Last year, in the wake of the Barclays Libor revelations, Gary S. Becker, a Nobel Prize winner in economics, and Richard A. Posner, a leading jurist, in their blog posed the question: "Is Banking Unusually Corrupt?" They appeared to offer an affirmative answer to the question.
Becker observed that "a highly regulated industry that manages enormous sums of money is likely to attract more than the average number of individuals who are willing to cut corners and violate regulations and laws, and sometimes their own company's rules, in the attempt to make very large incomes for themselves."
Last month, following more recent disclosures of alleged manipulation of foreign exchange markets, William Dudley, the President of the Federal Reserve Bank of New York, likewise decried the "apparent lack of respect for law, regulation and the public trust" within some large financial institutions. He cited evidence of "deep-seated cultural and ethical failures at many large financial institutions."
Dudley could have easily been alluding to the self-styled "Bandits' Club" or "cartel" of foreign exchange traders working through electronic chat rooms. Or perhaps to a recently disclosed exchange between a Rabobank Libor submitter and a colleague: "Don't worry mate – there's bigger crooks in the market than us guys!"
The alleged manipulation of Libor and pricing in other markets, such as foreign exchange and credit default swaps, have elicited statements of shock from regulators, legislators, editorial writers and senior management at banking institutions alike. Perhaps the biggest surprise is that these constituencies were surprised.
The banking industry has undergone a fundamental transformation in the last 30 years. It has moved significantly away from a relationship business to a transactional business and from a customer to a counterparty business model. One need not accept the hypothesis in the Becker-Posner blog to recognize that the transformation in the banking business model nonetheless represents a long-term shift with inherently higher compliance and legal risk than the traditional banking model.
Bankers Trust Company was one of the pioneers of this transformation. History records the outcome of its transformation. When the firm was sued in 1994 by Procter & Gamble in connection with a series of highly leveraged derivative transactions, the litigation discovery process revealed the internal workings of the Bankers Trust derivatives team. These revelations were shocking – at least at the time. A derivatives trader was recorded on tape explaining to a colleague: "Funny business, you know? Lull people into that calm and then just totally [expletive deleted] 'em."
Other tapes recorded Bankers Trust employees regularly referring to the "rip-off factor" in their transactions with counterparties. The statements on the Bankers Trust tapes were every bit as cavalier as anything to be found in the Libor and foreign exchange emails or instant messaging. The medium may be different today, but the message is the same.
The behavior of the Bankers Trust derivatives traders was not idiosyncratic. It flowed from the change in the bank's business model. The traditional banking model contained an inherent, if paradoxical, risk-mitigating factor: asymmetry of information. In the traditional banking model, borrowers know more about their finances than the bank does and, as such, the risk of the asymmetry of information falls on the banking institution. The task of the traditional commercial banker was to reduce the asymmetry by obtaining as much information as possible about the business and prospects of commercial borrowers in order to make a judgment about entering into a long-term relationship with them. The same may be said of the original approach to residential mortgage lending.
As commercial banks evolved into full service financial institutions, the risk of asymmetry of information became inverted. Many customers and counterparties know less about the risks posed by the financial products than the banks offering the products.. Thus, new bank products and new bank relationships have been originated in an environment that lacks one of the natural safeguards of the traditional banking model. The transformation in the bank business model was also accompanied and complicated by changes in the bank compensation model with an overriding emphasis on bonuses and sales promotion.
These changes contributed to an operating environment in which the opportunity for abuse and deception increased. This is not intended as an ethical observation on the new products and relationships. Many of the new products and relationships are presumably beneficial to various categories of customers and counterparties and to the functioning of the markets as a whole. It is simply intended as a practical observation. The necessary governance response for banking institutions is to treat the new products and relationships as inherently presenting higher risk, requiring greater compliance, audit, real-time monitoring and other risk management controls (as, for example, in revised compensation approaches).
In the end it is necessary for all constituencies to recognize that the modern banking model presents inherently higher compliance risks than the traditional banking model. It is also necessary to recognize that the diversity of financial products and functions in the modern banking model adds to the challenges. The range of risk analyses and control systems necessary to cover such disparate areas as, for example, anti-money laundering measures, residential mortgage foreclosure procedures, and hybrid-product design and sales is daunting. Despite efforts at heightened control measures, the inevitable result of the shift in the banking model will be – at least for the foreseeable future – more frequent and prominent enforcement actions.
Paul L. Lee is of counsel and a member of the Financial Institutions Group at Debevoise & Plimpton LLP. He is also a member of the adjunct faculty at Columbia Law School.