By James Saft
March 8 (Reuters) - Now that it is official that the U.S. Justice Department pulls its punches when it comes to prosecuting the largest banks, it is time for investors to understand why they, too, are the losers.
Attorney General Eric Holder came right out this week and told the Senate Judiciary Committee what many observers have long suspected - that his department has refrained from more aggressive criminal prosecutions of the so-called too-big-to-fail banks, exactly because of their special status.
"I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that ... if we do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy," Holder said on Tuesday. "I think that is a function of the fact that some of these institutions have become too large."
Lawmakers have expressed surprise that no corporate or personal criminal prosecutions emerged from the HSBC Holdings Plc case, in which the bank was fined $1.9 billion over money laundering, including money from Mexican and Colombian drug cartels.
Justice Department officials also cited economic stability concerns in December when announcing a $1.5 billion fine, but no criminal charges, against UBS AG, in a multiyear scheme to manipulate Libor and other benchmark interest rates.
In short, we have the top law enforcement official in the United States admitting that if a bank is big enough and systematically important enough, it will not be subject to the same laws as the rest of us.
First of all, it is Holder's job to enforce all laws - not just the ones that he thinks are consistent with financial stability.
Secondly, he is almost certainly dead wrong that slamming a too-big-to-fail bank with a criminal prosecution would hurt the global economy. Indeed, it is quite the reverse.
The too-big-to-fail (TBTF) and too-big-to-jail status serves as a tax on the rest of us - everyone who uses a bank, invests in a bank, or invests in a company that uses banks, suffers.
Many investors commit funds to the too-big-to-fail banks because they figure their investments will benefit from the special status they enjoy. What, they reason, is not to like about a bank with implicit government backing and which, if it is caught with its hand in the cookie jar, won't pay the full price?
A look at the funding costs of the biggest banks, estimated in an IMF paper at 0.8 percent lower annually than the rest of the market, reveals that investors are indeed putting their money behind TBTF banks.
For investors, there is no getting on the right side of this kind of wrongdoing as the very poor share performance of the TBTF banks over the past decade amply demonstrates.
Lots of people were getting rich off of Citigroup, for example, but they weren't the widows and orphans with Citi shares in their mutual funds; they were employees who took big risks, took home big rewards and didn't have to stand good for the mess they made.
The strength of the rule of law has to be one of the biggest protections for shareholders, and whatever weakens it threatens them. A country with lawless and entitled large banks is a country which will have lower structural growth and worse investment returns. Sound familiar?
Money will be badly allocated, both because TBTF banks will have an incentive to make financial products as complex as possible, and because bank employees will game the system to their own advantage. Heard this story before?
Imagine for a moment that a certain class of large hospital got a big subsidy, like the banks in funding, but couldn't be sued for malpractice. What do you imagine the impact on healthcare would be?
Looked at from ground level, this is going to sting investors even if they try to take advantage of TBTF banks' special status.
TBTF bank employees will have even more incentive than before the crisis to take on too much risk and to flout the law. After all, they will continue to pocket huge sums and the most they can lose is their job rather than their liberty.
Senior managers, whatever they say, have less reason to control their subordinates, and given the short shelf life of so many banking careers, that much more incentive to make coin while times are good. Money will flow into and out of the largest banks, but very little of it will be captured by those actually footing the bill.
While Holder was right in calling for better measures to end too-big-to-fail, he was dead wrong in his calculations of the costs of the matter. We are all paying, every day.