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In November last year, I wrote an article on Credit Suisse (NYSE:CS), in which I identified them as a rogue bank, citing multiple episodes of unlawful, unethical or reckless behavior. Since then, as revelations about manipulating Libor on the part Barclays (NYSE:BCS) and others, and gambling with FDIC insured deposits in the case of JP Morgan (NYSE:JPM) have come to the fore, I've thought about writing a series on big banks, kind of a rogue of the week club.

That would be tiresome and repetitious, an interminable blur of details, differing only in the names of the banks, the size of the chump change fines imposed by regulators, and the slap on the wrist penalties imposed on individual offenders.

There is no major U.S. bank that has not been the subject of SEC enforcement action. The fines paid are regarded as a business expense, as successive actions have no deterrent effect. The profits derived from the criminal activities, when compared to the likelihood of being prosecuted and the cost of fines imposed, must be very substantial; otherwise, the banks would have cleaned up their act.

Banks as Utilities

The proper function of banks in the economy and financial system is best likened to utilities providing water, sewage, electricity or natural gas service. Credit and capital must flow reliably to where they are needed, and risk must flow to where it can be appropriately managed.

Or, closer to home in the financial services industry, they may be likened to insurance companies. Because the transfer of risk is affected by the public interest, insurance companies are heavily and effectively regulated. Banks, and speculators using their facilities, use CDS to transfer risk here and there in very destructive and manipulative ways.

The effect of this ability to pipe risk here and there in the economy is startling. It's as if a homeowner flips a light switch and 10,000 volts zaps into his living room. Or turns the faucet in his bathtub and sewage gushes out. Or turns on the stove, and his house is immolated in a massive fireball.

What the banks collectively have done might be likened to polluting the public water supply. The mortgage based assets underlying our financial system have been debased by massive fraud, and the legal system has been clogged with litigation arising from their refusal to rectify their wrongs, or to honor their contractual obligations under representations and warranties.

Drop the Fiction of Self-Regulation

Neo-liberalism, as espoused by academics and the financial and business community, holds that the market is perfectly self-regulating. Under this set of precepts, the members of a market, by banding together, can set up self regulatory agencies and be free from harassment and interference from government bureaucracies. As a benefit, the size of government, and its involvement in regulating private behavior, can be minimized.

Ask Madoff's victims how much FINRA helped them. Or ask Corzine's victims how effective CME was.

Alan Greenspan, a disciple of Ayn Rand, an outspoken exponent of neo-liberalism, famously experienced an epiphany while testifying before Congress in the wake of the financial crisis. Briefly, and in a blinding flash of light, the scales fell from his eyes. Here are his words:

Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief.

Shocked. He was in a state of shocked disbelief. When questioned on the truth of his ideology, he confessed:

Yes, I've found a flaw. I don't know how significant or permanent it is. But I've been very distressed by that fact.

I have information for Mr. Greenspan. The flaws are very significant, and permanent.

The British Bankers Association, in the wake of the Libor fixing scandal, has requested that the FSA and BOE get involved, by sitting on the committee that supervises the rate setting. Having fouled their own nest and destroyed their own credibility, they invite government to clean up after them.

Dodd Frank doesn't work because it is based on maintaining the status quo, consulting the subjects of regulation as to what regulations will work, and be convenient, and not cause any trouble. The Fed as banking regulator is already hopelessly compromised. The big banks are heavily represented on the board. It's self-regulation, yet once more. And it won't work.

Where to Start

Nobody knows where the risk lies. Flip the switch: you might get 110 volts, you might get 220, you might get 10,000. Draw yourself a bath: it might be water, it might be sewage, or it could be sulfuric acid.

It's about risk: the creation, transfer and management of risk.

To start with, the industry has developed progressively more elaborate methods of quantifying risk. These systems have one common element: they rely on the concept of normal distributions, and they encourage fat tail accidents.

Many human attributes are normally distributed. Height and weight would be good examples: the average human stands between 5 and 7 feet tall, and weighs between 100 and 300 pounds. The extremes diminish fairly rapidly: have you ever seen an 8 foot man? Or a 1,000 pound man?

Very regrettably, attributes such as greed and dishonesty are not subject to any such limitations that conform to a normal distribution. Credible arguments have been advanced, that the most effective competitor in the modern financial field is a psychopath, devoid of conscience or concern for the rights of others.

The point is, that greed and dishonesty don't fit normal distributions. The risk that must be contained in the financial system will never fit into a model based on a nice orderly bell-shaped curve.

Information on Human Nature

Psychological research into human nature is suggesting that increased wealth makes people more unethical. Psychologist Paul Piff and his colleagues have conducted research that points in that direction. According to Piff:

Occupying privileged positions in society has this natural psychological effect of insulating you from others. You're less likely to perceive the impact your behavior has on others. As a result, at least in this paper, you're more likely to break the rules.

Some of the examples provided by the research are relatively mundane. Persons driving expensive automobiles are more likely to stretch the yellow light, or cut others off in traffic. In the aggregate, they are damning. Persons with higher SES (Social Economic Status) regard greed more favorably, and are more likely to cheat.

Researchers and Psychologists such as Clive Boddy and Dr. Robert Hare have found that psychopaths are four time more prevalent in the executive suite than in the general population. According to Hare:

People tend to think of psychopaths as criminals. In fact, the majority of psychopaths aren't criminal. They don't go out and maim, rob and rape but find other ways to satisfy themselves without doing something necessarily illegal ... such as taking risks with someone else's property or money.

Dick Fuld comes to mind. This research raises the possibility that large institutions such as Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and JP Morgan are in point of fact headed by, or heavily staffed with, psychopaths. The culture is one of unfettered greed. The London Whale is only the most recent episode.

Images of Clueless Arrogance

During the financial crisis, Bear Stearns CEO James Cayne gained considerable notoriety, playing bridge while the firm imploded. He was reputed to smoke pot excessively. The image lingers on, like a modern Nero, playing cards and smoking pot while the markets burned.

Equally damning, John Thain, CEO of Merrill Lynch, saw fit to adorn his office with a $35,000 commode. In fairness to Thain, the commode was not a toilet per se, but rather a small antique cabinet, one portion of which would have held a chamber pot, prior to the advent of indoor plumbing.

Lloyd Blankfein famously described Goldman Sachs as doing "God's work." If one must imagine Goldman serving a metaphysical conception, Greed Incarnate, rather than the Deity, comes to mind.

Controlling Exponential Greed

The effects discussed above operate with exponential force. Quite simply, the man who commutes to his big bank job in a helicopter views his fellow beings as ants on the pavement.

The answer is quite simple. Downsize the big banks. Doing the math: Breaking them up into 10 equal parts each would decrease the psychopathic arrogance by a factor of 100. That sounds about right.

As for winnowing the excess population of psychopaths that may be present in bank management: the SEC and DOJ, or the NY Attorney General, for that matter, could simply enforce the laws, prosecute the offenders, and mete out jail sentences.

Investment Implications

Big banks are speculative investments, for the simple fact that management assiduously serves their own interests, instincts that have served them well in their climb to their present bad eminence. The investor may be able to participate in their success, but he has no assurance that management will share the proceeds fairly.

The danger to the U.S. economy has been greatly reduced by the requirement of massive amounts of additional capital. As such, the risk of further systemic accidents has been greatly reduced. However, the markets will continue as dangerous venues for the unwary. The harms done by past conduct have not been fully repaired, and markets are likely to be volatile and unstable for the foreseeable future.

As of this writing, U.S. equities are modestly undervalued, and the risks posed by rogue banks are not sufficient to deter a prudent investor from owning well-capitalized and capably managed companies. If and when the big banks are firmly directed toward serving the real economy, along the lines of utilities, investment prospects will be greatly improved.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Big Banks: A Rogue Industry