THE BIG PICTURE

From 1975 to 1988, the late Senator William Proxmire bestowed a monthly Golden Fleece Award that highlighted what he saw as wasteful government projects.  Proxmire was a talented self-promoter, and the press ate it up.  Unfortunately, his characterization of the supposed waste was sometimes misleading.  The amounts involved were often trivial relative to overall government spending and illustrates a tendency in both business and government to dwell on the trivial while paying too little attention to the bigger picture.

The Golden Fleece

The Golden Fleece Award often focused on government-funded scientific research, which can lend itself to misleading caricatures.  The accompanying press releases were often clever but light on substance and bordered on the defamatory.  Scientific research can often sound absurd without further context.  Imagine what Proxmire would have said about preventing beer from going sour (pasteurization) or studying molds growing around cantaloupes (penicillin). 

The Golden Fleece Awards often focused on paltry amounts, even by 1980s standards.  Some of the most frequently cited cases ran not in the billions, or even millions, but thousands.  It’s not as though Senator Proxmire had nothing else to do.  Proxmire chaired the Senate Banking Committee from 1987-89 and Congress’s dithering over the recapitalization of the savings and loan insurance fund probably cost taxpayers – billions.

Watch those Paper Clips

The private sector can also obsess over the trivial.  Bear Stearns CEO Ace Greenberg demanded his staff reuse paper clips, sending out an all-staff memo to that effect.  By comparison, the Wall Street Journal reported that Bear Stearns’ top five executives received a total of $87 million in compensation in 1997 ($166 million in 2023 dollars).  Bebchuk, Cohen, and Spamann report that from 2000-2007, Bear Stearns executives received $327 million in cash bonuses as they led the company toward insolvency.  That’s a lot of paper clips.

While these examples are extreme, companies frequently cut corners on technology and control functions as cost saving moves.  These investments don’t necessarily come cheaply.  For example, a Bloomberg terminal is expensive for a community bank. But it represents just a fraction of the potential losses from an imprudently selected investment portfolio.

Pennywise Government Policy

We see a similar lack of perspective in government policy.  The OCC supervises banks with total assets of nearly $15 trillion and had annual expenses of $1.2 billion in FY 2023.  Resolution costs for bank failures in 2023 totaled $35 billion.  There’s certainly no one-to-one relationship between regulatory spending and bank failure prevention but the costs of failures give some idea of the stakes involved.

IRS funding provides a more direct example.  The Congressional Budget Office estimates that the Administration’s proposal to increase funding for the IRS by $80 billion over the 2022-2031 period would increase revenues by $200 billion over those ten years.  Previous cuts to IRS funding have left a lot of money on the table but it serves the interests of a key political constituency:  wealthy tax cheats.

“Efficiency” and “Reducing Burden”

Beyond broader funding issues, bank regulators also took some dubious actions in the name of “efficiency” or its close cousin, “reducing regulatory burden.”  As higher risk mortgage products began to proliferate in the early 2000s, regulators were reluctant to expand reporting requirements.  Not until 2007 did information on negatively amortizing mortgages and Option ARMs make it to the quarterly Thrift Financial Report (TFR).  Option ARM reporting never made it to the Call Report.  I don’t recall these reports including subprime reporting either.1] Instead, we relied on informal surveys and annual examinations to obtain the information.  As a result, the reporting was neither comprehensive nor efficient.

A similar drive for “efficiency” led to gaps in interest rate risk reporting.  The Office of Thrift Supervision had developed a supervisory IRR model, which also involved detailed maturity and rate reporting on the TFR.  When the OTS went away, so did the supervisory model and the enhanced IRR reporting.  When announcing the replacement of the TFR with the Call Report, the banking agencies expressed their belief that “having common financial reports and reporting processes among all FDIC-insured entities would be more efficient.” (I suspect that “Not Invented Here” Syndrome may have played a role as well.)  As a result, there was more offsite IRR information available on a $100 million thrift in the early 1990s than for a $100 billion bank in 2023.  When it comes to interest rate risk, banking regulators apparently believe banks should design and grade their own tests.  We’ve seen how well that worked out.

On the Other Hand…

None of this means that we should take inefficiency and waste lightly, even if the amounts involved are small.  Waste is waste.  There’s nothing wrong with reusing paper clips either.  It is important, however, to place supposed cost savings in perspective.  Will they have much impact?  Will a focus on small, if easy to relate items divert attention from more significant issues?

While some obsess over the trivial, others dismiss more serious process and control weaknesses on grounds of “materiality.”  The concept of materiality is often misinterpreted as some sort of get out of jail free card.  Financial reporting provides a good case in point.  Following GAAP and other financial reporting principles should be the starting point.  Materiality should only come into play when it comes to fixing a mistake, such as a decision to restate financials. 

Large organizations are especially prone to what Acting Comptroller of the Currency Michael Hsu called “the [im]materiality illusion.” If a bank has more than a trillion dollars in total assets, hardly anything looks large in percentage terms.  The dollar amounts involved can still be huge.  A billion here and a billion there can add up to real money.  Banks themselves are not necessarily consistent in this regard.  Try telling your bank that you don’t need to pay your credit card bill because the few thousand involved isn’t material for a trillion-dollar bank.  Good luck with that.  If the amounts are not large, examiners (or auditors or risk managers) should emphasize whether and to what extent they suggest broader control or process deficiencies.  Defining the issue wisely is the best way to maintain credibility.

---

[1] If you’re aware of formal reporting requirements for subprime mortgages, please indicate in the comments.