Financial scandals and their cost take center stage

In his Wall Street Journal column, Simon Nixon looks at how financial scandals have taken center stage and how this is necessary for fixing the financial system.

For financial journalists, scandals are the new deals. In the boom, business news was dominated by the latest corporate takeover; in today's zombie economy, the main source of excitement is the endless revelations of skulduggery and egregious rent-seeking in the financial world, with many of the worst cases emanating from the City of London....

Over the summer, Barclays, HSBC and Standard Chartered were fined hundreds of millions of dollars for Libor-rigging, money-laundering and sanctions-busting respectively. 

All the major U.K. banks are on notice for further giant fines from U.S. regulators for a range of misdemeanors. At the same time banks are having to shell out billions of pounds in compensation to customers sold inappropriate products. The bill for payment-protection-insurance misselling has already hit £12 billion ($19.06 billion). ... 

There is a reason for this sudden discovery—and heightened awareness—of so much scandal. What we are witnessing is the unwinding of what the economist J.K. Galbraith called "the bezzle," the stock of undiscovered embezzled wealth that accumulates during the boom in a country's business and banks. 

It's the ill-gotten—but not necessarily illegally-gotten—gains of a financial system whose rules have been bent to suit insiders at the expense of wider society. 

"In good times, people are relaxed, trusting and money is plentiful," Galbraith wrote in "The Great Crash 1929." 

"But even though money is plentiful, there are always many people who need more. Under these circumstances, the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks." 

One reason why the scale of the bezzle is only coming to light now, five years after the crisis struck: the global economy has been anesthetized by ultralow interest rates, quantitative easing and deficit spending. Until recently, the doped-up financial world was in the grip of a pleasant hallucination that the crash was cyclical and the good times would return.

A hallucinogen administered by the policymakers and financial regulators.  The very people who should have been preventing the bezzle in the first place.

But as time has passed, it has become clear the good times are not returning. Instead, the unpleasant side effects of loose money addiction are becoming apparent: tough decisions have been avoided too long. 

Meanwhile, ultralow investment returns are a source of despair to those living off their savings or trying to save for their retirement. 

As the English used to say in Victorian times, "John Bull can stand many things, but he can't stand 2%."

Savers are asking why they have to suffer when the bankers continue to reap excessive bonuses.

A revolution—or perhaps, more accurately, a reformation—is now under way: a full-scale assault on what Bank of England Deputy Governor Paul Tucker called the "cesspit" in the City. This has come as a terrible shock to many City workers who believe they lead blameless lives of tireless devotion to clients. 

But it wasn't just the "casino bankers" in the fixed-income divisions who lost their moral bearings. Few parts of the City weren't compromised, aided by London's famously "light touch" regulatory regime that often seemed to favor the industry over its customers. 

There were the commission-hungry retail bankers guilty of misselling; the investment bankers who gamed the listing rules to bring emerging-market companies with appalling governance to the London market, often targeting passive investment funds; the executives who colluded in the vast escalation of boardroom pay; the fund managers, whose excessive fees—often deeply embedded—for mediocre performance ate into their clients' savings; the hedge funds that paid inflated commissions to secure access to market-moving information the moment—or was that the moment just before?—it was published; the auditors who signed off on aggressive accounting treatments knowing lucrative consulting contracts were at stake; the lawyers whose clever ruses enabled companies to operate at the outer limit of the law, not least in their tax affairs.

What a list of financial market participants that a siphoning off cash.

But for this reformation to be successful, it cannot simply be driven by politicians and regulators—whose reform efforts are too often emotionally-driven and likely to be counterproductive—but by the market itself....

Regular readers know that sunlight is the best disinfectant.  By bringing transparency to all the opaque corners of the financial system, the market can clean up the bezzle and prevent its recurring.

Yet there is a long way to go to unwind the grotesque conflicts of interest that proliferated during the boom. Even now, many still insist the City is misunderstood, that its problem is simply poor public relations. 

Of course, this reformation will have real world consequences. Implicit in the unwinding of the bezzle is a redistribution of wealth from finance to businesses and savers.

This is a healthy process—after all, the gains were only ever "psychic," as Galbraith noted—but it will feel painful. Overhauling structures and changing business will cost the industry and the U.K. economy in terms of lost jobs and revenues. 

A banking system forced to disgorge past excesses may be less able to lend or to support the ancillary industries that cater to its every pleasure and whim. 

And the longer the process takes, the longer the current economic uncertainty will be prolonged, delaying the reallocation of capital and resources to more productive sectors.

This is one of the advantages of adopting the Swedish Model with ultra transparency.  It eliminates both the excess debt in the financial system while protecting the real economy and it eliminates the bezzle.