Wednesday, 25 July 2012

“As Taken Aback As Everyone Else”: The Salz Inquiry At Barclays

“The global review will assess the bank’s current values, principles and standards of operation and determine to what extent those need to change; test how well current decision-making processes incorporate the bank’s values, standards and principles and outline any changes required; and determine whether or not the appropriate training, development, incentives and disciplinary processes are in place. The review’s findings and recommendations will be published, based on evidence gathered through extensive engagement with all of the bank’s stakeholders and a thorough review of all pertinent documentary evidence. Any interested party is encouraged to provide input to the review by submitting a perspective or evidence via

Thus, the Barclays press release announced that Anthony Salz is to conduct an independent review of Barclays culture which will conclude by next April. This is a fairly straightforward, low risk, defensive move by a bank which has sustained massive reputational damage in the past few weeks since it was fined for fixing Libor

First, the CEO and chairman have to go, as a kind of penance. Then Barclays performs a kind of corporate moving on. Hence the independent inquiry whose (not too onerous) recommendations can  be ostentatiously implemented.

The precautionary motives of Barclays now manifest themselves in two ways, through the terms of reference of the inquiry and the choice of the lead inquirer.

First, the inquiry’s terms of reference are narrowly defined as “ business practices” understood as “values, principles and standards of operation”. And that fits with an idealist and dematerialised definition of culture as “instinctive behaviour and beliefs” The investigation does not consider the Barclays  business model in retail and in investment banking. Salz will not ask whether expensive branches and free current accounts means mis-selling in retail to recover costs. Nor ask why investment banking is a joint venture which benefits bankers more than shareholders and generates a balance sheet larger than British GDP.

Second the inquiry will be led by a silver haired corporate lawyer who is one of their own. Salz is, a man with an “urbane manner and establishment background” according to the BBC ‘s Robert Peston who has known him “for donkey’s years”. Salz is well networked in investment banking via his role as lead lawyer on twenty years of M&A deals at the law firm Freshfields where he was senior partner until 2006. He is also one of the great and the good, with roles including senior positions on the BBC board, alongside Barclay’s now disgraced chairman Marcus Agius. Barclays chose this man Salz and not, for example, an awkward churchman with a conscience like Rowan Williams.

Salz has the track record, reputation and recent experience that fits him for this kind of independent inquiry into banking culture. Let's recall Money Week's profile of Salz in 2006. This looked back to the takeover deal which helped to make his name and from which Salz emerged stronger while others went to jail:

"In 1986, he advised Guinness on its bid to buy Distillers and “was as taken aback as everyone else by the wrongdoing that emerged”, says The Sunday Times. Salz claimed he had repeatedly warned directors of the illegality of their actions – a version of events that conflicted with that of Guinness chief Ernest Saunders. It was a nail-biting time, but Salz won the day and emerged from the episode stronger

And Money Week explained that Salz was the man to make sure that everything was within the law:

"Corporate lawyers are two a penny. What makes Salz so special? Clients claim it is his bold, imaginative approach that makes him a star. “Most lawyers tell you why not to  do something, but Anthony is creative,” says David Mayhew at Cazenove. “He will show you how to do it within the law. And he has a wicked sense of humour.” 

We would add that Salz has since 2006 has added experience of chairing inquiries. According to his profile in the Barclays press release 

(Salz) chaired the Independent Commission on Youth Crime and Antisocial Behaviour in England and Wales, which reported in 2010. He also chaired two review groups on press self-regulation on behalf of the Media Standards Trust (on which Board he sits), which published reports and recommendations in 2009 and in June 2012.

The failure of press self regulation  and serial misbehaviour by the tabloids of course led to Leveson. And this independent inquiry into Barclays under  Anthony Salz is a poor substitute for the Leveson for the banks which CRESC and others have been asking for.

Dyfal Donc

HSBC: Loose Control

The revelations about HSBC’s alleged indiscretions are sobering. What has emerged from the Permanent Subcommittee On Investigations to date is a tale of systematic and deliberate avoidance of anti money laundering (AML) programmes in the US. It is not an edifying read.

The central institution in this story is HSBC’s largest US affiliate: HSBC Bank USA or ‘HBUS’. HBUS is key because it provides HSBC’s overseas clients with access to dollar markets and the US financial system, which is important because the dollar’s role as leading trade currency makes it a prime target for launderers.

Perhaps most staggering is the finding that between 2007-2008, HSBC’s Mexican affiliate, HBMX, shipped $7 billion in physical U.S. dollars to HBUS, more than any other Mexican bank, even one twice HBMX’s size. According to the Chair’s report:

“HBMX operates in a high risk country battling drug cartels; it has had high-risk clients such as casas de cambios; and it has offered high risk products such as U.S. dollar accounts in the Cayman Islands, a jurisdiction known for secrecy and money laundering. HBMX also has a long history of severe AML deficiencies. Add all that up and the U.S. bank should have treated HBMX, the Mexican affiliate, as a high risk account for AML purposes. But it didn’t. Instead, HBUS treated HBMX as such a low risk client bank that it didn’t even monitor their account activity for suspicious transactions. In addition, for three years from mid-2006 to mid-2009, HBUS conducted no monitoring of a banknotes account used by HBMX to physically deposit billions of U.S. dollars from clients, even though large cash transactions are inherently risky and Mexican drug cartels launder U.S. dollars from illegal drug sales. Because our tough AML laws in the United States have made it hard for drug cartels to find a U.S. bank willing to accept huge unexplained deposits of cash, they now smuggle U.S. dollars across the border into Mexico and look for a Mexican bank or casa de cambio willing to take the cash. Some of those casas de cambios had accounts at HBMX. HBMX, in turn, took all the physical dollars it got and transported them by armored car or aircraft back across the border to HBUS for deposit into its U.S. banknotes account, completing the laundering cycle”.

This situation occurred because of the particular way HSBC is run. The report makes it clear that HSBC Group HQ in London instructed its affiliates to assume that every other HSBC affiliate met the group’s AML standards and so should be provided with correspondent banking services. HBUS merely followed this instruction, ignoring more stringent US law which requires due diligence reviews before any US account can be opened for a foreign bank.

In addition to the cross border movement of physical notes, it was also found that HSBC affiliates in Europe and the Middle East circumvented filters set up by the US Treasury Department’s Office of Foreign Assets Control (OFAC) to prevent the funding of terrorist organisations: references to Iran in $19bn worth of US dollar transactions between Iranian entities and HBUS or other US affiliates were stripped out of or omitted from paperwork in 85% of cases, in full knowledge of HSBC’s Chief Compliance Officer and other senior executives in London. There were similar allegations of negligence and cover-ups made regarding HSBC’s ties with the suspect Al Rajhi Bank; clearing travellers cheques for suspicious Russian used car business via a Japanese bank; and offering accounts to ‘bearer share’ corporations, which due to their anonymity are prime vehicles for money laundering and other illicit activity.

It is difficult to dignify such actions with the descriptor ‘neglect’. ‘Neglect’ suggests fault through casual disregard, carelessness or indifference. This kind of behaviour is not an accident; it is written into the DNA of banking in its current form. It is a culture borne of particular structures.

So what structures nurture this kind of behaviour? Two interesting blog posts are illuminating on this issue. The first, an interesting post by an ex-investment banker, Honestly Banking, outlines the problems of what he/she terms ‘loose control’ at HSBC HQ in London. HSBC encourage a quasi-decentralised system whereby relatively autonomous and highly paid 'International Managers' (IMs) are posted to the various HSBC affiliates in senior roles. According to Honestly Banking, loose control creates local mandarins: these IMs make critical decisions in those affiliates and have the right to accept or ignore the recommendations of the local compliance officers. It is unlikely that these IMs run their organisations autocratically, it is likely that decentralisation is replicated at the affiliate level. That is a very effective way of building an organisation that maximises returns from different regions, but it may also encourage accommodation and entanglement with all kinds of risky and unpalatable local operations.

The FT puts this outcome more directly: it is one where “the bank’s business interests trump its compliance obligations”. But that is to confuse the interests of the institution with those who stand to gain individually from this activity. We need to ask a more troubling question: was it really in the long term interests of the institution to behave like this? A second blog post by London Banker highlights this broader tension and the problem of decentralised management. Using the metaphor of a wooden ship, he/she describes a situation where the crew, oblivious to the history and craft of the vessel, are tasked with turning a profit individually, or face being turned ashore. The crew respond by pulling nails from the ship and selling them at each port, at each stage telling themselves that the Admiralty do not understand ships and had specified too many nails in the first place. This sets in train a disastrous set of consequences:

“They self-certify to their warrant officer, who self-certifies to the midshipman, who self-certifies to the lieutenant, who self-certifies to the captain, who self-certifies to the admiral, who self-certifies to the Sea Lords that every nail is where it should be and the supply of surplus nails remains adequate to meet unexpected reverses. And they turn a profit, so everyone is happy and the crew are given bonuses.”

London Banker’s post is concerned with residential mortgage backed securities. But the point applies. Loose control produces both the returns and the information that suites those who have most to gain; but loose control also gradually erodes the hull of the institution. And once the water begins to seep through the timber, all too often it is an emasculated compliance officer that is sacrificed; a most convenient firewall between the authorities and the mandarins in the absence of a paper trail.

Decentralised structures extend the option of informal direction to those in the upper ranks of an organisation and put a lot of people with much responsibility and little power between senior bankers and the regulators. Fining the institution does not begin to address this problem of how elite individuals navigate organisational structures to secure their position and means.


Monday, 23 July 2012

Banks: A Loose Federation Of Money Making Franchises

The LIBOR fixing affair continues to throw up new information and insights which are mostly entirely predictable.  Consider two of last week’s front page news stories:

(1)    The FT led with a shock, horror story about collusion in fixing Euribor (the European equivalent of Libor) because a named Barclays trader Philippe Moryoussef  had allegedly organised collusive rate fixing with three other named individuals at Credit Agricole, HSBC and Deutsche. We did not before reading this story know the names involved in this new scandal. But the nature of the LIBOR (and Euribor) reporting process was such that we did already know that any kind of rate fixing must have required collusion between traders at several banks (and such collusion of course must then raise questions about the involvement of middling and senior management).

(2)    The Wall Street Journal led its front page on Wednesday 18th with a political analysis of the Bank of England. Mervyn King had appeared before the Treasury Select Committee and explained that the Bank of England was not suspicious about LIBOR rate fixing because nobody had formally told the Bank: “The first I knew of any alleged wrong doing was when the reports came out two weeks ago….we’ve been through all our records; there is no evidence of wrong doing or reporting of wrong doing to the bank”. This absence of curiosity is entirely predictable. From the Guinness stock manipulation affair in the mid 1980s to LIBOR rate fixing in 2012, wrong doing is uncovered  by American investigators who, in effect, oblige the uncurious Brits to take action.

There is something about the reporting of such news stories which connects one world of behaviour which is very English with another world of judgement which is New York Jewish. Mervyn King’s testimony to the Select Committee brings to mind that refrain from the Paul Simon song: “when something goes wrong, I’m the first to admit it and the last one to know”. Or, as Paul Simon’s psychoanalyst might put it: “how is it possible for these English elite technocrats to be so clever and yet lack all knowledge of self and others?”. And, of course, though the news stories are different each year, there is then nothing really new about that disabling absence of self knowledge and worldly curiosity in English elite figures who, like our prime minister, aspired to the top job because he thought he would be rather good at it.

 But, to be fair, we have learnt something new last week. The learning was about the internal organisation of banks from other witnesses who testified on investment bank rate fixing before the Treasury Committee and on money laundering in a US Senate hearing. We are already indebted here to anthropologists like Joris Luyendijk and Karen Ho who have described the processes of selection and acculturation which produce a dangerously conformist mentality inside banking firms which operate like silos. But last week’s public testimony by senior bankers In London or New York highlights larger questions about how the organisation of giant banks makes them unfit for purpose. Here we are taking up some of the issues which Joris raised some in his blog about out of control banks. 

Let’s begin with some generalities which should be familiar to anyone who has done an introductory course in organisation studies.  A firm is a space of bureaucratic coordination which requires internal hierarchy and division of labour which implies expectations and rules about what can and cannot be done at different levels, and runs partly on active instructions and permissions de haut en bas. Any organisation then requires individual and group initiative because rules and instructions cannot be complete and improvisation is required. But such improvisation operates within procedural limits so that, for example, authorisation of expenditure or breach of standard procedure usually requires some kind of signing off and a paper trail.

All this is a mixed blessing. The firm or any other large organisation is for bureaucratic reasons typically an inflexible, unreflective economic and social actor with a limited capacity to respond to how things have gone wrong or indeed to recognise that things have gone wrong or will go wrong. Think about BP’s succession of accidents and environmental disasters  after the Browne led  mergers had created  a much larger firm where operating control was a major unresolved problem; or, worse still, think about how hierarchy allowed the Catholic Church to cover up child abuse in many jurisdictions.

But the investment bank illustrates two different problems which make investment banks like Barclays or retail banks like HSBC positively frightening, not just poorly controlled like BP or unintentionally collusive like the Catholic Church. On the basis of last week’s testimony in London and New York, the present day investment bank is a thoroughly informal organisation where many things, including gross rule breaking at middling levels, can go on without formal authorisation. The bank actively institutionalises the insouciant lack of concern passively manifest in elite English individuals.

On Monday 16th, Jerry del Missier, the recently departed chief operating officer of Barclays appeared before the Treasury Select Committee and gave an account of how Barclays came to ‘lowball’ its Libor submissions in the aftermath of the phone call of 29th October between Paul Tucker of the Bank and Bob Diamond at Barclays, which led Diamond to produce an email note. There was, to put it neutrally, a misunderstanding at this point about whether the Bank was instructing Barclays to lowball (because of the public interest in making Barclays look sounder than it was).

The interesting point is that, along the internal chain of command at Barclays, all the instructions were verbal, even though the instruction was for Barclays to do something irregular at the (second hand reported) invitation of the Bank of England.

The internal chain in Barclays ran from Diamond to Jerry del Missier as co-head of investment banking to Mark Dearlove as head of the money market desk. “ Yes it was” an instruction said del Messier in last week’s testimony when he claimed he had “passed on the instruction as I received it” And how did Del Messier receive it? The FT reported:   “in a phone conversation the day before he received the email note” from Diamond which did no more than report another phone conversation with Tucker.

Let’s pause here. Barclays is clearly not an organisation of the staid, formal kind which most academics will be familiar with.  Let us hypothetically suppose the nearly unthinkable. Some senior authority outside our University (for whatever reason) wants to adjust the academic grades on our degree programmes.  That would require written orders down the chain, then a series of committee meetings so that all those affected could discuss any concerns about issues of authority and implementation. And the committee chairs would be expected to have a written instruction from an external point of origin after, for example, the university’s academic registrar had forwarded an outsider’s direct and explicit email instruction to fix the grades (rather than the registrar’s recall of a phone call).

The investment banker’s counter argument is that such formal bureaucratic safeguards are quaintly inappropriate in the fast moving world of banking: “just do it” because there is no time for all this procedural stuff which still regrettably clutters up the hierarchical public sector. But that raises a serious question. What protects economy and society if the investment bank (as organisation) does without the bureaucratic safeguards which in other cases protect us from compounded misunderstandings and active malpractice? Because, in this world of informality, junior bankers at desks will simply follow verbal orders from their team leaders and their seniors may have a very limited knowledge of what is informally going on at the lower levels.

The social protection is supposed to be supplied internally by a bank’s internal compliance department which enforces standards and polices wrong doing. But, the ineffectiveness of such arrangements were dramatized on Tuesday last week when senior HSBC executives appeared before a US senate hearing to explain how and why HSBC had, despite repeated  US regulatory censure and internal whistle blowing, continued to allow drug proceeds from Mexico to be laundered through the bank and allowed terrorist financiers to obtain US dollars.

David Bagley, HSBC’s chief compliance officer since 2002, admitted to the US Senate that his position lacked any power. As the FT reported, on his own testimony, David Bagley did not control compliance in national affiliates like Mexico because his job was only “to set policy and to escalate issues that were reported to him”. This was front page news partly because of Bagley’s tactical resignation from the job on the day he testified.

But, the largely unreported parallel Senate testimony of Paul Thurston, HSBC chief executive for retail banking and wealth management, was even more devastating; not least because it described an absence of control and rules in retail banking where customers and regulators would quite reasonably expect them. The key exchange was with Senator Levin:

Sen. Levin:  Why did these things fester for so many years at this bank [HSBC Mexico]? This isn’t something discovered in hindsight, this is something that people knew was going on at that bank. Why was it allowed to continue?

Thurston:  The business model was complicated and decentralized. It was very difficult for the center to get controls.

The difficulty of central control was separately explained by Thurston:  

“It became apparent that decision-making process concerning Anti Money Laundering were not satisfactory [at HSBC Mexico]. Over time, it also became clear that this was not only a question of process and technology, but that the underlying business model needed to be examined. Branch managers operated as local franchise owners, with considerable autonomy and a focus on business development, reinforced by an incentive compensation scheme which rewarded new accounts and growth, not quality controls.  

Banks and banking are defined in most dictionaries in terms of business conducted and services offered. In organisational terms, after last week’s testimony, it might be fairer to describe a bank as a loose federation of money making franchises (with always troubling and sometimes dire economic and social consequences).

Dyfal Donc

Thursday, 12 July 2012

The New World Of Finance Politics

It has been a depressing few days for democrats, and especially for those democrats worried about the power of business.   The shiftiness of Bob Diamond and the extraordinary innocence of Paul Tucker about money market practices coincided with the publication of two reports that highlight the way corporate interests are organised to shape public policy in the UK.  Democratic Audit, which has now been auditing democratic practices in the UK and elsewhere for over twenty years, published its fourth audit of democracy in the UK. (Downloadable at  The Bureau of Investigative Journalism meanwhile published the most comprehensive and well researched study we have yet seen of the lobbying activities of interests in the City of London (downloadable at  The section in Democratic Audit’s report on accountable government, combined with the Bureau’s investigation of the web of corporate patronage spun by the City, together give us the essential background to the extraordinary arrogance revealed by the behaviour in the Libor scandal and the astonishing blindness to this behaviour displayed by senior regulators like Mr Tucker.

What these two reports show is a fundamental change in the recent decades in the way business has exercised power in the UK.  Some of this change is due to factors external to business itself, factors that are a major theme of the work of Democratic Audit.  These changes are atrophying the official institutions of democratic participation.  The two most obvious indicators concern voting in general elections – the single most important summary sign of the health of national democracy – and the membership of the political parties.  Voting offers us a paradox.  In the last couple of decades voting opportunities (referendums, elections for devolved systems of government, elections for mayors and even now for police commissioners) have proliferated; but turnout has declined.  Meanwhile the mass party – the capillary tube of the democracy – has simply vanished: parties that a generation ago had millions of members now typically have less than 200,000. The Westminster parties in particular have shrunk to tiny cadres of professional careerists. 

The decline of these institutions and practices has created a vacuum now being filled by other institutions and interests. This is how we should understand the new world of corporate lobbying documented by Democratic Audit and, especially, by the Bureau of Investigative Journalism’s work on the City.  A generation ago business had to work alongside, and often in opposition to, powerful institutions of civil society: a trade union movement with large and well organised membership in the private sector; political parties that could rely on mass membership to generate the bulk of the money that they needed.  Business certainly exercised power, and the City in particular exercised great influence through a network of informal contacts, mostly funnelled through the Bank of England.  But the decline of so many countervailing influences in civil society, and especially of the mass party, has created the opportunity for much better organised, and more pervasive, corporate influence.  The new world of City politics revealed by the Bureau’s work shows, in particular, three profound developments.  The first is the colonisation of the parties through the use of money.  Since corporate lobbying is opportunistic this mostly affects parties in office, or those with a reasonable prospect of office: this explains the surge of financial support from the City for the Conservatives since David Cameron’s assumption of the leadership in 2005, closely documented in the Bureau’s report.  The second is the pervasive infiltration of City interests into the institutions of government.  Of the many instances of this penetration in the work of both the Bureau and Democratic Audit, one of the most revealing and hitherto neglected is the way City interests have colonised the House of Lords: 16 per cent of active members of the House (124 out of 775) declare paid positions in finance firms.  And that’s only the most minimal measure of connection, based as it is on a declarable interest.  The significance of this is simply not appreciated, because the significance of the Lords is not appreciated.  The second chamber is no longer a joke.  The Life Peerage reforms (dating from 1958) have transformed the institution.  It is now a much more expert and competent body than the Commons, and much the better place for interests to shape the detail of policy and legislation.  And in financial regulation it is the detail that matters.

The third great change is probably the least appreciated of all: the City has revolutionised its internal government.  The Corporation, until recently a mostly charitable and ceremonial body, has been turned into a largely autonomous governing institution for the richest bit of territory in the UK.  And, as the Bureau’s investigations show, it is turning its considerable firepower – money, and the advocacy skills that money buys – into a sustained promotion of the interests of the finance sector.

In the wake of the report from John Vickers’ Commission, and the most recent banking scandals, attention has, quite reasonably, focused on the problem of the substantive reforms of the banking sector.  But reform of institutions and business practices is not enough, and indeed will probably be impossible to achieve until the power of the City as an organised lobby is confronted.  The Bureau’s work, and the continuing work of Democratic Audit, is a start on that long hard road.


Monday, 9 July 2012

On Banking 'Culture'

Within the press and blogosphere much has been made of Bob Diamond’s note which implies senior officials at the Bank of England and in Whitehall gave Barclays implicit consent to under-report their LIBOR submissions. Such an event, if proven, would be devastating to popular trust in our political and regulatory establishment. For decades our elected leaders granted finance unprecedented privileges and freedom to maraud. The outcome of that freedom was a growing sense of invulnerability that still pervades the trading rooms of major banks today. So it is important, with the mute sense of collusion between regulators and regulated still lingering, to understand these internal cultures and behaviours within the structures that nurtured them.

Last Wednesday’s timid Treasury Select Committee meeting with Bob Diamond was a typical affair, with lots of self-righteous indignation but few probing questions which got into any level of analytical detail about the structural pressures and context of moral laxity. The refrain of the committee, and most likely any Parliamentary Inquiry that may follow, is that banks have a ‘cultural’ problem, and that this needs to change. Like giddy, overexcited children who knock things over at parties, it is assumed bankers can be taught to calm down and behave simply by giving them a stern talking and getting them to admit fault; only then can they be pushed back safely into the melee. ‘Bankers have got carried away’ we are told ‘and so need to take a long, hard look at themselves’.

Cultures set the boundaries of what is and is not permissible. Those rules are not necessarily spoken, they are rooted in behaviour and patterns of reward. When a CEO says ‘we want no more of that sort of thing’ and then increases derivatives trader bonuses, it is the reward rather than the words which reproduce that culture. These are the structures of culture. True, it is important to remember there are different ‘tribes’ with different cultures within banks (there is good journalistic and academic work on this), but it is also true that banks are hierarchies which impose a broader and more potent disciplinary logic: to maximise income for the senior traders. Donald MacKenzie in his most recent revisionist work, refers to this as the principle of ‘maximising Day One P&L’ (for the elite workforce), which often engulfs these silo cultures.

This ‘engulfing’ is what we really saw in this LIBOR fixing scandal: the normalising force of a culture which puts individual bonuses (not institutional profits) at its centre. What is perhaps most startling about the findings of the FSA, is not just the cavalier and open way with which corrupt practices were conducted, but the finding outlined in paragraph 8 of the proceedings which states:

 “Barclays acted inappropriately and breached Principle 5 on numerous occasions between January 2005 and July 2008 by making US dollar LIBOR and EURIBOR submissions which took into account requests made by its interest rate derivatives traders (“Derivatives Traders”). At times these included requests made on behalf of derivatives traders at other banks. The Derivatives Traders were motivated by profit and sought to benefit Barclays’ trading positions.” (my emphasis)

That employees from Barclays were willing to manipulate their own institution’s reported borrowing rates, (with uncertain effects for their employers), to benefit an individual at a competitor company says something profound about banking culture and the structures which support it. It tells us that the boundaries within and between institutions are fluid and that banking culture promotes, perhaps even exalts, the maximisation of personal gain, even if that means building and maintaining interpersonal networks across institutions.

So what is the purpose the institution under such circumstances? Classically in the ‘theory of the firm’ literature, firm boundaries are rigid: they exist to minimise transaction costs (the Coasian perspective), or to manage agency problems (the Jensen and Meckling perspective) or to protect and coordinate certain skills and competences (the Teece et al perspective). All of these theories presume that the firm ‘contains’ activity and in doing so performs some functional purpose for the broader economic good. None of them adequately explain banks. Banks represent something different: an institution captured by its elite workforce, where the purpose of the firm is to act as both shield and sword for its captors. The institution provides cover for the manipulation of prices and markets, for the proliferation of asymmetric information from which private gains are made. The current banking firm allows privacy and insiderism to flourish and incentivises strategies of position, disguise and deception. The outcome is akin to what Akerlof and Romer (1994) described as ‘looting’: maximising individual rewards at the expense of the institution when accounting is poor, regulation is lax and there are few penalties for abuse. The individuals take from the trading profits and the institution is left with the liability.

Psychologically, this is a difficult thing to grasp for the many politicians and regulators who for most of the 1990s and 2000s were absorbed by discussions about financial innovations that improved capital allocation and market efficiency and new whizzbang models that distributed risk away from the financial core, which all justified the need for light touch regulation. In doing so they forgot the crucial point that banks are run by people, and that markets involve a series of intermediated formal and informal agreements between individuals. The problem with banking is that the interests of the individual and of the institution are not necessarily aligned. Modern banking is particularly prone to looting, most obviously because the looting can only go on as long as the institution remains solvent, which is a long time when there is a State bailout guarantee. But more elaborately looting is possible because the presence or absence of profit on a particular trade or at the firm aggregate relies on the quality of the numerical inputs and valuation models used when assigning a price to often complex derivative assets on the balance sheet. Banks are conversion centres: they turn assets into income streams and income streams into bonuses. When derivatives traders ask someone on the cash desk to fix LIBOR, that affects the value of an asset which flatters the return on that trade. It produces, not profit, but the simulacrum of profit. And that is looting.

Of course Barclays no longer uses LIBOR to price many of its interest rate products. The game moves on. It now uses much more complex calculations to value its assets. On its valuation of collateralised interest rates it uses:

“Overnight Index Swap (OIS) rates…to reflect the impact of cheapest to deliver collateral on discounting curves, where counterparty CSA (Credit Support Annex) agreements specify the right of the counterparty to choose the currency of collateral posted”

And on interest rate derivative cash flows it uses:

“…interest rate yield curves whereby observable market data is used to construct the term structure of forward rates. This is then used to project and discount future cash flows based on the parameters of the trade. Instruments and optionality are valued using a volatility surface constructed from market observable inputs. Exotic interest rates derivatives are valued using industry standard and bespoke models based on observable market parameters which are determined separately for each parameter and underlying instrument. Where unobservable a parameter will be set with reference to an observable proxy. Inflation forward curves and interest rate yield curves are extrapolated beyond observable tenors”.
Barclays Annual Report & Accounts, year ending 2011, p234

Given what we know from the past week in banking, we are entitled to ask ‘what does that mean’? Do these accounting values from which revenues are booked and bonuses paid reflect the underlying reality of their financial position?

When you price assets using inputs of uncertain verity which are run through models of great complexity, it is tempting to assume that such convoluted calculations are designed to avoid writing down the value of assets. This would have an income effect and reduce the pot from which bonuses are paid. Do these accounting numbers present the simulacrum of solvency, which avoids the day of reckoning and allows the continuing payment of high incomes to senior bankers? It is something of a curiosity that just as the economics profession has become more and more concerned with finessing ever more complex models, so the financial sector has become acutely aware of its own sociology: a reflexive understanding of the signalling power of numbers. These are active numbers reported to elicit an effect in the future, rather than passive numbers designed to faithfully depict an image of the present. Thus LIBOR is not the rate at which you access unsecured funds, LIBOR is the signal to investors that everything is under control, or that a trade has been particularly profitable.

For many years here at CRESC we have had a growing sense that the instruments of finance have been put to different use from that originally intended. It is quite another thing to think that the most fundamental institution of the capitalist world, the public limited company, is itself being arbitraged in the interests of its elite workforce. But when a bank becomes a tower of assets built on the quicksand of confidence, the incentives to signal good news through numbers is great. It may well be that the more fundamental crisis going forward is not whether there was collusion between regulators and regulated, but whether – again – there is a collective loss of faith in the quality of the accounting data produced by these institutions.

This takes us back to structures. The culture that arises within banks is the product of particular structures, or rather the absence of structures, at three levels: accounting systems, organisation and activity level.

It is clear that the accounting numbers need to better represent the financial position of these organisations. There is too much leeway granted to these institutions to value their own derivative products – it gives rise to huge conflicts of interest. Much of this problem emanates from the pursuit of Day One P&L, which is largely an accounting phenomenon. As a basic start we should reconsider accounting rule HKAS39 which allows this practice to continue. As we have argued elsewhere, if costs were booked upfront and risks calculated non-normally it would mean most products would book immediate losses and only produce profits later in the product cycle. It would therefore tie in bonus pay to the long term performance of the particular products created. Similarly the structurers of those products would have to contemplate counterparty risks going forward, and thus think reflexively about whether they were passing on ‘too much’ risk to others – rather than current practice which is to maximize volume and pass off risk via a swap and consider it ‘somebody else’s problem’.

At the level of the organisation and activity, it is naïve to assume that banking culture will embrace restraint and responsibility without significant structural reform. That reform must take as its core organisational principle that banks must become public utilities with the duty to serve the wider economy. This is a considerable political challenge, and one that must begin by uncovering the patterns of patronage that fostered ‘light touch’ and nurtured the culture of invincibility in the City. Only then can an honest review take place of what needs to be done. Our recommendations are outlined here, in our Deep Stall Paper.


Thursday, 5 July 2012

Haldane And MacKenzie On Gaussian Copulas

I had the privilege of hearing the Bank of England’s Executive Director of Financial Stability, Andy Haldane speak at the University of Edinburgh on the 8th June. Haldane presented his new paper. For those familiar with Haldane’s output, this continues his familiar style of jargon-free prose and ideas expressed with unerring simplicity and logic, supported by an impressive armature of complex empirical exhibits. This paper moves beyond previous concerns with the scale of bank balance sheets and the problems of interconnectedness in complex systems, and instead begins to unpack the theoretical assumptions that underpin dominant neoclassical theories of mathematical finance and form the skeleton of many financial products.

His argument is that the normal or Gaussian statistical distributions (the bell curve) that are at the heart of these assumptions do not accurately describe huge swathes of human and natural phenomena, whether it is the volume of monthly rainfall, earthquake intensity over time, the occurrence of unique words in novels, historical prices in rice spot markets or equity markets, or even annual growth in GDP or real bank loans. These examples are instead characterized by non-normal or ‘fat tailed’ distributions, where extreme events are much more likely to occur than Gaussian distributions imply.

Such ideas are not new: Nassim Taleb and Benoit Mandelbrot have argued this point for some time. But Haldane’s novelty lies in his history of ‘normality’, which outlines the migration of Gaussian principles from the physical sciences into economics and mathematical finance. Haldane’s view is that this migration is part memetic transmission across the sciences and part inspired by a kind of primordial desire for symmetry within the human brain which makes normal ‘bell curve’ distributions appealing in a very aesthetic sense. Breaking with normalcy is therefore difficult but essential if financial regulation is to do what is now done in meteorology, where complex computer systems using non-normal models have been better able to predict and prepare for weather system risks. Haldane’s conclusion was that it is only by using non-normal, fat-tailed models and mapping system risk that the effects of financial crisis will diminish over time.

Haldane’s work has again introduced many thought-provoking observations on the world of banking and finance, as well as practical solutions for how it might be better regulated. But I am still left with one misgiving, which was expressed in our earlier CRESC work on Haldane: that weather systems have neither the capacity nor the incentive to game those non-normal models or maps of system risk once introduced. Finance does, and therefore the extent to which the methods used to prepare for fat tail events in the natural world can be transposed effectively to the world of financial regulation remains moot. Perhaps for that reason I am more receptive to Taleb’s view – that there are limits to the predictive power of statistics in complex systems like finance, and so the job at hand is to make the system smaller and simpler.

Haldane’s convincing empirical exhibits demonstrate the prevalence of fat-tail distributions in many walks of life. But they do raise an interesting paradox: why do banks – or perhaps more accurately the quants working within banks - persist with Gaussian models if normal distributions in economic and financial systems are so very rare? This was the interesting start point for Donald MacKenzie, Professor of Sociology at Edinburgh University, whose paper followed Andy Haldane’s.

MacKenzie’s answer, based on a detailed ethnography of bank quants was that the majority simply do not believe in Gaussian copula models. MacKenzie’s story is one of quants married to the aesthetic of mathematical purity and rigour, who embrace the elegance of a model like Black Scholes, but hold little regard for the Gaussian copula. This is a problem when most financial risk measures like Value at Risk and the structuring and pricing of financial products, like CDOs are built upon Gaussian principles. So why continue using them? Here, MacKenzie argues, the reasons are rooted fundamentally in culture – an ‘evaluative culture’ with Gaussian copula models at their centre, where exit costs are high. Those exit costs relate specifically to the aim of securing ‘Day One P&L’ – the lump of risk free profit on a deal from which bonuses are allocated.

MacKenzie explains that if non-Gaussian rather than Gaussian assumptions were used in the measurement of risk, then Day One P&L would be much smaller and perhaps even impossible to calculate because many more risky scenarios and unanticipated events would need to be priced in: the lump of profit would not be ‘risk-free’.

This finding very much chimes with discussions and briefing notes that were passed around the secretive ‘dark pool’ exchange that is CRESC whilst writing our book. These ideas broadly suggested that the role of derivatives in banking had been misunderstood. That a Credit Default Swap was not necessarily a tool of risk management or an instrument of wanton speculation, but a vital component in underwriting bankers’ high pay. If securitization was always about bringing forward revenues from the future and realizing them in the present, then derivatives played a vital part in passing on the uncertainties of the future to another party. Thus various swaps would enable banking divisions to strip default risk, interest rate risk etc from the block of revenue on a deal, leaving behind a notionally risk-free lump. Locking in ‘arbitrage profits’ for example by holding AAA securities, financing them with a repo and selling on the default risk via a CDS, would enable the deal brokers to get the revenues onto the P&L and claim their bonus. Of course, this incentive encouraged the expansion of a vast transaction-generating machine, as mortgage volumes were ramped up and worked through the CDO mincer, while risk was passed on to naïve operators at AIG and monoline insurers. The result: system-wide counterparty risk that blew up spectacularly in the aftermath of Lehmans collapse.

Two things emerge from this for me. First, an intellectual question about where performativity theory goes from hereon in? My (albeit limited) understanding of Callonian influenced writing (with which MacKenzie has aligned himself in the past) is that economics performs the economy – it creates the economy in its own image, provided the correct assemblages can be mobilised to bring those assumptions into reality. What MacKenzie is now describing, it seems to me, is something quite different: that the desire to maximise Day One P&L (a financial incentive in other words) influences the models used within specific evaluation cultures, even though those models appear to bear little relation to empirical outcomes over time. This is not a million miles away from questions we have been asking for some time: why those models and why those models at that time?

Second, it also raises an interesting question about how you might regulate such institutions going forward. If that evaluative culture could change, and that non-normal models were used to price in fat tail events, it would remove many of the more pernicious incentives we currently see in the banking sector. If lawyer and accountancy costs were booked up front on deal and revenues were not realized immediately, those products would initially be loss making, and only become profitable after a period of years. It would therefore tie in bonus pay better to the long term performance of the particular products created. Structurers of those products might also have to contemplate counterparty risks going forward, and thus think reflexively about whether they were passing on ‘too much’ risk to others – rather than maximizing volume and passing off risk as ‘somebody else’s problem’. It may also resolve intra-firm moral hazard when many ‘innocent’ bankers are penalized by excessive risk taking in another banking division which causes the value of their bonus options collapse.