The Real Reason That Big Banks Have So Many Scandals

(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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Reuters

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.

Presented by

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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