The real rea­son why big banks have so many scan­dals

The Pak Banker - - COMPANIES/BOSS -

This spring has seen a ver­i­ta­ble fes­ti­val of rev­e­la­tions of illegal, stupid, and dis­hon­est be­hav­ior by some of the largest banks in the world.

There's the mas­sive trad­ing loss at JPMor­gan, orig­i­nally quoted at $2 bil­lion, now up to $5.8 bil­lion at latest count. There's the laun­der­ing of drug and ter­ror­ism money by HSBC. And, most spec­tac­u­larly, there are the ad­mis­sions of LIBOR-rig­ging at Bar­clays, and on­go­ing in­ves­ti­ga­tions at many other banks.Note that JPMor­gan, HSBC, and Bar­clays were all sup­posed to be "good" banks that made it through the cri­sis wear­ing ha­los com­pared to the sup­posed "bad" banks like Cit­i­group, Bank of Amer­ica, and RBS.

This has prompted a new spate of ar­ti­cles ask­ing what, if any­thing, can be done to bring these be­he­moth banks un­der con­trol. Re­cently, Gary Becker and Richard Pos­ner-two of the in­tel­lec­tual giants be­hind the con­ser­va­tive law and eco­nom­ics move­ment and the mar­ket-first, dereg­u­la­tory cul­ture of the late 20th cen­tury-asked if bank­ing is "un­usu­ally cor­rupt." For both, the (im­plicit) an­swer is yes. Becker blames the enor­mous amounts of money at stake.* Pos­ner blamed the at­trac­tions of high lever­age and gov­ern­ment guar­an­tees, and be­cause of the op­por­tu­nity to make large amounts of money in the short term.

Sure, there's a lot of money in bank­ing, but that's not all there is to it. There's a lot of money in Sil­i­con Val­ley, too, and we don't think Google and Ap­ple are cor­rupt (just, per­haps, bent on world dom­i­na­tion and to­tal con­trol of their cus­tomers). Mod­ern­day bank­ing is dif­fer­ent. Not only are the in­cen­tives set up to en­cour­age risk­tak­ing, but it's ap­par­ently dif­fi­cult if not im­pos­si­ble for bank ex­ec­u­tives to keep their em­ploy­ees in line.

Take the JPMor­gan blowup, for ex­am­ple. Bloomberg re­cently re­ported un­ex­plained surges in the vol­ume of trades ref­er­enc­ing a Markit in­dex-that the JPMor­gan trade was prob­a­bly based on-surged at the end of Jan­uary and Fe­bru­ary, just be­fore month-end au­dits used to de­ter­mine the value of the trade. In each case, the price moved in a di­rec­tion that made JPMor­gan's trade ap­pear bet­ter than it ac­tu­ally was. This ac­tiv­ity, which was prob­a­bly an at­tempt to mask losses, was only un­cov­ered by the bank's in­ter­nal re­view long af­ter the trade blew up.

It's of­ten been said, and it's true, that in­di­vid­ual traders have the in­cen­tive to take on huge amounts of risk be­cause they en­joy the gains, in the form of large bonuses, but do not bear the po­ten­tial losses, be­cause there is no such thing as a neg­a­tive bonus. Bank man­agers know that, and that's why they have poli­cies in place (cap­i­tal al­lo­ca­tion, risk re­view, etc.) to keep traders in line. But this ex­am­ple shows that the traders can evade those con­trols.

How does this com­pare to other busi­nesses? I used to be an ex­ec­u­tive at a soft­ware com­pany. It's hard to think of how any in­di­vid­ual em­ployee could cre­ate a large amount of op­er­a­tional risk sin­gle-hand­edly. If a devel­oper cut corners writ­ing code, it wouldn't have made it past our au­to­mated test­ing setup-as­sum­ing it made it past our other lev­els of code re­view-and she wouldn't have had the in­cen­tive, any­way. The clos­est ana­log would be a sales rep­re­sen­ta­tive who tried to give a cus­tomer non-stan­dard terms to win a deal. For ex­am­ple, promis­ing a prod­uct would do some­thing that our de­vel­op­ment team hadn't signed off on. But we were small enough that ev­ery con­tract was re­viewed by plenty of man­agers to make sure that didn't hap­pen.

This isn't to say Hey, look how eth­i­cal soft­ware com­pa­nies are! It's to point out a fun­da­men­tal dif­fer­ence in in­cen­tives at banks ver­sus other firms. In an or­di­nary com­pany that makes stuff, there just isn't a lot of op­por­tu­nity to en­rich your­self per­son­ally at the ex­pense of the com­pany, short of old­fash­ioned em­bez­zle­ment.

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