The Real Reason That Big Banks Have So Many Scandals

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(1) There's so much money at stake for individual players. (2) There's so much complexity in the laws and rules. (3) There's so much reluctance at the top to make fundamental changes.

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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). Modern-day banking is different. Not only are the incentives set up to encourage risk-taking, 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 old-fashioned embezzlement.

The same is true of traditional commercial banking. It isn't that hard to set up limits for mortgages or commercial loans and approval procedures for loans that exceed those limits. Sure, plenty of banks have failed, but that's usually because of stupid business decisions made by people at the top--not-unauthorized, self-motivated risk-taking by ordinary employees.

So why can't today's bank CEOs prevent their employees from cheating and breaking the law? How come derivatives traders can get their buddies to submit false LIBOR quotes so they can make their trades look better? The amount of money at stake is certainly one reason. The individual payoffs are much, much higher than in other businesses. Another is complexity. It's hard for managers, even those who used to be traders, to properly evaluate the sophisticated trades that are routine in a contemporary proprietary trading operation.

But the main reason is that they just don't want to. Jamie Dimon wants his traders taking on lots of risk because he has the exact same payoff structure that they do: lots of upside and not much downside. That's why he pushed his chief investment office, which once just looked after spare cash, into riskier positions. Bob Diamond may not want his employees lying about their cost of funds, but he does want them doing things that maximize bank profits, as long as he knows little enough about the details to retain plausible deniability. They don't want tighter controls, because those controls will cut into profits.

You would think that banks would be more cautious about their reputations following an international meltdown. Instead, the pursuit of profit in an uncertain global environment has only led to the revelation of ever-more-shocking scandals. On the bright side, for the banks at least, they're making money just fine, thank you. Any fines they may have to pay to the SEC or the FSA are just a cost of doing business, and not a terribly big one at that.

Maybe that's why the CEOs are perfectly happy leaving the inmates in charge of the asylum.

___________________

*Becker also claims that regulated industries attract corrupt people because of the opportunity to make money by evading regulation. That's circular, however, because he's defining as corruption something (evading regulation) that isn't even possible in a hypothetical unregulated industry.

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    James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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    James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.
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