Monday, 21 October 2013

Rewards and Responsibility in the Banking Sector

The source of a particularly spirited 4-hour debate in a bar in Istanbul with Will Abel (we know how to have fun) – I thought I would bring this debate to a broader discussion in, dare I say it, a more intellectually rigorous environment.
In the lead-up to the financial crisis of 2007-8, senior executives at investment banks oversaw a system in which their firms reaped substantial rewards for selling products which they knew would ultimately lead to substantial losses for whichever firm was left ‘holding the buck’. The result of these actions we know all too well: an international financial crisis which has negatively impacted the livelihoods of billions of people worldwide.
The low number of criminal prosecutions for these actions appears to be due to a combination of the complexity of the financial products involved, the widespread and interconnected nature of the transactions and the fact that it is notoriously difficult to prove harmful intent. Thus, while their actions were dishonest, immoral and reckless, they were not technically illegal.
If a doctor were to knowingly take risks when treating a patient and that patient were to be adversely affected as a result, the doctor would be criminally liable for their actions. Likewise, if an individual takes the risk of driving when overtired or intoxicated and injures another person as a result, the driver would be criminally liable. Yet, in the case of banking, we require an additional proof of intentional malfeasance in order to prosecute.
At the current time, senior banking executives are entitled to large scale benefits while passing on the risk to their shareholders, the taxpayers who are (effectively) forced to bail them out, and a global community which relies on a banking sector in order to function. Sanctions, meanwhile, have focused on fining the offending institutions – punishing shareholders and reducing banks’ ability to lend to individuals and small businesses – rather than the individuals who ultimately made these decisions. 
I move that, given the banking industry’s importance to society and the large benefits bestowed upon its senior custodians, they have a responsibility to avert such systemic levels of risk and should be legally liable for creating such levels of risk, regardless of intentional malfeasance. Not only is this a more just alignment of power and responsibility, it is a more effective way to deter reckless behavior in the future, thereby benefiting society more broadly in the long term.
Admittedly, there are difficulties in defining exactly what level of risk is palatable for society, assigning responsibility to specific individuals (since in this case the practice was so widespread) and how to deal with rogue traders such as JP Morgan Chase’s Bruno Iksil. To an extent, however, I think that these issues can be resolved on a case-by-case basis – in a sector which perennially finds new and innovative ways to make money this may even be preferable. But by establishing a precedent that not just intentional malfeasance but a negligent attitude to risk is an illegal act, we can develop a more just reward-responsibility balance and protect the interests of society from the excesses of the few.
Finally, as much as I still hope to see prosecutions brought against individuals whose actions led to the 2007-8 crisis, I do not advocate for retrospective punishment and would intend for the standards outlined above to implemented only moving forward. As frustrated as I have been by the lack of widespread prosecutions, I take solace in the fact that the rule of law has been upheld in the face of strong public pressure. Conducting prosecutions based on retrospective law changes could ultimately create a broader ‘chilling effect’ on society which would be contrary to my intentions.

14 comments:

  1. Alex, having done some research on/with an "ethical" bank that operates very differently, on many levels, I found one thing striking: they told me right at the beginning that in many of the countries in which they operate, the legal system doesn't work very well, cases take ages, and might involved bad PR. Which is why they often cannot rely on sueing clients who don't pay back (clients may or may not anticipate this). Which is why they *really* have to be carefuly in the analysis of their clients, to make sure they are able and willing to pay back loans, and there really is a potential for a win-win situation.
    What would happen to our financial system if courts refused to enforce contracts that are not clearly and demonstrably in the interests of everyone concerned?
    I'm not saying that this is all that needs to change, and I'm not sure to what degree it would tackle the issue of systemic risk, but I think it would be a good starting point!

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  2. Alex, I really enjoyed this post. The subject you raise is ripe for more careful attention and the line you take is an interesting one. In various ways, I am in agreement with you. What I would like to discuss further is some of the specifics, especially regarding a difficulty with the idea that you note yourself. To wit, specifying *what kind* of risk and *to whom*? On these issues, there are differences to the parallel you draw with drink-driving and medicine, where usually we are focused on a very identifiable risk often to specific individuals. The risks imposed by the financial sector are, as you say yourself, rather more difficult to track, both in terms of what constitutes a risk and who is being put at risk (especially when one considers that both of these factors depend somewhat on other social and political structures). We might be able to get somewhat greater clarity ex post or look at it on a case by case basis as you suggest, but to avoid your worry about retrospective justice, we would need to be able to say something ex ante for a fair legal system on this issue. These issues can be tackled, I think, but they clearly do pose a question of how the system will operate. So, my question would be: do you have some conception of a system that is able to identify, say, gross negligence with sufficient clarity ex ante for the rules to be observed and violations to be reasonably determinable? Perhaps a model might be something like the regulations that surround nuclear energy or the kind of testing required in car manufacturing, where we stipulate certain probabilities of certain numbers and types of harm constituting a threshold. Would that be the kind of arrangement you have in mind? (Ideas welcome from others too.)

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  4. I personally think it will be very hard to create a system of rules which can effectively do what many people desire Alex and hence why I disagreed with you when we debated this.

    However – I think it is an interesting challenge that’s worthy of pursuit, so I’m going to have a go scoping out some first ideas below:

    What are the specific actions from the crisis that some people object to:

    1. Selling products to those who do not understand them or their associated risks and cannot reasonably be expected to know them. Here we are thinking about selling certain mortgage products with complex repayment schemes to household borrowers.

    2. Selling products to those who cannot afford them. I would further flesh this out by describing this as a product which will have such extreme costs for an individual that the state will have to provide some sort of intervention (typically benefits) X% of the time (let’s say 10%).

    3. Taking advantage of moral hazard situations / making one way bets. This occurs when bankers take positions where if they lose they expect some degree of bail out from government. Here we are blaming senior executives who design the strategy of the bank/financial firm.

    I will also presume that we don’t object to:

    1. Selling products to those who are in a position to be informed whether or not they actually are. I cannot see how anyone is to blame for selling CDS contracts to AIG. When you are one of the largest insurers in America and you are taking a huge position on a product, you have a duty to be as fully informed as possible as to the nature of the risk you are taking.

    Very happy for people to add to either of these lists.

    We now start running into problem turning our problems which we’re objecting to into principles. Problem 1 is already illegal and covered by consumer protection organisations such as the SEC or the FCA.

    Problem 2 requires us to take a position on what someone can or cannot afford and making the decision of a purchase for them. This is highly paternalistic and anti-liberal. I would point out that many people now have housing that never would have been able to afford it were it not for being able to take these kinds of risks. We also have significant protection in place in the form of bankruptcy laws and welfare nets. Are people really willing to propose this as a law? I would not be.

    Problem 3: This is the hardest and most difficult problem to solve. The international response has been to try and remove these incentive structures (which I personally think is the right response). I think it is hard to blame someone for acting to the incentives placed in front of them, especially when it is distinctly unclear what the downside risks involved are. I absolutely think people should be punished for taking ‘reckless action with disregard to others’, but this is much easier to spot when drink driving than compared to when you are selling financial products. This matter is further deepened when I think it is fair to argue that there is a distinction between 1) taking a risk that you know might cause a financial crisis and 2) Once you think there will be a financial crisis taking moves which shovel the costs onto other financial counterparties. I think individuals were largely doing the latter rather than the former as the former is much harder to recognise.

    As such in trying to scope out principles, I find it hard to isolate an action which I believe we should punish and is yet not currently punished.

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  5. One addition – I would argue that one of the reasons people wish to see bankers punished, is that they are very unhappy living in a world where the un-coordinated actions of individuals, all who act in a fairly moral (or at least not highly immoral) way, leads to such horrendous pain and suffering for millions of people.

    Good analysis I think shows that it is the system that is to blame and must be changed. Not the people.

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  6. Hi Alex. This is interesting and it is something I have been reading a little bit about in the recent weeks. One question that seems relevant to your post is that of *who* should be blamed and punished for unjust risk-taking in the banking sector. You say that CEOs are responsible, but how responsible are other employees? That is, how widespread is the responsibility that you point to?

    To phrase this issue more clearly, let us consider the following employees: the bank's cleaners, the bank's cashiers, those on the bank's graduate scheme. In each of these cases, there could be cases made in defence of, and against, each employee being responsible in the morally relevant sense. Perhaps the employees either had no choice or their (harmful) impact was too minimal to sanction responsibility, for example.

    I'd be interested to hear about what people think about these questions.

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  7. Thanks Alex. You said that you "take solace in the fact that the rule of law has been upheld in the face of strong public pressure." Do you think its the rule of law thats been upheld here or is it more a reflection of the power bankers have over politicians and the public discourse?

    To me the fact that the 'rule of law' was brought down on those protesting the greed and destructiveness of the banking system (Occupy, Indignados, etc) rather than the bankers suggests just how much the rule of law and who gets prosecuted is skewed towards the powerful.

    Which reminds me of an old Dave Chappelle sketch:
    http://www.comedycentral.com/video-clips/3vk26x/chappelle-s-show-tron-carter-s-law---order

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    1. Bruno, I think ineffective changes in regulation are due to the power of banks. I am not sure the failure to punish them is.

      What law have they broken? In your ideal world what law would you have which they would have violated?

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    2. Compare the way the banks were treated with the London riots. Judges and police put a huge effort into finding people, charging them for whatever they could and giving them the maximum sentence possible. The judges and police were quite happy to bend to political pressure in this situation.

      No comparable investigation has however happened with the banks. There has been no determined official campaign to bring them under intensive and widespread investigation and prosecution. This is because the justice system in attitudes and institutional setup is biased towards seeing white-collar crime (and a global financial crises!) as less reprehensible than breaking a shop window.

      I agree that the main problem is that they are able to influence what the law in fact is, but bankers (and their political allies) are also able to influence how the law is selectively enforced.

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    3. Firstly I think the fact that every central bank and international economic organisation has been investing a mass of resources into this problem cannot be dismissed (we are not in anyway ignoring this thing).

      Secondly I feel the contrast isn't applicable - rioters did break a law, bankers didn't, why should we therefore assume equal treatment?

      Still waiting for an ideal law which should've existed which would allow us to prosecute bankers...

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    4. Will, I don't know about the laws that do exist, but in terms of laws that should exist: what about a general duty of due diligence not only vis-à-vis individual business partners, but also with regard to the system as a whole? This would still leave open many questions about the distribution of responsibility (within banks and between banks), but if there were such a law, it could include regulations about how banks have to agree among themselves, *before* the introduction of a new class of products, who is going to be responsible for what if things go wrong?
      I think, however, that in this, and in many other problems of the financial sector, one has to face the fundamental problems of some players within it being so much more powerful, politically connected, and in possession of the best analysts/lawyers/clever people in general, that they will try to push the costs down to other members of the system… Maybe they should all be broken up into smaller banks, or maybe you'd have to have some system of assigning responsibility in proportion to how big they are….

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    5. Will, I think that the point is that if the banks had been subject to the same level of judicial determination to 'bring them to justice' then my suspicion is we would have found wrongdoing. I think the law always has some leeway and rioters have it applied to them as strictly as possible, whereas bankers (and other powerful people) would get it much easier. Thats why I can' see the lack of prosecutions as a victory for the 'rule of law'.

      I agree with Lisa that roughly my answer would be much smaller banks. I would want the banking sector to consist solely of cooperatives and building societies. That would I think help stop a huge amount of risk because it reduces the crazy profit motives (and would have many other benefits).

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    6. Bruno, I am very sympathetic to cooperatives and building societies, but I think there would also have to be more specialized financial institutions - and insurance mechanisms *for* all the small banks. I have heard that many internationally active German NGOs have accounts with Deutsche Bank, not because they like them, but because they are the only ones who have a world-wide network. Or think of financing large projects such as building skyscrapers. What would be important, though, is that clients know very clearly who they are dealing with: a profit oriented, sophisticated institution, or a bread-and-butter house bank that wants to cover its costs and maybe have moderate profits in order to be independent in the long-run. You could classes of institutions, with clear (and visible!) commitments and categories of products they can or cannot offer… Hah, if only any of these ideas had any impact on the real world…

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  8. An interesting contribution to this topic: Taleb on having "skin in the game". http://www.econtalk.org/archives/2013/09/taleb_on_skin_i.html.

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