Call me the bus driver because today, Iâm taking you to school:
Last week, Barclays was busted for manipulating Libor, that is, the London Interbank Offered Rate. Libor is
the interest rate banks charge to lend to each other. It is the globally
recognized reference rate for most banking transactions and it is used to set
rates for some $400 trillion
in global financial transactions from consumer lending to derivatives.
Libor is based on a daily survey of banks like
Barclays. Those banks are known
as “reference banks”. The information they provide in that
survey sets the Libor rate, which is then used to set the rate for those nearly
$400 trillion transactions.
So, Barclay’s rate manipulation is not some victimless
crime. It’s almost certain that
millions if not tens of millions of individuals and companies worldwide could
have been ripped off because of this conspiracy.
By the way, Barclay’s made money when they understated
the rate AND when they overstated it.
The importance of the global interest rate rigging
scandal goes far beyond Barclays and its $453 million fine. There are 20 global banks currently under
investigation for the same offense that caused Barclays to
settle. Barclays and the other banks are being investigated for intentionally providing information that
they knew would result in setting a false Libor rate. This means
that these 20 or so of the biggest banks in the world conspired to manipulate
one of the most important rates in the world.
So, Whatâs Wrong?
This isn’t about Libor – this is about Lie-More
It is
clear that banks as presently constituted and managed, cannot be trusted to
perform any publicly important function if it is against the personal economic
interests of their management. Todayâs banks are steeped in a culture that is
the result of profit-seeking behavior taken to its logical limits, where the
only questions asked by senior staff are not what is their duty or their
responsibility, but how much can we
get away with? It is about scoring the highest total compensation at
whatever the cost.
Consider
this: In a recent survey of 500 senior banking executives in the United States
and the UK;
â˘
26 % of respondents said they
had observed or had firsthand knowledge of wrongdoing in the workplace
â˘
24 % said they believed
financial services professionals may need to engage in unethical or illegal
conduct to be successful
â˘
16 % of respondents said they
would commit insider trading if they could get away with it
â˘
30 % said their compensation
plans created pressure to compromise ethical standards or violate the law
This survey was conducted by the
law firm Labaton Sucharow. Jordan Thomas, partner and chair of their
whistleblower practice, stated: “When
misconduct is common and accepted by financial services professionals, the
integrity of our entire financial system is at risk.”
The current culture and behavior of bankers is incompatible with the survival of a
sophisticated market economy. Trust is not an optional extra in
banking, it is essential.
When you read the survey above, you have to conclude
that bankers simply cannot be trusted in the current system where the pressure
to make the most profit possible out of the banking license at the expense of
clients and/or competitors is so prevalent.
Banks should not be allowed to play around with our
money solely to create profits for management in good times, while in bad
times, as we have seen over and over again, create losses that have to be
underwritten by the taxpayers.
As Eduardo Porter said in the NYT, bigger markets allow bigger frauds. Bigger
companies, with more complex balance sheets, have more places to hide them. And
banks, when they get big enough that no government will let them fail, have the
biggest incentive of all.
A 20-year-old study by the economists Paul Romer and George Akerloff
pointed out that the most lucrative strategy for executives at too-big-to-fail
banks would be to loot them to pay themselves vast rewards â knowing full well
that the government would save them from bankruptcy.
What will Work?
An important driver of the risks that a bank will take
is the bank’s senior management’s risk tolerance, which is based on how it will affect their
compensation. One change made since the downturn is to have executives take
more of their compensation in the stock of their bank and hold it for longer
periods of time. This won’t work:
Dick
Fuld, CEO of Lehman Brothers held several hundred million dollars of Lehman
stock, but was that enough to rein in Lehman’s risk taking? Clearly, no.
In addition, as the Wrongologist has
argued, equity investors’ goals of “stock price performance now”
arguably flies in the face of our broader economic need for banking safety and
soundness.
We also
know that fixed income investors are risk-averse. For them, upside on their
investment is limited, since the most they receive back at maturity of the
investment is 100 cents on the dollar, plus interest. Thus they are laser-focused on avoiding risks that will cause
losses, because they don’t get any more than that 100 cents if the bets win.
An idea outlined by Sallie Krawcheck in the June issue of the Harvard Business Review, uses a
combination of the equity and fixed income instruments of the institution to
compensate the deal makers.
Here is
how it could work: If a bank is funded with $1 in debt for every $1 in equity
(a very under-leveraged position for a bank), executive compensation would
mirror that; if the bonus component of an executive’s compensation is $2
million, then he/she would be paid in $1 million in debt and $1 million in
equity. The executive would maintain a healthy risk appetite, giving some good
amount of his focus to increasing the value of his $1 million of stock.
If the
capital structure of the bank shifted to, say, $40 in debt for every $1 in
equity (similar to the equity allocated to derivatives trading), then the same
executive’s $2 million would be paid $1.95 million in fixed income instruments
and $50,000 in equity. As the bank’s capital structure becomes riskier, the
executive would likely become much more risk averse, focusing more on
maintaining the value of the $1.95 million in bonds, rather than increasing the
value of the $50,000. This provides a natural hedge.
The value
of this compensation system is not that it will immediately make bank CEOs
behave differently (though it should), but, as it spreads down through the deal
making ranks, it will impact the risk tolerance of the executives actually
managing businesses, the trading desks and the trading positions themselves.
The
entire organization will shift naturally from one of looking to take on more
risk to one of looking to reduce risk as financial leverage increases. In doing
so, the interests of the bond holders, deposit holders and the public at large
will be more aligned with that of the management team.
So
bankers, if you want to gamble, be our guest. But do so on your own time and on
your own dime. Weâre going to let you continue to exercise your significant
skills and (generally) good judgment, but in a way that doesnât threaten our
savings, jobs, families and economy.
Part of
the answer must be a true separation of the trading businesses of todayâs
investment banking from the lending/service culture of old-fashioned commercial
banking. Make the traders buy the
equity in these new Merchant Banks from their Bank Holding Companies with the
bonuses they have already received.
From here
on out youâll have to work within a new financial system, let’s call it Limited
Purpose Banking that makes you stick to your legitimate purposes and not have
500+ subsidiaries like JP Morgan Chase to help move assets around with little
transparency. This would include your
newly spun off derivatives businesses.
All banks
will be subject to the same regulation and regulator, regardless of their
particular line of business, with the regulators having the ability and
jurisdiction to reach across borders if it is a US bank. A single federal
regulator will verify, disclose, and supervise the custody and independent
rating of all securities held by all financial institutions.
This will
require some government agencies to be merged and new budget money to be
allocated to the job of increased oversight, much like we did with Homeland Security.
CPA
firms: No more treating zombie banking assets as alive and well. You must mark
all assets to market every quarter.
We must seize the initiative and force Congress, the regulators and
the auditors to take charge of this asylum.
The crooks and liars have had their turn.
