Thursday, 6 December 2012

If They're London's Revenues, They're London's Liabilities

“I would like somebody, anybody, to fight for me – the middle class of London and the South East.... As a standalone entity, the people of Berkshire, Buckinghamshire, Sussex, Hampshire, Kent, Oxfordshire, Surrey and London are 18th in the global GDP league, just ahead of Indonesia and just behind Turkey. If you took this region out of the UK economy, it would be called Ethiopia...The subsidy from London and the South East to the rest of the country is truly astonishing...This area needs its own party. It needs a leader who believes that the striving classes in the South are overtaxed and overburdened”. (Kelvin MacKenzie, Telegraph 2 December 2012).

"You can't revive the regions just through handouts from Whitehall…Revenues from the financial services sector were recycled round the rest of the country through the long arm of the state, creating the illusion of strong, national growth. Jobs were created but in an unbalanced way, over-relying on the public sector, funded by tax receipts from the City of London. And we've seen what happens when the conveyor belt breaks, as it did spectacularly in 2008. Those tax receipts fall, the money stops flowing and the whole country feels the consequences as the public sector contracts and jobs are lost. This nation is made up of 100,000 square miles. It cannot rely so heavily on one." (Nick Clegg, October 2012)

A financial crisis will always lead to greater competition over resources, and so the steady flow of news articles about the ‘unfair’ subsidies received by the regions is of no great surprise. Neither is the response from the condottieres of the Thatcherite Right like MacKenzie who have seized upon such reports to invoke a new moral language which asserts regional proprietorial rights over revenue streams and laments the distorted incentives which encourage an indolent North to live off the efforts of hard-working Londoners; all highly emotive in these austere times. In Nick Clegg these defenders of the brave South have found a Parliamentarian from the North willing to carry - and embellish - this story. Similar tales are told across Tory and Labour front benches; and within the metropolis, certain progressives and conservatives are united in their belief that the North has had it a bit too easy for far too long.

But as Londoners and their informal representatives look on jealously as the bank notes disappear over the Watford horizon, it is perhaps worth revisiting this argument. And it is a complex issue that deserves balance and open-mindedness to understand the diversity of flows in a national economy.

It is a story that we have touched on in the past. In a previous paper titled Rebalancing The Economy we emphasised the importance of the state and para-state as a source of Gross Value Added (GVA) and employment growth in the regions. We also noted the growing GVA per capita relative to the national average in London and to a lesser extent the SE, and the growing presence of financial services GVA in London relative to the national average. So, in a very simplistic way using static data there is a degree of truth in the claim that private sector surpluses generated in London and the South East were recycled as public sector jobs in the regions. But this is to put arithmetic to a very basic misuse.

This story ignores the general problems of a national business model that relies less on the manufacture of things and more on the manufacture of credit. It is a startling fact that the real value of housing equity withdrawal under Thatcher and Blair was marginally larger than the real value of GDP growth, suggesting that for our national economy to grow we require free flowing credit pushing against asset prices which can quickly and easily be cashed out. It is within that context that we should perhaps understand the current attempts by the Bank of England, the State and its various exigencies to prop up house prices by keeping interest rates low, and by encouraging lenders to avoid repossessing properties where households are in arrears on their mortgage. This nervousness about feedback effects and the fragility of the finance sector shows what a truly sorry state of affairs we are currently in. And it is a state of affairs that can be directly traced to the attack on industry by the Thatcher government which has left us with a kind of modern day credit-based equivalent of Eisenhower’s military-industrial complex of the 1960s and 70s.

Perhaps more importantly this Londo-centric story also ignores the vast public costs of underwriting the capital’s financial services sector: by our calculations, the Treasury received taxes of £203 billion over five years up to 2006/7, which were substantially less than the cost of the UK bank bailouts, estimated at between £289 billion to £1,183 billion by the IMF. So Clegg is fundamentally wrong on this issue: the banks are a net recipient of State funds which the whole country must pay for, even though the private gains are largely realised in London and the SE. From this perspective, we, in the North, have also seen our bank notes disappear over the Watford gap to keep well-heeled investment bankers in a manner to which they are accustomed.

This might sound like cheap point scoring, but beneath it lie subtler questions about the direction of the financial subsidies in a national economy. Is a reliance on State support the preserve of the North, as Clegg and MacKenzie suppose?

It is possible to deconstruct London’s success differently. Global cities like London do attract capital, but they do so because they are a kind of conversion machine, taking national and international assets, converting them into revenue streams from which well placed individuals skim high pay. London attracts capital because it is also extractive in other words. This can be seen from investment banking to private equity to infrastructure PFIs. This process of extraction requires an active state, through bailouts and subventions in the banking system to the underwriting of risks in infrastructure PPPs and PFIs. This implies the centrality of the state to a proportion of the UKs private sector.

PPPs and PFIs are a good example of where ‘extraction’ has distinct regional effects. The decomposition of activities around a contracted-out infrastructure project leads to a fragmentation of corporations around specialised functions, so that one company may provide the finance, another may build the school or hospital, another may manage the asset etc etc. In theory some of these functions need not be located on the site of the project. And certainly the revenue streams do not all circulate regionally: the finance company probably has its operating office in London, as might the asset management office. Even the operations might be co-ordinated from London using local contractors on site. Overseas companies that invest in PPPs/PFIs are likely to have an office in London, and those senior workers are likely to be extremely well paid.

Before PPPs and PFIs, projects that were State funded had revenue streams that would congeal in the regions where those projects were based, kicking in multipliers that would further benefit the local economy. The fragmentation of activities has led to a concentration of certain functions like financing and asset management in London. This has diminished capacity in the regions through the withering of broad competences, the fragmenting of supply and project chains, and skills drift as talent is forced to relocate down South to find a job. State-sponsored investment projects across the country have benefited private sector growth in London and the South East.

But infrastructure projects are not just about where the revenues go, but what liabilities are taken on to generate those revenues; and crucially who assumes responsibility for those liabilities when things go wrong. Many PPP/PFI schemes are highly levered: before the crisis projects were financed on around a 90/10 split debt to equity, though this has now levelled down to around 70/30. Even so, leverage produces interest payments that require servicing and a manifest risk of default. So the flipside to the revenue streams clipped by metropolitan elites is a tower of hidden contingent liabilities that may be passed onto the State, as when NHS Trusts cannot repay their PFI loans. Similarly on the operations side, contracts which allow companies to exit their obligations (designed to attract initial bidders) may leave the State with unexpected costs. This is what First Group did when it walked away from the backloaded premium payments on its First Great Western franchise, costing the taxpayer an estimated £800m in lost receipts. On the contracting side, unwieldy contracts can produce inefficiencies and exorbitant penalty clauses which are costly to renegotiate. And this is before we discuss the many contracts that overshoot their original estimates. All of these interventions should be thought of as State subsidies; received mainly by private subsidiaries operating in the capital, and paid for by taxpayers the length and breadth of the country.

This quiet cross-subsidy from North and West to South East has been running un-noticed for a long period of time. Its unanticipated result is a kind of regional moral hazard: the metropolitanisation of gains, and the nationalisation of losses.

So returning to the question of fairness and national cross subsidies: it strikes me that Kelvin MacKenzie is the kind of odious character who, had he been alive in Biblical times, would have written a sneering editorial about the ‘beggar’s charter’ created by the actions of do-gooder Samaritans. He will therefore understand this dilemma about regional moral hazard because London receives a subsidy that is not paid for by Londoners. If we are to resort to the kind of petty proprietorial politics that MacKezie and Clegg espouse, then let’s get one thing straight: if they’re London’s revenue streams, they’re London’s liabilities too. So next time, when the banks blow up or another PFI deal hits the wall, the liability costs should fall on the shoulders of Londoners and the South East alone. Let those metropolitan taxpayers bail out the banks. Which political party or mayoral candidate could fail to get elected on that platform?


Tuesday, 30 October 2012

So, define 'talent'...

Ask anyone within the apologencia of the financial services industry why bankers are paid so much and the stock answer you will receive is that in a knowledge-based world, talent is the key source of competitive advantage; and so banks pay the market rate to retain talent and remain competitive. But with banks across North America and Europe still on central bank life-support, how well does this argument stack up five years on from the 2007 crash?

The apologists’ answer is to emphasise recent hardships and the perennial threat of talent flight. In terms of hardship, many emphasise that talent have lost their jobs and have lower bonuses (than last year). Others argue that the shift towards non-cash, deferred bonuses has robbed talent of its deserved payout because an individual’s pay is now more reliant on the performance of their company’s stock, over which any one unit of talent has little control. The 50% tax rate on high earners also pushed talent to the brink, so that further attacks on their pay could potentially lead to talent flight to competing sectors in Switzerland, France, Germany, Hong Kong and Singapore. And that is some threat, if we are to believe Nick Clegg’s recent assertion that without the tax paid by financial services during the 2000s, there would be little public sector job growth outside of London (though we shouldn’t because it is patently incorrect).

For all the made-for-TV, strategic emotion around the loss of banking talent, are we in danger of becoming paralyzed by the fear of losing something that perhaps wasn’t really there in the first place? Answering this question really depends on what we mean by ‘talent’ and how we understand the relation between skill, performance and reward. Is talent something you have, or something you demonstrate? And is reward something that reflects your achievements, or reflects the context within which your achievements take place? These questions are all the more pertinent at a time when billions, perhaps trillions, of central bank money is being poured into the UK’s financial institutions, yet so much still ends up in the pockets of a very select few. By what metrics might we know ‘talent’? By what achievements might we award it its name? Perhaps we might gain some insight by briefly looking at the particular history of the term.

The etymology of the noun ‘talent’ is interesting in its own right. In its first meaning, dating back to the ninth century, ‘a talent’ was an ancient weight or a money of account widely used by the Assyrians, Babylonians, Greeks, Romans, and others so that, for example, a Babylonian silver talent was equal to 3000 shekels. By the early 17th Century the themes of measurement, value and field of application were transposed to the realm of human endeavour: ‘talent’ defined an aptitude for something expressed or implied. Talent was given its name only in a particular field, where superior skills could be assessed, valued and valorised.

But like many English words and phrases with such history, there is blur, overlap and polysemy as the ebb and flow of language carves new distributaries which divert from the main stem. ‘Talent’ again around the 17th Century also took on an additional meaning, one with a quasi-spiritual accent. This second ‘talent’ was used to describe a divinely entrusted power or ability of mind or body; one that required space and nurturing to flourish. This talent had no referable field of application, this talent was mercurial and precocious, embodied and thus inimitable, but also boundless in its application.

It is this latter ‘talent’ that is now summonsed in the defence of bankers pay. It is an abstract talent that is not only portable but - like fairy dust – has the ability to transform whatever or whomever it touches: it is dextrous and dynamic so that it can be applied to any industry, any field. In a knowledge-based economy, this is the kind of talent that all organisations want, and are so desperate to pay for.

This quasi-spiritual definition is particularly convenient for the apologists of finance. It allows all economic questions to be framed in terms of the need to provide freedom for and reward god-given talent, and the important of talent-friendly legislation to attract it to these shores. But evidence of genuinely portable, transformative talents are rare. Even in the cultural industries where the uniqueness of talent is perhaps unparalleled, there are profound limits to its effects when applied to new domains. Take a superstar like Madonna for instance, despite an illustrious musical career her acting career has earned her a record five Golden Raspberry Awards; while retiring sports men and women notoriously struggle to repeat their successes in other fields, often leading to feelings of social dislocation and depression.

So let’s be more grown up about it. Talent is not fairy dust and skill and expertise have a very specific context within which it is best applied. That doesn’t discount the possibility that specialised skills can make large differences in niche areas, which may justify large rewards. But that then means we need some kind of activity or operating measure to gauge the presence or absence of ‘talent’.

In banking arguably the most appropriate operating measure of any banker’s skill is the return on assets figure: ‘how much net return can you generate from the assets you purchase or create’? Here, the figures are illuminating. The table below uses the 2011 results for Barclays (though we could have used other years and other banks). It shows that in its capital markets arm where the best paid bankers work, Barclays Capital, actually shows a disappointing return on assets – lower than Barclaycard, their retail arm and ‘other’ activities. Furthermore it tells us something of the precariousness of the monestised asset values from which elite bankers draw their high pay. Barclays Capital makes more pre-tax income than any other segment and roughly 50% of the group total, but it does so by stacking an astronomical £1.16 trillion of assets onto the group balance sheet, which was 75% of the group total (and staggering only a little less than UK GDP, which was £1.44 trillion in 2011). Here the value of BarCap’s assets would need to fall a mere 0.25% to completely wipe out the segment’s pre-tax profit; 0.5% to wipe out group profits; and 3.5% to wipe out its profits and Core Tier 1 Capital (valued at £43,066m).

As we know, the value of these assets do fall and when they do, the repercussions for other stakeholders are dramatic. The table below presents a stakeholder analysis of the top 6 UK banks from 2001-2009. It presents the cumulative average gains for the state (tax income received and direct bailout expense) for shareholders (capital gain/loss and dividends) and for the workforce (staff costs) across the five institutions.  The bailout figures do NOT include the bailouts of Northern Rock (£25bn, 14 Sept 2007) and Bradford and Bingley (£42bn 29 Sept 2008); or emergency loans to HBOS & RBS October 2008 (totalling £62bn); or special liquidity scheme/credit guarantee scheme (£500bn in total); or asset guarantee scheme 24 Feb 2009 (£325bn). The shareholder figure is for total capital gains/losses and dividend payouts and does not measure returns to shareholders owning shares in 2001. So this figure, if anything, understates the diverging fortunes of different stakeholders.

It would be difficult to credit those bankers at the heart of the leveraged, CDO boom ‘talented’ by these graphs, even if they do have an impressive record of educational attainment. In the same way that I would struggle to justify the same term myself if, despite any apparent intelligence and skill, I chose only to teach my students through the medium of mime and blew my departmental budget on powerful hallucinogens which led me to perform demented shamanic rituals on the ashes of my unmarked exam scripts. Talent must be recognised in a particular context, and if the results disappoint then you have to raise serious question about whether those skills are appropriate for that industry, whether high pay is merited, and whether we should be thinking of these people as ‘talent’ at all.

If talent should be judged by performance, and performance is disappointing, how do we explain the endurance of high pay norms then? It may simply reflect two key industry features: i) the revenue earning capacity (NB not profitability) of an industry or field and ii) the number of other charges and claims on that revenue stream. The best paid UK academic will always command a lower price than the best paid UK banker, not because the banker is better in some market for abstract talent, but because a university has an externally imposed revenue ceiling (student quotas, the resources available from funding bodies etc) and a range of administrative, teaching and research costs which mean claims on revenues are distributed amongst the many rather than concentrated amongst the few. Similarly, a graduate with an engineering or physics PhD will be differently remunerated depending on the industry in which he or she chooses to work. Those skills may add equal value in manufacturing or finance, but they will be more generously remunerated in finance because there are a relatively smaller set of claims on that quantum of revenue. The central claim of our 2006 book still stands: high pay is a function of position, not necessarily talent. The real reason elite bankers are paid so much is because they are a small group of interconnected individuals close to a big till.

This ‘big till’ and its attendant high pay norms are a dead weight loss. A dead-weight loss refers to a situation where an implied subsidy or some other distortion leads to an allocative inefficiency. It is usually used by neo-classical economists to describe the distorting effects of taxation, minimum wages etc on a free market. It has even been used by bah-humbug-ers to describe the net losses of gift-giving at Christmas. But here it could be used to describe the effects of a bailout guarantee on the unit value of elite labour. Bank bailouts have had two effects. First they have kept banks on life support and allowed the continued payment of high fees to elite workers, when by rights banks should be cutting costs and writing down debt. Second, with QE, central banks have reduced the costs of capital to banks, allowing them to ramp spreads on their outstanding and future loans – thus providing funds to both recapitalise and maintain pay norms, while passing on costs to their customers (as well as taxpayers and the public sector). This would not happen in any other distressed business, where the workforce would immediately bear the brunt of adjustment.

The big till is underwritten by government and central banks. But what are the social returns? The social dividend is limited by problems of insider claims and opportunity costs. On the former, for example, the generally accepted view of the mutual fund industry is that actively managed funds pay more for their stock pickers than those passive funds who simply buy the index, but that active funds underperform passive funds (eg Gruber 1996). Further studies suggest that net returns to investors are negatively correlated with a fund’s expense levels, which are generally higher in actively managed funds (Carhart 1997). In purely economic terms, this means that talent is overpaid on a marginal cost basis: the skill of active stock pickers may allow the fund to generate superior gross returns, but they incur higher costs from transactions, information and pay, so that net returns to investors are lower. Put in the language of ‘claims’, this is the same as saying that any benefits which might accrue from more accurate stock picking are captured almost entirely by insider talent working within actively managed funds. The same may also be true of activities like high-frequency trading which involve eye-watering sums spent on algorithm-builders, code-writers and telecoms infrastructure which improve latency by milliseconds and give traders manning the war machines of finance fleeting advantages. Returns on individual trades may be marginally higher, but those gains are largely claimed by insiders within the bank. Outcomes for markets are as yet unclear because it is open to all kinds of socially useless wargaming, while returns to investors appear modest and may disappear quickly. And, as Knight Capital’s investors can attest, it may leave your capital exposed to unforeseen software malfunctions and other unanticipated interactions in complex systems – the likes of which Charles Perrow has discussed.

If the higher returns that accrue from modest or superior performance are captured by a small number of insiders, then we need also to think about opportunity costs. That is – if those skills were applied to another area of the economy, would they improve the national economy relatively? If, rather than spending their time writing code for high frequency trading, the same skilled engineers and mathematicians developed new software for high tech manufacturing or green technologies or some other high skill, technology intensive industry, would they produce more jobs, more spin-off activities, more economic multipliers etc? I have no data or study to answer this question (and it is a complex one because HFT clearly creates its own demand for high-tech telecommunications investment), but my hunch is that on balance, they may well do. Skilled workers would undoubtedly be paid less in other non-finance industries, even if their net economic contribution were greater. Is high pay in finance therefore more a market distortion rather than a sign of an efficient market for talent?

It seems that the ‘market for talent’ metaphor is inappropriate when explaining high pay in banking. Activity performance by any measure has been poor, which suggests that whilst these individuals clearly have skills, they cannot be considered ‘talent’ in many instances. Similarly high pay is only possible because the industry is heavily subsidised and operates in a permissive, lightly regulated environment. Their talent is not ‘bid up’ due to its scarcity nor its transformative power. Even at the peak of the boom surveys like that conducted by Deloitte found that only very small numbers of CFOs within financial services claimed there was an ‘inadequate’ supply of talent (defined as “high potential individuals likely to excel in finance”). With such a thing in mind, perhaps the role of the banking institution is not to put a ceiling on elite bankers pay, but rather to put an implicit floor under it by sanctioning certain high risk, high volume, low return activities and creating positions which allow a select few insiders to value skim for considerable personal gain?


Wednesday, 15 August 2012

Spaceship Finance And The Displacement Of Blame

I like Joris Luyendijk’s Guardian blog. And the latest revelations about Standard Chartered in the cavalcade of misdemeanour that is the financial services industry reminded me of one particularly pertinent post of his. In his February 17th blog Joris described the peculiar world of ‘spaceship finance’: the world of elites working close to the clouds in the top floors of the tallest buildings in the square mile, with no allegiance to any particular national project and little regard for the opinions of the national populace. This was exemplified in his interview with ‘Phillipe’, a financial services headhunter who was asked a very simple question: “how can bankers live with themselves?”. This was his reply:

"They feel unjustly singled out…What I hear is: look, nobody would run a bank with the intention of wrecking it, would they? Banks lent to people who couldn't repay. But nobody forced these people to take out loans that they must have known were far beyond their means. Banks may have been enablers, but in the end it was reckless individuals who did this. But what politician is going to blame this crisis on his voters, some of who must have been among the reckless borrowers? Much easier to heap it all on the bankers….Then again, many of my clients simply don't seem to care a whole lot about what the general public think. These are extremely well-educated and multilingual professionals. Many are in mixed marriages with kids who have lived on two or three continents. These people don't belong anywhere and don't feel beholden to any national project. They want to pay as little in tax as they can, and they want to be safe. That's it. Rule of law is very important for them.”

It should be said that many within the industry accept something has gone seriously wrong in banking, and that behaviour must change. But the kind of alternative history expressed above which exculpates their own and implicates others still remains a powerful narrative within spaceship finance. 

It is, of course, beyond plausibility that those discussed by the interviewee did not sense the wrongdoing in their organisations: they may not have been familiar with the detail of those excesses, but they must have suspected that enterprise was a little loose in the engine rooms. It is, then, all the more perplexing that contrition is expressed only under duress in the public circus of the Select Committee or under the glare of the television cameras. Even here remorse may take the form of inoculation where a tincture of guilt is added to disarm critics and to make a more extravagant claim about banking’s national benefits appear more reasonable. Privately, it is clear that often no such remorse exists – indeed there is a deeply engrained sense of defensiveness and injustice within the banking sector. They view themselves as convenient scapegoats for a global crisis.

So how is it possible to be both aware of fast and loose play in your organisation yet remain so defensive about its culture? The simple and easy answer is delusion – that this is a group of people so wrapped up in their own self-interests that they cannot see the wood for the trees. Another answer is that it’s a smoke and mirrors tactic: bankers have a lot to lose if the propitious regulatory conditions and mindboggling innovation which create ample opportunity for enrichment within the sector are threatened. Both are undoubtedly part of the story. But from the few conversations I have had with friends, associates, and others working in the industry, I think there is another equally valid explanation, which brings us back to the issues around cultures and structures discussed elsewhere in this blog series.

For some in the industry, there seems to be a genuine internal conflict - the feeling of persecution is real. They feel they are blamed, yet also feel they did nothing wrong because they always obeyed the formal and informal codes of conduct within the organisation (or at least kept within acceptable deviations from those norms and codes). Their internal conflict here is born out of psychological dissonance when the reflexive ‘other’ changes, and individuals re-evaluate their cocooned, insular world of the spacecraft - with its own autochthonous understandings, explanations, history, culture and morality - in a different moral register. How individuals come to terms with those conflicting values plays out in different ways. Some, particularly those leaving the industry (often involuntarily), reject the banking industry culture as if they were leaving a cult and become major critics. The bookstores and blogosphere are full of poacher turned gatekeeper stories like those of Michael Lewis, Tetsuya Ishikawa, Yves Smith at Naked Capitalism et al. Others, perhaps the more instrumentally minded, find a bit of dissonance no problem, and life goes on. But a third group - like those in Joris’ extract – react in a very different way; one that reflects the peculiar parallel universe within which many bankers operate. They preserve inner coherence by defending their organisational culture and externalising blame.

This reaction should come as no surprise to psychologists and criminologists familiar with the work of Gresham Sykes and David Matza. They argue that those who engage in delinquent behaviour are not immune to the demands of social and moral conformity, but when accused, draw on certain framing devices to justify their actions. They term these devices ‘techniques of neutralisation’. These include: denial of responsibility ("It wasn't my fault"); denial of injury (“It’s no big deal”); denial of the victim ("They had it coming"); condemnation of the condemners ("They were just as bad"); and appeal to higher loyalties ("We did it in the interests of others”). These techniques reduce the social controls over the actor and allow the person to rationalise or justify transgressive acts, and so explain continued patterns of deviation.

If I were to summarise three explanations I have heard bankers use to justify or defend action in the financial services industry, they powerfully echo these techniques of neutralisation.

The first explanation is a familiar one about moral hazard, and the corrupt incentives produced by government and its regulatory exigencies. The second, and the one preferred by Standard Chartered’s own CEO Peter Sands, is that banks are overly-enthusiastic, waiters in a system where everyone was hell bent on getting drunk. The third, that everyone has blood on their hands, so no one can take the moral high ground.

The moral hazard argument is a classic case of 'denial of responsibility': bankers here represent themselves as playthings of the wind, tossed and blown from one act to another; inert agents responding mechanically and unthinkingly in a moral vacuum to the incentives created by someone or something else. It is those who produce the incentives, not the agents who act on them, who are to blame. This is the equivalent of saying that if you park near broken bricks, then it is your fault (not that of the thief) if your window gets smashed and your briefcase stolen.

The overly enthusiastic waiter argument is another form of displacement of responsibility, only here there is an 'appeal to higher loyalties' – that of their service to customers. Here fault and blame are loaded onto the clients or onto an impersonal ‘system’ who ‘make them do things’ they otherwise would not have done. The more cynical ‘everyone has blood on their hands’ argument is one that bankers use to blame the credit rating agencies, the central banks, Fannie and Freddie, the regulators, politicians and homeowners. 'Condemning the condemners' by questioning whether any actor has the moral high ground to judge is another powerful way of displacing their individual blame.

Blame displacement, and its allied hostility to reproach from outsiders, is a cultural feature of the financial services industry. This culture is hot-housed in an environment of late hours, high intensity work and ‘up or out’ competition. It produces an identity, a unity, a sense of ‘us’ and ‘them’. It also produces groupthink and confirmation bias. And those are particularly damaging in our core financial institutions because they encourage arrogance, detachment and disregard.

Those cultures, as we have previously argued, evolve in particular structures. When banks become loose federations of money making franchises, fast and loose activity can be expected when safety controls and oversight duties are dampened to maximise returns. The sense of invulnerability, of immunity from criticism, comes from those fluid organisational structures where small groups within silos lift large values. Here, power and status drifts inexorably to key traders or 'the bricoleurs', who subsequently become untouchable. The sense of invincibility is also caused by weak regulatory regimes which open out large spaces for autonomous action and privately advantageous (but socially useless) innovation. The absence of paranoia, of fear of moral judgement and legal redress that a more panoptic regime might bring, is a recipe for hubris. We should all be worried when more and more activity reaches for the shadows.

The result, as the headhunter in Joris’ extract later explains, is the hardening of a genuinely global elite with no connection to or regard for its national base:

“A highly educated professional in the City of London has much more in common with a peer in Hong Kong, New York City or Rio de Janeiro, than with a monolingual, mono-cultural teacher or nurse somewhere up in Birmingham or Manchester. Solidarity for the new global elite is not geography-based or tied up with a state”

I have heard this kind of rhetoric before; and not from within the pages of the Harvard Business Review or the Journal of Finance. This is the language of class. In form and language it is strikingly reminiscent of the kind of thing that would appear as caricatures in pamphlets of the Trotskyite left. Perhaps our politicians and regulators should begin to understand finance as finance sees itself?: less as a set of impersonal national economic institutions, and more a collection of densely networked individuals with shared backgrounds and interests whose temporary base for their spaceship is the jurisdiction which expresses the least resistance.  And although, as the Bischoff and Wigley Reports show, finance is particularly adept at mobilising the national imaginary when it suits their purpose, isn’t it now in all of our interests that we begin to think about how we exert greater democratic control over these elite networks? Banking culture will only change when we develop regulatory structures that are the equivalent of Bentham's panopticon: a space of open visibility and moral judgement that checks the power of unaccountable elites to work against the national interest.


Wednesday, 25 July 2012

“As Taken Aback As Everyone Else”: The Salz Inquiry At Barclays

“The global review will assess the bank’s current values, principles and standards of operation and determine to what extent those need to change; test how well current decision-making processes incorporate the bank’s values, standards and principles and outline any changes required; and determine whether or not the appropriate training, development, incentives and disciplinary processes are in place. The review’s findings and recommendations will be published, based on evidence gathered through extensive engagement with all of the bank’s stakeholders and a thorough review of all pertinent documentary evidence. Any interested party is encouraged to provide input to the review by submitting a perspective or evidence via

Thus, the Barclays press release announced that Anthony Salz is to conduct an independent review of Barclays culture which will conclude by next April. This is a fairly straightforward, low risk, defensive move by a bank which has sustained massive reputational damage in the past few weeks since it was fined for fixing Libor

First, the CEO and chairman have to go, as a kind of penance. Then Barclays performs a kind of corporate moving on. Hence the independent inquiry whose (not too onerous) recommendations can  be ostentatiously implemented.

The precautionary motives of Barclays now manifest themselves in two ways, through the terms of reference of the inquiry and the choice of the lead inquirer.

First, the inquiry’s terms of reference are narrowly defined as “ business practices” understood as “values, principles and standards of operation”. And that fits with an idealist and dematerialised definition of culture as “instinctive behaviour and beliefs” The investigation does not consider the Barclays  business model in retail and in investment banking. Salz will not ask whether expensive branches and free current accounts means mis-selling in retail to recover costs. Nor ask why investment banking is a joint venture which benefits bankers more than shareholders and generates a balance sheet larger than British GDP.

Second the inquiry will be led by a silver haired corporate lawyer who is one of their own. Salz is, a man with an “urbane manner and establishment background” according to the BBC ‘s Robert Peston who has known him “for donkey’s years”. Salz is well networked in investment banking via his role as lead lawyer on twenty years of M&A deals at the law firm Freshfields where he was senior partner until 2006. He is also one of the great and the good, with roles including senior positions on the BBC board, alongside Barclay’s now disgraced chairman Marcus Agius. Barclays chose this man Salz and not, for example, an awkward churchman with a conscience like Rowan Williams.

Salz has the track record, reputation and recent experience that fits him for this kind of independent inquiry into banking culture. Let's recall Money Week's profile of Salz in 2006. This looked back to the takeover deal which helped to make his name and from which Salz emerged stronger while others went to jail:

"In 1986, he advised Guinness on its bid to buy Distillers and “was as taken aback as everyone else by the wrongdoing that emerged”, says The Sunday Times. Salz claimed he had repeatedly warned directors of the illegality of their actions – a version of events that conflicted with that of Guinness chief Ernest Saunders. It was a nail-biting time, but Salz won the day and emerged from the episode stronger

And Money Week explained that Salz was the man to make sure that everything was within the law:

"Corporate lawyers are two a penny. What makes Salz so special? Clients claim it is his bold, imaginative approach that makes him a star. “Most lawyers tell you why not to  do something, but Anthony is creative,” says David Mayhew at Cazenove. “He will show you how to do it within the law. And he has a wicked sense of humour.” 

We would add that Salz has since 2006 has added experience of chairing inquiries. According to his profile in the Barclays press release 

(Salz) chaired the Independent Commission on Youth Crime and Antisocial Behaviour in England and Wales, which reported in 2010. He also chaired two review groups on press self-regulation on behalf of the Media Standards Trust (on which Board he sits), which published reports and recommendations in 2009 and in June 2012.

The failure of press self regulation  and serial misbehaviour by the tabloids of course led to Leveson. And this independent inquiry into Barclays under  Anthony Salz is a poor substitute for the Leveson for the banks which CRESC and others have been asking for.

Dyfal Donc

HSBC: Loose Control

The revelations about HSBC’s alleged indiscretions are sobering. What has emerged from the Permanent Subcommittee On Investigations to date is a tale of systematic and deliberate avoidance of anti money laundering (AML) programmes in the US. It is not an edifying read.

The central institution in this story is HSBC’s largest US affiliate: HSBC Bank USA or ‘HBUS’. HBUS is key because it provides HSBC’s overseas clients with access to dollar markets and the US financial system, which is important because the dollar’s role as leading trade currency makes it a prime target for launderers.

Perhaps most staggering is the finding that between 2007-2008, HSBC’s Mexican affiliate, HBMX, shipped $7 billion in physical U.S. dollars to HBUS, more than any other Mexican bank, even one twice HBMX’s size. According to the Chair’s report:

“HBMX operates in a high risk country battling drug cartels; it has had high-risk clients such as casas de cambios; and it has offered high risk products such as U.S. dollar accounts in the Cayman Islands, a jurisdiction known for secrecy and money laundering. HBMX also has a long history of severe AML deficiencies. Add all that up and the U.S. bank should have treated HBMX, the Mexican affiliate, as a high risk account for AML purposes. But it didn’t. Instead, HBUS treated HBMX as such a low risk client bank that it didn’t even monitor their account activity for suspicious transactions. In addition, for three years from mid-2006 to mid-2009, HBUS conducted no monitoring of a banknotes account used by HBMX to physically deposit billions of U.S. dollars from clients, even though large cash transactions are inherently risky and Mexican drug cartels launder U.S. dollars from illegal drug sales. Because our tough AML laws in the United States have made it hard for drug cartels to find a U.S. bank willing to accept huge unexplained deposits of cash, they now smuggle U.S. dollars across the border into Mexico and look for a Mexican bank or casa de cambio willing to take the cash. Some of those casas de cambios had accounts at HBMX. HBMX, in turn, took all the physical dollars it got and transported them by armored car or aircraft back across the border to HBUS for deposit into its U.S. banknotes account, completing the laundering cycle”.

This situation occurred because of the particular way HSBC is run. The report makes it clear that HSBC Group HQ in London instructed its affiliates to assume that every other HSBC affiliate met the group’s AML standards and so should be provided with correspondent banking services. HBUS merely followed this instruction, ignoring more stringent US law which requires due diligence reviews before any US account can be opened for a foreign bank.

In addition to the cross border movement of physical notes, it was also found that HSBC affiliates in Europe and the Middle East circumvented filters set up by the US Treasury Department’s Office of Foreign Assets Control (OFAC) to prevent the funding of terrorist organisations: references to Iran in $19bn worth of US dollar transactions between Iranian entities and HBUS or other US affiliates were stripped out of or omitted from paperwork in 85% of cases, in full knowledge of HSBC’s Chief Compliance Officer and other senior executives in London. There were similar allegations of negligence and cover-ups made regarding HSBC’s ties with the suspect Al Rajhi Bank; clearing travellers cheques for suspicious Russian used car business via a Japanese bank; and offering accounts to ‘bearer share’ corporations, which due to their anonymity are prime vehicles for money laundering and other illicit activity.

It is difficult to dignify such actions with the descriptor ‘neglect’. ‘Neglect’ suggests fault through casual disregard, carelessness or indifference. This kind of behaviour is not an accident; it is written into the DNA of banking in its current form. It is a culture borne of particular structures.

So what structures nurture this kind of behaviour? Two interesting blog posts are illuminating on this issue. The first, an interesting post by an ex-investment banker, Honestly Banking, outlines the problems of what he/she terms ‘loose control’ at HSBC HQ in London. HSBC encourage a quasi-decentralised system whereby relatively autonomous and highly paid 'International Managers' (IMs) are posted to the various HSBC affiliates in senior roles. According to Honestly Banking, loose control creates local mandarins: these IMs make critical decisions in those affiliates and have the right to accept or ignore the recommendations of the local compliance officers. It is unlikely that these IMs run their organisations autocratically, it is likely that decentralisation is replicated at the affiliate level. That is a very effective way of building an organisation that maximises returns from different regions, but it may also encourage accommodation and entanglement with all kinds of risky and unpalatable local operations.

The FT puts this outcome more directly: it is one where “the bank’s business interests trump its compliance obligations”. But that is to confuse the interests of the institution with those who stand to gain individually from this activity. We need to ask a more troubling question: was it really in the long term interests of the institution to behave like this? A second blog post by London Banker highlights this broader tension and the problem of decentralised management. Using the metaphor of a wooden ship, he/she describes a situation where the crew, oblivious to the history and craft of the vessel, are tasked with turning a profit individually, or face being turned ashore. The crew respond by pulling nails from the ship and selling them at each port, at each stage telling themselves that the Admiralty do not understand ships and had specified too many nails in the first place. This sets in train a disastrous set of consequences:

“They self-certify to their warrant officer, who self-certifies to the midshipman, who self-certifies to the lieutenant, who self-certifies to the captain, who self-certifies to the admiral, who self-certifies to the Sea Lords that every nail is where it should be and the supply of surplus nails remains adequate to meet unexpected reverses. And they turn a profit, so everyone is happy and the crew are given bonuses.”

London Banker’s post is concerned with residential mortgage backed securities. But the point applies. Loose control produces both the returns and the information that suites those who have most to gain; but loose control also gradually erodes the hull of the institution. And once the water begins to seep through the timber, all too often it is an emasculated compliance officer that is sacrificed; a most convenient firewall between the authorities and the mandarins in the absence of a paper trail.

Decentralised structures extend the option of informal direction to those in the upper ranks of an organisation and put a lot of people with much responsibility and little power between senior bankers and the regulators. Fining the institution does not begin to address this problem of how elite individuals navigate organisational structures to secure their position and means.


Monday, 23 July 2012

Banks: A Loose Federation Of Money Making Franchises

The LIBOR fixing affair continues to throw up new information and insights which are mostly entirely predictable.  Consider two of last week’s front page news stories:

(1)    The FT led with a shock, horror story about collusion in fixing Euribor (the European equivalent of Libor) because a named Barclays trader Philippe Moryoussef  had allegedly organised collusive rate fixing with three other named individuals at Credit Agricole, HSBC and Deutsche. We did not before reading this story know the names involved in this new scandal. But the nature of the LIBOR (and Euribor) reporting process was such that we did already know that any kind of rate fixing must have required collusion between traders at several banks (and such collusion of course must then raise questions about the involvement of middling and senior management).

(2)    The Wall Street Journal led its front page on Wednesday 18th with a political analysis of the Bank of England. Mervyn King had appeared before the Treasury Select Committee and explained that the Bank of England was not suspicious about LIBOR rate fixing because nobody had formally told the Bank: “The first I knew of any alleged wrong doing was when the reports came out two weeks ago….we’ve been through all our records; there is no evidence of wrong doing or reporting of wrong doing to the bank”. This absence of curiosity is entirely predictable. From the Guinness stock manipulation affair in the mid 1980s to LIBOR rate fixing in 2012, wrong doing is uncovered  by American investigators who, in effect, oblige the uncurious Brits to take action.

There is something about the reporting of such news stories which connects one world of behaviour which is very English with another world of judgement which is New York Jewish. Mervyn King’s testimony to the Select Committee brings to mind that refrain from the Paul Simon song: “when something goes wrong, I’m the first to admit it and the last one to know”. Or, as Paul Simon’s psychoanalyst might put it: “how is it possible for these English elite technocrats to be so clever and yet lack all knowledge of self and others?”. And, of course, though the news stories are different each year, there is then nothing really new about that disabling absence of self knowledge and worldly curiosity in English elite figures who, like our prime minister, aspired to the top job because he thought he would be rather good at it.

 But, to be fair, we have learnt something new last week. The learning was about the internal organisation of banks from other witnesses who testified on investment bank rate fixing before the Treasury Committee and on money laundering in a US Senate hearing. We are already indebted here to anthropologists like Joris Luyendijk and Karen Ho who have described the processes of selection and acculturation which produce a dangerously conformist mentality inside banking firms which operate like silos. But last week’s public testimony by senior bankers In London or New York highlights larger questions about how the organisation of giant banks makes them unfit for purpose. Here we are taking up some of the issues which Joris raised some in his blog about out of control banks. 

Let’s begin with some generalities which should be familiar to anyone who has done an introductory course in organisation studies.  A firm is a space of bureaucratic coordination which requires internal hierarchy and division of labour which implies expectations and rules about what can and cannot be done at different levels, and runs partly on active instructions and permissions de haut en bas. Any organisation then requires individual and group initiative because rules and instructions cannot be complete and improvisation is required. But such improvisation operates within procedural limits so that, for example, authorisation of expenditure or breach of standard procedure usually requires some kind of signing off and a paper trail.

All this is a mixed blessing. The firm or any other large organisation is for bureaucratic reasons typically an inflexible, unreflective economic and social actor with a limited capacity to respond to how things have gone wrong or indeed to recognise that things have gone wrong or will go wrong. Think about BP’s succession of accidents and environmental disasters  after the Browne led  mergers had created  a much larger firm where operating control was a major unresolved problem; or, worse still, think about how hierarchy allowed the Catholic Church to cover up child abuse in many jurisdictions.

But the investment bank illustrates two different problems which make investment banks like Barclays or retail banks like HSBC positively frightening, not just poorly controlled like BP or unintentionally collusive like the Catholic Church. On the basis of last week’s testimony in London and New York, the present day investment bank is a thoroughly informal organisation where many things, including gross rule breaking at middling levels, can go on without formal authorisation. The bank actively institutionalises the insouciant lack of concern passively manifest in elite English individuals.

On Monday 16th, Jerry del Missier, the recently departed chief operating officer of Barclays appeared before the Treasury Select Committee and gave an account of how Barclays came to ‘lowball’ its Libor submissions in the aftermath of the phone call of 29th October between Paul Tucker of the Bank and Bob Diamond at Barclays, which led Diamond to produce an email note. There was, to put it neutrally, a misunderstanding at this point about whether the Bank was instructing Barclays to lowball (because of the public interest in making Barclays look sounder than it was).

The interesting point is that, along the internal chain of command at Barclays, all the instructions were verbal, even though the instruction was for Barclays to do something irregular at the (second hand reported) invitation of the Bank of England.

The internal chain in Barclays ran from Diamond to Jerry del Missier as co-head of investment banking to Mark Dearlove as head of the money market desk. “ Yes it was” an instruction said del Messier in last week’s testimony when he claimed he had “passed on the instruction as I received it” And how did Del Messier receive it? The FT reported:   “in a phone conversation the day before he received the email note” from Diamond which did no more than report another phone conversation with Tucker.

Let’s pause here. Barclays is clearly not an organisation of the staid, formal kind which most academics will be familiar with.  Let us hypothetically suppose the nearly unthinkable. Some senior authority outside our University (for whatever reason) wants to adjust the academic grades on our degree programmes.  That would require written orders down the chain, then a series of committee meetings so that all those affected could discuss any concerns about issues of authority and implementation. And the committee chairs would be expected to have a written instruction from an external point of origin after, for example, the university’s academic registrar had forwarded an outsider’s direct and explicit email instruction to fix the grades (rather than the registrar’s recall of a phone call).

The investment banker’s counter argument is that such formal bureaucratic safeguards are quaintly inappropriate in the fast moving world of banking: “just do it” because there is no time for all this procedural stuff which still regrettably clutters up the hierarchical public sector. But that raises a serious question. What protects economy and society if the investment bank (as organisation) does without the bureaucratic safeguards which in other cases protect us from compounded misunderstandings and active malpractice? Because, in this world of informality, junior bankers at desks will simply follow verbal orders from their team leaders and their seniors may have a very limited knowledge of what is informally going on at the lower levels.

The social protection is supposed to be supplied internally by a bank’s internal compliance department which enforces standards and polices wrong doing. But, the ineffectiveness of such arrangements were dramatized on Tuesday last week when senior HSBC executives appeared before a US senate hearing to explain how and why HSBC had, despite repeated  US regulatory censure and internal whistle blowing, continued to allow drug proceeds from Mexico to be laundered through the bank and allowed terrorist financiers to obtain US dollars.

David Bagley, HSBC’s chief compliance officer since 2002, admitted to the US Senate that his position lacked any power. As the FT reported, on his own testimony, David Bagley did not control compliance in national affiliates like Mexico because his job was only “to set policy and to escalate issues that were reported to him”. This was front page news partly because of Bagley’s tactical resignation from the job on the day he testified.

But, the largely unreported parallel Senate testimony of Paul Thurston, HSBC chief executive for retail banking and wealth management, was even more devastating; not least because it described an absence of control and rules in retail banking where customers and regulators would quite reasonably expect them. The key exchange was with Senator Levin:

Sen. Levin:  Why did these things fester for so many years at this bank [HSBC Mexico]? This isn’t something discovered in hindsight, this is something that people knew was going on at that bank. Why was it allowed to continue?

Thurston:  The business model was complicated and decentralized. It was very difficult for the center to get controls.

The difficulty of central control was separately explained by Thurston:  

“It became apparent that decision-making process concerning Anti Money Laundering were not satisfactory [at HSBC Mexico]. Over time, it also became clear that this was not only a question of process and technology, but that the underlying business model needed to be examined. Branch managers operated as local franchise owners, with considerable autonomy and a focus on business development, reinforced by an incentive compensation scheme which rewarded new accounts and growth, not quality controls.  

Banks and banking are defined in most dictionaries in terms of business conducted and services offered. In organisational terms, after last week’s testimony, it might be fairer to describe a bank as a loose federation of money making franchises (with always troubling and sometimes dire economic and social consequences).

Dyfal Donc

Thursday, 12 July 2012

The New World Of Finance Politics

It has been a depressing few days for democrats, and especially for those democrats worried about the power of business.   The shiftiness of Bob Diamond and the extraordinary innocence of Paul Tucker about money market practices coincided with the publication of two reports that highlight the way corporate interests are organised to shape public policy in the UK.  Democratic Audit, which has now been auditing democratic practices in the UK and elsewhere for over twenty years, published its fourth audit of democracy in the UK. (Downloadable at  The Bureau of Investigative Journalism meanwhile published the most comprehensive and well researched study we have yet seen of the lobbying activities of interests in the City of London (downloadable at  The section in Democratic Audit’s report on accountable government, combined with the Bureau’s investigation of the web of corporate patronage spun by the City, together give us the essential background to the extraordinary arrogance revealed by the behaviour in the Libor scandal and the astonishing blindness to this behaviour displayed by senior regulators like Mr Tucker.

What these two reports show is a fundamental change in the recent decades in the way business has exercised power in the UK.  Some of this change is due to factors external to business itself, factors that are a major theme of the work of Democratic Audit.  These changes are atrophying the official institutions of democratic participation.  The two most obvious indicators concern voting in general elections – the single most important summary sign of the health of national democracy – and the membership of the political parties.  Voting offers us a paradox.  In the last couple of decades voting opportunities (referendums, elections for devolved systems of government, elections for mayors and even now for police commissioners) have proliferated; but turnout has declined.  Meanwhile the mass party – the capillary tube of the democracy – has simply vanished: parties that a generation ago had millions of members now typically have less than 200,000. The Westminster parties in particular have shrunk to tiny cadres of professional careerists. 

The decline of these institutions and practices has created a vacuum now being filled by other institutions and interests. This is how we should understand the new world of corporate lobbying documented by Democratic Audit and, especially, by the Bureau of Investigative Journalism’s work on the City.  A generation ago business had to work alongside, and often in opposition to, powerful institutions of civil society: a trade union movement with large and well organised membership in the private sector; political parties that could rely on mass membership to generate the bulk of the money that they needed.  Business certainly exercised power, and the City in particular exercised great influence through a network of informal contacts, mostly funnelled through the Bank of England.  But the decline of so many countervailing influences in civil society, and especially of the mass party, has created the opportunity for much better organised, and more pervasive, corporate influence.  The new world of City politics revealed by the Bureau’s work shows, in particular, three profound developments.  The first is the colonisation of the parties through the use of money.  Since corporate lobbying is opportunistic this mostly affects parties in office, or those with a reasonable prospect of office: this explains the surge of financial support from the City for the Conservatives since David Cameron’s assumption of the leadership in 2005, closely documented in the Bureau’s report.  The second is the pervasive infiltration of City interests into the institutions of government.  Of the many instances of this penetration in the work of both the Bureau and Democratic Audit, one of the most revealing and hitherto neglected is the way City interests have colonised the House of Lords: 16 per cent of active members of the House (124 out of 775) declare paid positions in finance firms.  And that’s only the most minimal measure of connection, based as it is on a declarable interest.  The significance of this is simply not appreciated, because the significance of the Lords is not appreciated.  The second chamber is no longer a joke.  The Life Peerage reforms (dating from 1958) have transformed the institution.  It is now a much more expert and competent body than the Commons, and much the better place for interests to shape the detail of policy and legislation.  And in financial regulation it is the detail that matters.

The third great change is probably the least appreciated of all: the City has revolutionised its internal government.  The Corporation, until recently a mostly charitable and ceremonial body, has been turned into a largely autonomous governing institution for the richest bit of territory in the UK.  And, as the Bureau’s investigations show, it is turning its considerable firepower – money, and the advocacy skills that money buys – into a sustained promotion of the interests of the finance sector.

In the wake of the report from John Vickers’ Commission, and the most recent banking scandals, attention has, quite reasonably, focused on the problem of the substantive reforms of the banking sector.  But reform of institutions and business practices is not enough, and indeed will probably be impossible to achieve until the power of the City as an organised lobby is confronted.  The Bureau’s work, and the continuing work of Democratic Audit, is a start on that long hard road.


Monday, 9 July 2012

On Banking 'Culture'

Within the press and blogosphere much has been made of Bob Diamond’s note which implies senior officials at the Bank of England and in Whitehall gave Barclays implicit consent to under-report their LIBOR submissions. Such an event, if proven, would be devastating to popular trust in our political and regulatory establishment. For decades our elected leaders granted finance unprecedented privileges and freedom to maraud. The outcome of that freedom was a growing sense of invulnerability that still pervades the trading rooms of major banks today. So it is important, with the mute sense of collusion between regulators and regulated still lingering, to understand these internal cultures and behaviours within the structures that nurtured them.

Last Wednesday’s timid Treasury Select Committee meeting with Bob Diamond was a typical affair, with lots of self-righteous indignation but few probing questions which got into any level of analytical detail about the structural pressures and context of moral laxity. The refrain of the committee, and most likely any Parliamentary Inquiry that may follow, is that banks have a ‘cultural’ problem, and that this needs to change. Like giddy, overexcited children who knock things over at parties, it is assumed bankers can be taught to calm down and behave simply by giving them a stern talking and getting them to admit fault; only then can they be pushed back safely into the melee. ‘Bankers have got carried away’ we are told ‘and so need to take a long, hard look at themselves’.

Cultures set the boundaries of what is and is not permissible. Those rules are not necessarily spoken, they are rooted in behaviour and patterns of reward. When a CEO says ‘we want no more of that sort of thing’ and then increases derivatives trader bonuses, it is the reward rather than the words which reproduce that culture. These are the structures of culture. True, it is important to remember there are different ‘tribes’ with different cultures within banks (there is good journalistic and academic work on this), but it is also true that banks are hierarchies which impose a broader and more potent disciplinary logic: to maximise income for the senior traders. Donald MacKenzie in his most recent revisionist work, refers to this as the principle of ‘maximising Day One P&L’ (for the elite workforce), which often engulfs these silo cultures.

This ‘engulfing’ is what we really saw in this LIBOR fixing scandal: the normalising force of a culture which puts individual bonuses (not institutional profits) at its centre. What is perhaps most startling about the findings of the FSA, is not just the cavalier and open way with which corrupt practices were conducted, but the finding outlined in paragraph 8 of the proceedings which states:

 “Barclays acted inappropriately and breached Principle 5 on numerous occasions between January 2005 and July 2008 by making US dollar LIBOR and EURIBOR submissions which took into account requests made by its interest rate derivatives traders (“Derivatives Traders”). At times these included requests made on behalf of derivatives traders at other banks. The Derivatives Traders were motivated by profit and sought to benefit Barclays’ trading positions.” (my emphasis)

That employees from Barclays were willing to manipulate their own institution’s reported borrowing rates, (with uncertain effects for their employers), to benefit an individual at a competitor company says something profound about banking culture and the structures which support it. It tells us that the boundaries within and between institutions are fluid and that banking culture promotes, perhaps even exalts, the maximisation of personal gain, even if that means building and maintaining interpersonal networks across institutions.

So what is the purpose the institution under such circumstances? Classically in the ‘theory of the firm’ literature, firm boundaries are rigid: they exist to minimise transaction costs (the Coasian perspective), or to manage agency problems (the Jensen and Meckling perspective) or to protect and coordinate certain skills and competences (the Teece et al perspective). All of these theories presume that the firm ‘contains’ activity and in doing so performs some functional purpose for the broader economic good. None of them adequately explain banks. Banks represent something different: an institution captured by its elite workforce, where the purpose of the firm is to act as both shield and sword for its captors. The institution provides cover for the manipulation of prices and markets, for the proliferation of asymmetric information from which private gains are made. The current banking firm allows privacy and insiderism to flourish and incentivises strategies of position, disguise and deception. The outcome is akin to what Akerlof and Romer (1994) described as ‘looting’: maximising individual rewards at the expense of the institution when accounting is poor, regulation is lax and there are few penalties for abuse. The individuals take from the trading profits and the institution is left with the liability.

Psychologically, this is a difficult thing to grasp for the many politicians and regulators who for most of the 1990s and 2000s were absorbed by discussions about financial innovations that improved capital allocation and market efficiency and new whizzbang models that distributed risk away from the financial core, which all justified the need for light touch regulation. In doing so they forgot the crucial point that banks are run by people, and that markets involve a series of intermediated formal and informal agreements between individuals. The problem with banking is that the interests of the individual and of the institution are not necessarily aligned. Modern banking is particularly prone to looting, most obviously because the looting can only go on as long as the institution remains solvent, which is a long time when there is a State bailout guarantee. But more elaborately looting is possible because the presence or absence of profit on a particular trade or at the firm aggregate relies on the quality of the numerical inputs and valuation models used when assigning a price to often complex derivative assets on the balance sheet. Banks are conversion centres: they turn assets into income streams and income streams into bonuses. When derivatives traders ask someone on the cash desk to fix LIBOR, that affects the value of an asset which flatters the return on that trade. It produces, not profit, but the simulacrum of profit. And that is looting.

Of course Barclays no longer uses LIBOR to price many of its interest rate products. The game moves on. It now uses much more complex calculations to value its assets. On its valuation of collateralised interest rates it uses:

“Overnight Index Swap (OIS) rates…to reflect the impact of cheapest to deliver collateral on discounting curves, where counterparty CSA (Credit Support Annex) agreements specify the right of the counterparty to choose the currency of collateral posted”

And on interest rate derivative cash flows it uses:

“…interest rate yield curves whereby observable market data is used to construct the term structure of forward rates. This is then used to project and discount future cash flows based on the parameters of the trade. Instruments and optionality are valued using a volatility surface constructed from market observable inputs. Exotic interest rates derivatives are valued using industry standard and bespoke models based on observable market parameters which are determined separately for each parameter and underlying instrument. Where unobservable a parameter will be set with reference to an observable proxy. Inflation forward curves and interest rate yield curves are extrapolated beyond observable tenors”.
Barclays Annual Report & Accounts, year ending 2011, p234

Given what we know from the past week in banking, we are entitled to ask ‘what does that mean’? Do these accounting values from which revenues are booked and bonuses paid reflect the underlying reality of their financial position?

When you price assets using inputs of uncertain verity which are run through models of great complexity, it is tempting to assume that such convoluted calculations are designed to avoid writing down the value of assets. This would have an income effect and reduce the pot from which bonuses are paid. Do these accounting numbers present the simulacrum of solvency, which avoids the day of reckoning and allows the continuing payment of high incomes to senior bankers? It is something of a curiosity that just as the economics profession has become more and more concerned with finessing ever more complex models, so the financial sector has become acutely aware of its own sociology: a reflexive understanding of the signalling power of numbers. These are active numbers reported to elicit an effect in the future, rather than passive numbers designed to faithfully depict an image of the present. Thus LIBOR is not the rate at which you access unsecured funds, LIBOR is the signal to investors that everything is under control, or that a trade has been particularly profitable.

For many years here at CRESC we have had a growing sense that the instruments of finance have been put to different use from that originally intended. It is quite another thing to think that the most fundamental institution of the capitalist world, the public limited company, is itself being arbitraged in the interests of its elite workforce. But when a bank becomes a tower of assets built on the quicksand of confidence, the incentives to signal good news through numbers is great. It may well be that the more fundamental crisis going forward is not whether there was collusion between regulators and regulated, but whether – again – there is a collective loss of faith in the quality of the accounting data produced by these institutions.

This takes us back to structures. The culture that arises within banks is the product of particular structures, or rather the absence of structures, at three levels: accounting systems, organisation and activity level.

It is clear that the accounting numbers need to better represent the financial position of these organisations. There is too much leeway granted to these institutions to value their own derivative products – it gives rise to huge conflicts of interest. Much of this problem emanates from the pursuit of Day One P&L, which is largely an accounting phenomenon. As a basic start we should reconsider accounting rule HKAS39 which allows this practice to continue. As we have argued elsewhere, if costs were booked upfront and risks calculated non-normally it would mean most products would book immediate losses and only produce profits later in the product cycle. It would therefore tie in bonus pay to the long term performance of the particular products created. Similarly the structurers of those products would have to contemplate counterparty risks going forward, and thus think reflexively about whether they were passing on ‘too much’ risk to others – rather than current practice which is to maximize volume and pass off risk via a swap and consider it ‘somebody else’s problem’.

At the level of the organisation and activity, it is naïve to assume that banking culture will embrace restraint and responsibility without significant structural reform. That reform must take as its core organisational principle that banks must become public utilities with the duty to serve the wider economy. This is a considerable political challenge, and one that must begin by uncovering the patterns of patronage that fostered ‘light touch’ and nurtured the culture of invincibility in the City. Only then can an honest review take place of what needs to be done. Our recommendations are outlined here, in our Deep Stall Paper.


Thursday, 5 July 2012

Haldane And MacKenzie On Gaussian Copulas

I had the privilege of hearing the Bank of England’s Executive Director of Financial Stability, Andy Haldane speak at the University of Edinburgh on the 8th June. Haldane presented his new paper. For those familiar with Haldane’s output, this continues his familiar style of jargon-free prose and ideas expressed with unerring simplicity and logic, supported by an impressive armature of complex empirical exhibits. This paper moves beyond previous concerns with the scale of bank balance sheets and the problems of interconnectedness in complex systems, and instead begins to unpack the theoretical assumptions that underpin dominant neoclassical theories of mathematical finance and form the skeleton of many financial products.

His argument is that the normal or Gaussian statistical distributions (the bell curve) that are at the heart of these assumptions do not accurately describe huge swathes of human and natural phenomena, whether it is the volume of monthly rainfall, earthquake intensity over time, the occurrence of unique words in novels, historical prices in rice spot markets or equity markets, or even annual growth in GDP or real bank loans. These examples are instead characterized by non-normal or ‘fat tailed’ distributions, where extreme events are much more likely to occur than Gaussian distributions imply.

Such ideas are not new: Nassim Taleb and Benoit Mandelbrot have argued this point for some time. But Haldane’s novelty lies in his history of ‘normality’, which outlines the migration of Gaussian principles from the physical sciences into economics and mathematical finance. Haldane’s view is that this migration is part memetic transmission across the sciences and part inspired by a kind of primordial desire for symmetry within the human brain which makes normal ‘bell curve’ distributions appealing in a very aesthetic sense. Breaking with normalcy is therefore difficult but essential if financial regulation is to do what is now done in meteorology, where complex computer systems using non-normal models have been better able to predict and prepare for weather system risks. Haldane’s conclusion was that it is only by using non-normal, fat-tailed models and mapping system risk that the effects of financial crisis will diminish over time.

Haldane’s work has again introduced many thought-provoking observations on the world of banking and finance, as well as practical solutions for how it might be better regulated. But I am still left with one misgiving, which was expressed in our earlier CRESC work on Haldane: that weather systems have neither the capacity nor the incentive to game those non-normal models or maps of system risk once introduced. Finance does, and therefore the extent to which the methods used to prepare for fat tail events in the natural world can be transposed effectively to the world of financial regulation remains moot. Perhaps for that reason I am more receptive to Taleb’s view – that there are limits to the predictive power of statistics in complex systems like finance, and so the job at hand is to make the system smaller and simpler.

Haldane’s convincing empirical exhibits demonstrate the prevalence of fat-tail distributions in many walks of life. But they do raise an interesting paradox: why do banks – or perhaps more accurately the quants working within banks - persist with Gaussian models if normal distributions in economic and financial systems are so very rare? This was the interesting start point for Donald MacKenzie, Professor of Sociology at Edinburgh University, whose paper followed Andy Haldane’s.

MacKenzie’s answer, based on a detailed ethnography of bank quants was that the majority simply do not believe in Gaussian copula models. MacKenzie’s story is one of quants married to the aesthetic of mathematical purity and rigour, who embrace the elegance of a model like Black Scholes, but hold little regard for the Gaussian copula. This is a problem when most financial risk measures like Value at Risk and the structuring and pricing of financial products, like CDOs are built upon Gaussian principles. So why continue using them? Here, MacKenzie argues, the reasons are rooted fundamentally in culture – an ‘evaluative culture’ with Gaussian copula models at their centre, where exit costs are high. Those exit costs relate specifically to the aim of securing ‘Day One P&L’ – the lump of risk free profit on a deal from which bonuses are allocated.

MacKenzie explains that if non-Gaussian rather than Gaussian assumptions were used in the measurement of risk, then Day One P&L would be much smaller and perhaps even impossible to calculate because many more risky scenarios and unanticipated events would need to be priced in: the lump of profit would not be ‘risk-free’.

This finding very much chimes with discussions and briefing notes that were passed around the secretive ‘dark pool’ exchange that is CRESC whilst writing our book. These ideas broadly suggested that the role of derivatives in banking had been misunderstood. That a Credit Default Swap was not necessarily a tool of risk management or an instrument of wanton speculation, but a vital component in underwriting bankers’ high pay. If securitization was always about bringing forward revenues from the future and realizing them in the present, then derivatives played a vital part in passing on the uncertainties of the future to another party. Thus various swaps would enable banking divisions to strip default risk, interest rate risk etc from the block of revenue on a deal, leaving behind a notionally risk-free lump. Locking in ‘arbitrage profits’ for example by holding AAA securities, financing them with a repo and selling on the default risk via a CDS, would enable the deal brokers to get the revenues onto the P&L and claim their bonus. Of course, this incentive encouraged the expansion of a vast transaction-generating machine, as mortgage volumes were ramped up and worked through the CDO mincer, while risk was passed on to naïve operators at AIG and monoline insurers. The result: system-wide counterparty risk that blew up spectacularly in the aftermath of Lehmans collapse.

Two things emerge from this for me. First, an intellectual question about where performativity theory goes from hereon in? My (albeit limited) understanding of Callonian influenced writing (with which MacKenzie has aligned himself in the past) is that economics performs the economy – it creates the economy in its own image, provided the correct assemblages can be mobilised to bring those assumptions into reality. What MacKenzie is now describing, it seems to me, is something quite different: that the desire to maximise Day One P&L (a financial incentive in other words) influences the models used within specific evaluation cultures, even though those models appear to bear little relation to empirical outcomes over time. This is not a million miles away from questions we have been asking for some time: why those models and why those models at that time?

Second, it also raises an interesting question about how you might regulate such institutions going forward. If that evaluative culture could change, and that non-normal models were used to price in fat tail events, it would remove many of the more pernicious incentives we currently see in the banking sector. If lawyer and accountancy costs were booked up front on deal and revenues were not realized immediately, those products would initially be loss making, and only become profitable after a period of years. It would therefore tie in bonus pay better to the long term performance of the particular products created. Structurers of those products might also have to contemplate counterparty risks going forward, and thus think reflexively about whether they were passing on ‘too much’ risk to others – rather than maximizing volume and passing off risk as ‘somebody else’s problem’. It may also resolve intra-firm moral hazard when many ‘innocent’ bankers are penalized by excessive risk taking in another banking division which causes the value of their bonus options collapse.