Tuesday, July 24, 2012

New Yorker's James Surowiecki: Bankers gone wild

In his New Yorker article, James Surowiecki looks at the need to restore trust in the financial system.

Regular readers know that trust in the financial system is a result of transparency.  With transparency, market participants can Trust, but Verify.

With transparency, market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess risk.  Market participants trust their own assessment.

Heading into the financial crisis, market participants substituted trust in the financial regulators for transparency as the financial regulators let large areas of the financial system become opaque.

This trust was shown to be misplaced.

The question is why would market participants ever trust the financial regulators again?  The old adage goes:  fool me once, shame on you; fool me twice, shame on me.

Mr. Surowiecki recommends actually enforcing the laws as a first step for financial regulators regaining the trust of market participants.
In order to work well, markets need a basic level of trust. As Alan Greenspan said, in 1999, “In virtually all transactions we rely on the word of those with whom we do business.” 
So what happens to a market in which the most fundamental assumptions turn out to be lies? .... 
The LIBOR (London Inter-bank Offered Rate) index is the most important set of numbers in the global financial system. ....
Yet we now know that for years LIBOR rates were rigged. ....
Rigging LIBOR was shockingly easy. The estimates aren’t audited. They’re not compared with market prices. And LIBOR is put together by a trade group, without any real supervision from government regulators. 
In other words, manipulating LIBOR didn’t require any complicated financial hoodoo. The banks just had to tell some simple lies. 
They had plenty of reasons to do so. At Barclays, for instance, traders were making big bets on derivatives whose value depended on LIBOR; changing rates by even a tiny bit could be exceptionally lucrative....
And, once the crisis hit, banks had a new incentive to distort LIBOR: if their estimates were higher than their peers’ (meaning that it would be expensive for them to borrow money), investors, creditors, and regulators would worry that they were about to go under. So the banks sent LIBOR downward in order to make themselves look stronger than they were. The result was that, instead of reflecting what was real, LIBOR reflected what the banks wanted us to believe was real. 
The most striking thing about this scandal is that it was predictable—the way LIBOR was designed practically invited corruption—yet no one did anything to stop it. 
It is an example of regulators failing to perform their primary task under the FDR Framework of ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.
That’s because, for decades, regulators and people in the financial industry assumed that banks’ desire to protect their reputations would keep them honest. If banks submitted false LIBOR estimates, the argument went, the market would inevitably find out, and people would stop trusting them, with dire consequences for their businesses.  
LIBOR was supposedly a great example of self-regulation, evidence that the market could look after itself better than regulators could. 
But, if recent history has taught us anything, it’s that self-regulation doesn’t work in finance, and that worries about reputation are a weak deterrent to corporate malfeasance. ...
The lesson is that in the absence of transparency self-regulation does not work in finance.  Without transparency, there is no way for market participants to keep the banks honest through Trust, but Verify.
Even in the absence of market discipline, self-regulation could work if institutions had strong internal safeguards against corruption. But while every institution says that it has these norms—that’s why scandals like LIBOR are always blamed on a “few rogue traders”—the track record of the banking industry over the past two decades doesn’t inspire confidence in its devotion to the truth or to the public interest. 
The Barclays traders, for instance, sent e-mails casually thanking their colleagues for lying, and sometimes talked with their supervisors about their plans, revealing a culture in which deception was simply part of how things got done. 
As the behavioral economist Dan Ariely writes in his new book, “The Honest Truth About Dishonesty,” cheating is contagious—when we see others succeed by cheating, it makes us more likely to cheat as well. So when institutions tolerate, and even reward, bad behavior, all that self-regulation gets you is bankers gone wild. 
How do we rein them in?
Simple, by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information,
We could start by making it harder for the banks to game the system—LIBOR, for instance, should be revamped so that it reflects actual market rates, not self-serving guesses....
This new approach would be intrusive and overbearing, and would make it harder for bankers to do what they want. In other words, it’s exactly what the financial industry needs.

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