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Scoundrels And Reformers In The Banking Business. A Suggestion From The Fed.

Various government officials just concluded a November 5th conference addressing banking ethics.

The regulators warned that if banks did not improve their ethics, the bank regulators would do something about it.

There is no evidence that this regulatory commitment to cure the banks' moral ills had an effect on financial market stock prices.

Without question, the value of every share of financial stock in the system is negatively affected by society's distrust of bankers. And global bank regulators recently convened to address the issue. If the news that regulators plan to improve banker's ethics affected this negative valuation, I missed it. I do not await the immediate improvement of financial ETFs such as Financial Select Sector SPDR, (NYSE: XLF); Fidelity MSCI Financial Index ETF, (NYSE ARCA:FNCL); or iShares U.S. Financial Services ETF (NYSE ARCA:IYG/IV). I expect the effect of government complaints to banker about ethics on banking stocks to be nil.

The public distrust of bankers may have hit bottom during the Depression, but I'm sure there were issues before that. I have been, off and on, required by university administrators to lecture on ethics in my finance classes. Annoying. The students look at me like I have two heads. They still live in the black-and-white world their parents told them about, the one they watch on TV. When they go to work they enter the world of grey. That's when we should talk.

Although his remarks were a little Delphic, New York Fed President Dudley's comments on the issue, as quoted in the New York Times, may be consistent with mine.

He said, "Virtue cannot be regulated. Even the strongest supervision cannot guarantee good conduct... The banking scandals that followed the crisis are evidence that something fundamental is wrong. I would encourage each of you to consider not just individual cases of misconduct, but the patterns within them that lead to underlying causes. I suspect we will see a strong overlap with those factors that led to the crisis. I think your focus should be less on the search for bad apples and more on how to improve the apple barrels. (Emphasis mine.)" In other words, the system in which bankers make ethical decisions should be designed so that the scope for dishonesty is as small as possible, and dishonestly easily identified. Making it difficult to cheat will outperform pep talks every time.

Dudley's remarks are in contrast with the high-minded statement from the Governor of the Bank of England, Mark J. Carney. Carney pointed out in a speech in Canada that "the sacred trust between bankers and the public has been broken," says the Times.

Please. Consider how the government views bankers. Since the depression, U.S. federal law requires that for banks to enter any new business (such as trading futures) the industry must show a positive public benefit to bank involvement. In other words, that non-banks cannot do the job as well as banks. The government's assumption is that banks are inherently evil, so there must be an offsetting public benefit to balance the score.

New York State law requires bankers, specifically, to take two continuous weeks of vacation each year. The presumption is that whatever scam the banker is running will be caught while the banker is gone.

When bankers are asked why they chose their profession, the answer is not "I wanted to help the poor and weak." Like other professionals, the intention is usually to acquire and use skills to help themselves, their families, and in some cases - to be an effective cog in the productive machine of capitalism. As with many on this site, sometimes understanding that machine and its workings becomes a motive in itself.

But if you are a greedy, fundamentally dishonest, person, banking is one of the legal professions that will appeal to you. And lectures from your professors and government officials won't change that.

The public has a reasonable expectation that bankers not break the law with great frequency. And a reasonable expectation that the legal apparatus will diligently uncover those who do. But the law is an ass.

On one hand, bankers are legally required to serve their stockholder's interest, within other legal constraints. On the other hand, ethics require that the public be informed. In an example of the conflict of interest, Kenneth Griffith of describes the bank's version of their role in markets in an article to be found in the Wall Street Journal. "Historically, banks have enjoyed a privileged position between buyers and sellers in the fixed income markets. Unsurprisingly the banks argue that their position must be maintained in order to facilitate liquidity during volatile periods. This is a myth intended to preserve their competitive moat around what has been a very lucrative business."

To paraphrase: The banks misinform the public in order to restrain trade in their dominant markets. This is perhaps unethical, but offset by the ethical responsibility to protect stockholder value. In Griffith's words, "You can't blame the big banks for trying to preserve their privileged market position." The ethics of finance is not black-and-white. It's grey.

The LIBOR Scandal: An Example of Ethics in Action. An excellent summary of the history of the Scandal by David Hou and David Skeie of the New York Fed may be found here.

How did the ethics issue play out for the banks that were sued for their roles in the various price-manipulation scandals: LIBOR, foreign exchange, and apparently now gold? Since the crisis there have been three basic kinds LIBOR market manipulation identified in the popular press: 1. big manipulation, 2. middle-sized manipulation, and 3. small manipulation. All of them have a certain greyness about them.

  1. Small manipulation: This is the form of manipulation we see in the news. Individual traders who, in this age of the internet, were stupid enough to discuss their manipulation of the LIBOR fixing for personal gain in chat rooms, and in taped phone conversations. But we know, for example, that the trader caught manipulating LIBOR at UBS was given a printed LIBOR manipulation manual. Yet as far as the outcome of the criminal law suit is concerned, he acted, the New York Times reports, as a "ringleader" for a group of conspirators at other banks, who colluded to set the rate. Maybe.
  2. Big manipulation: Big manipulation is the systematic action of senior officials of Too Big to Fail (TBTF) banks who sought to keep levels of LIBOR below market levels during and after the Crisis. Opinions about the duration of this form of LIBOR manipulation vary, from as early as 1991. There is conclusive evidence of its existence, and knowledge of its existence by senior US and British officials, on June 1st, 2008. But big manipulation is every bit as illegal as small manipulation.

There was, however, a difference in objectives between small and big manipulators. Big manipulation was, according to official remarks, in part an effort to protect the many (something in the neighborhood of $30 Trillion in dollar value) loans, funding everything from mortgages to municipal operations, from failing. But it was, of course, also an effort to protect the reputation of the institutions that were reporting. Should Tim Geithner be prosecuted because he was aware of this? The CEOs of Barclays and Rabobank lost their jobs, but no one will go to jail. That is not about the law; that is about power. After all, the law is not about good intentions. It is about actions.

  1. Middle-size manipulation: This is the missing link between the two forms of manipulation, big and small, that we know about.

When law enforcement catches a drug mule, typically the objective is to get this low-level criminal to "turn" on his employers, by offering a reduced sentence. The goal is to form a picture of the chain of command, ultimately to bring the full weight of the law down on the individuals that are most important to the functioning of the illegal enterprise as a whole.

Where is the fault line between the big manipulators, with the grey issue of responsibility for protection of the financial system and their banks, and the little manipulators, who were trying to win the zero-sum game of daily trading with a lie? The legal authorities show no interest in this question that I can detect.

What is apparent about the LIBOR scandal is that in spite of the post-crisis rhetoric to the contrary, there is no evidence that New York Fed President Dudley's advice will be taken. For example we will not be changing the LIBOR pricing system so that illegal acts of individuals who choose the LIBOR rates daily will be less likely. The providers of daily LIBOR quotes suddenly became anonymous after LIBOR calculation passed from the British Banker's Association to The Intercontinental Exchange (NYSE: ICE).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.