverage. Investment banks, which were not subject to FDIC or CoC supervision, felt free to get as levered as the markets would allow. Surveying the scene, the Greenspan Federal Reserve still counted on market discipline. What it didn’t count on was that discipline’s coming first being delayed and then blowing in like a storm.

The Rating Agencies arguably were worse. They completely missed the overleveraging of the banks as a credit rating issue. Once again markets witnessed the spectacle of titan institutions tottering on the brink of bankruptcy but still carrying investment-grade debt ratings. Even worse, the Rating Agencies allowed Wall Stree to talk them into using a macro-statistical approach to rating the highly complex subprime RMBS and CDOs. Without ever sampling the underlying mortgage collateral, simply assuming it was of comparable quality to much smaller volumes of historic subprime mortgages, the Agencies stamped huge quantities of toxic securities as investment grade and even AAA.

As for the toxic securities, they were generated as a by-product of a historic “race to the bottom” among mortgage originators and the Wall Street firms doing securitization packaging. What’s critical here is that by 2006, this descent was producing securities worth far less than their face value—many were essentially worthless as they were built from mortgages whose debtors lacked any basis for servicing their debt. Yet, and this was the critical point, these securities attracted the same high credit ratings from the Agencies as did earlier vintages. By failing to sample the underlying collateral, the Agencies missed the quality deterioration. Global investors bought the securities thinking the ratings assured them of quality comparable to corporate or government bonds with similar ratings. Investment and commercial banks doing the packaging and trading, kept sizable amounts on their balance sheets as new product raw material and trading inventory.

Thus was the stage set for a “run on the bank” meltdown. A sufficient volume of securities whose value was grossly overrated sat on the balance sheets of grossly over-leveraged banks. When the penny dropped—hey, maybe these securities aren’t worth anything close to par—it suddenly was not difficult to imagine that the equity at Bear Stearns, Lehman Brothers, even Citigroup, might be wiped out. Nobody knew how many of these instruments were contaminated by worthless mortgages – nobody had inspected the collateral. Nobody also knew how far prices would fall—after all, how can you “bottom fish” when you can’t distinguish a worthless CDO from one likely to see an 80% payout? Finally, nobody knew how much junk various institutions possessed. The banks had been very successful in disguising their subprime exposure. Some thought they were hedged—so long as their counterparties were capable of absorbing what now looked like huge losses. Counterparty risk suddenly compounded the primary risks visible at Bear Stearns, Lehman and Citi. When it became clear that even a “strong” counterparty like AIG lacked loss reserves for its CDSs, even “smart” firms like Goldman Sachs were suddenly at risk.

This bank run story is the essence of the Crisis. Others have correctly traced back the roots of the Crisis into loose monetary policy and such things as the Affordable Housing lobby/regulations driving the subprime securitization industry to come into being. These root causes are part of the story. That said, there had been other subprime security crises in the past—these did not develop into a worldwide contagion. What made this one different are the factors cited above—gross overleverage at financial firms, the generation of fraudulent, essentially worthless securities that were then grossly miss-rated and miss-priced in the market, and the retention of large amounts of these on the over-leveraged balance sheets of securitizing/trading banks.

It is against the forensic verdict that we can now evaluate the remedial steps taken since 2008.

This assessment must begin with Dodd-Frank (D-F). This gigantic piece of legislation was the government’s principal response to having to bail out the banking system. D-F receives few words of praise from either Wall Street institutions or the financial press. Yet, the judgment here is that D-F has been far more effective than its critics admit. Let’s survey this effectiveness and then ask—”Is it enough?”

For starters, D-F and re-empowered regulators have dramatically brought down bank leverage. Some of this happened before D-F’s passage, as the Morgan Stanley case makes clear. However, D-F’s framework demands stronger equity capitalization and penalizes systematically important institutions with even lower leverage limits. The evidence of progress on this front goes beyond mere accounting ratios. Firms like GE and MetLife have sold businesses rather than be classified as systematically significant financial institutions. Meanwhile, banks’ returns on equity now reside stubbornly in single digits. Recent MS&Co and Goldman ROEs are in the 6–8% range, a stark contrast to their 2006 performance. Repeated Federal Reserve “stress tests” demonstrated to the banks a new incentive structure—distributions to shareholders will be sharply curtailed until firms show they are well capitalized AND have robust risk management systems. To comply and boost their capital bases, many banks are shrinking activities and selling off businesses they no longer see as profitable under the new rules.

Enhanced capitalization combines well with the Volcker Rule’s sharp limits on proprietary trading. The former requires firms to charge more capital to trading while the latter curtails the situations where trading is allowed. The net result is to reduce the attractive trading opportunities available to firms. As a result, many have sharply reduced or even eliminated their proprietary trading desks—an August 2016 WSJ article memorialized Citi’s last proprietary trader leaving to go to a hedge fund.

In two other areas the post-D-F record is more mixed. The Rating Agencies operate largely as before—which is to say they remain public, for-profit firms selling ratings to their customers. The government’s response to their Financial Crisis role was essentially to threaten them with dismantlement if they repeated their mistakes. D-F did demand more transparency about method and regulators did sue S&P for in effect “selling its ratings.” So, the record is mixed—Rating Agencies retain the same perverse incentive structures and conflicts of interest in their business model, overlain with a macro-threat of massive government retaliation. For now, this has forestalled any repeat of the Agencies’ dismal 2003–08 performance. However, D-F has also encouraged more rating agencies to come into being. Counterintuitively, this “reform” may end up encouraging another ratings “race to the bottom” such as occurred among Moody’s, S&P and Fitch on subprime securities.

As for the regulators, they have become much more proactive and enforcement minded. As mentioned, the Federal Reserve stress tests have proven to be a powerful tool for reshaping bank behavior. Since 2011 the SEC and DOJ have also become much more active in pursuing law breaking. They’ve had great success extracting huge settlements from the banks for the pre-Crisis frauds. Critics complain this penalizes shareholders rather than the managements that perpetrated the frauds. There is an element of truth to this. That said, with the exception of Goldman’s Lloyd Blankfein, all major bank CEOs have “turned over.” Few if any of the new managers want to explain another round of $US multibillion impairments to earnings and dividends. As the Citi-Banamex case shows, bank CEOs know there is a limit to how many scandals they can survive. Enforcement, and the fear of punishment are reinforcing a rediscovered Wall Street concern for ethics.

All this is to say that D-F and its associated regulatory regime have proven quite effective in reining in bank risk-taking. Critics, especially those still concerned about “Too Big to Fail” have largely missed the approach being taken. The big financial institutions have been confronted with a new incentive structure. It encourages them to get smaller and to pick and choose which franchises can withstand the higher capital requirements. A kind of voluntary shrinkage has followed along with a recommitment to more traditional banking activities. When Goldman Sachs starts advertising to take online bank deposits and make credit card refinancing loans, clearly something has reshaped the franchise.