So, define 'talent'...

Ask anyone within the apologencia of the financial services industry why bankers are paid so much and the stock answer you will receive is that in a knowledge-based world, talent is the key source of competitive advantage; and so banks pay the market rate to retain talent and remain competitive. But with banks across North America and Europe still on central bank life-support, how well does this argument stack up five years on from the 2007 crash?

The apologists’ answer is to emphasise recent hardships and the perennial threat of talent flight. In terms of hardship, many emphasise that talent have lost their jobs and have lower bonuses (than last year). Others argue that the shift towards non-cash, deferred bonuses has robbed talent of its deserved payout because an individual’s pay is now more reliant on the performance of their company’s stock, over which any one unit of talent has little control. The 50% tax rate on high earners also pushed talent to the brink, so that further attacks on their pay could potentially lead to talent flight to competing sectors in Switzerland, France, Germany, Hong Kong and Singapore. And that is some threat, if we are to believe Nick Clegg’s recent assertion that without the tax paid by financial services during the 2000s, there would be little public sector job growth outside of London (though we shouldn’t because it is patently incorrect).

For all the made-for-TV, strategic emotion around the loss of banking talent, are we in danger of becoming paralyzed by the fear of losing something that perhaps wasn’t really there in the first place? Answering this question really depends on what we mean by ‘talent’ and how we understand the relation between skill, performance and reward. Is talent something you have, or something you demonstrate? And is reward something that reflects your achievements, or reflects the context within which your achievements take place? These questions are all the more pertinent at a time when billions, perhaps trillions, of central bank money is being poured into the UK’s financial institutions, yet so much still ends up in the pockets of a very select few. By what metrics might we know ‘talent’? By what achievements might we award it its name? Perhaps we might gain some insight by briefly looking at the particular history of the term.

The etymology of the noun ‘talent’ is interesting in its own right. In its first meaning, dating back to the ninth century, ‘a talent’ was an ancient weight or a money of account widely used by the Assyrians, Babylonians, Greeks, Romans, and others so that, for example, a Babylonian silver talent was equal to 3000 shekels. By the early 17^th Century the themes of measurement, value and field of application were transposed to the realm of human endeavour: ‘talent’ defined an aptitude for something expressed or implied. Talent was given its name only in a particular field, where superior skills could be assessed, valued and valorised.

But like many English words and phrases with such history, there is blur, overlap and polysemy as the ebb and flow of language carves new distributaries which divert from the main stem. ‘Talent’ again around the 17^th Century also took on an additional meaning, one with a quasi-spiritual accent. This second ‘talent’ was used to describe a divinely entrusted power or ability of mind or body; one that required space and nurturing to flourish. This talent had no referable field of application, this talent was mercurial and precocious, embodied and thus inimitable, but also boundless in its application.

It is this latter ‘talent’ that is now summonsed in the defence of bankers pay. It is an abstract talent that is not only portable but - like fairy dust – has the ability to transform whatever or whomever it touches: it is dextrous and dynamic so that it can be applied to any industry, any field. In a knowledge-based economy, this is the kind of talent that all organisations want, and are so desperate to pay for.

This quasi-spiritual definition is particularly convenient for the apologists of finance. It allows all economic questions to be framed in terms of the need to provide freedom for and reward god-given talent, and the important of talent-friendly legislation to attract it to these shores. But evidence of genuinely portable, transformative talents are rare. Even in the cultural industries where the uniqueness of talent is perhaps unparalleled, there are profound limits to its effects when applied to new domains. Take a superstar like Madonna for instance, despite an illustrious musical career her acting career has earned her a record five Golden Raspberry Awards; while retiring sports men and women notoriously struggle to repeat their successes in other fields, often leading to feelings of social dislocation and depression.

So let’s be more grown up about it. Talent is not fairy dust and skill and expertise have a very specific context within which it is best applied. That doesn’t discount the possibility that specialised skills can make large differences in niche areas, which may justify large rewards. But that then means we need some kind of activity or operating measure to gauge the presence or absence of ‘talent’.

In banking arguably the most appropriate operating measure of any banker’s skill is the return on assets figure: ‘how much net return can you generate from the assets you purchase or create’? Here, the figures are illuminating. The table below uses the 2011 results for Barclays (though we could have used other years and other banks). It shows that in its capital markets arm where the best paid bankers work, Barclays Capital, actually shows a disappointing return on assets – lower than Barclaycard, their retail arm and ‘other’ activities. Furthermore it tells us something of the precariousness of the monestised asset values from which elite bankers draw their high pay. Barclays Capital makes more pre-tax income than any other segment and roughly 50% of the group total, but it does so by stacking an astronomical £1.16 trillion of assets onto the group balance sheet, which was 75% of the group total (and staggering only a little less than UK GDP, which was £1.44 trillion in 2011). Here the value of BarCap’s assets would need to fall a mere 0.25% to completely wipe out the segment’s pre-tax profit; 0.5% to wipe out group profits; and 3.5% to wipe out its profits and Core Tier 1 Capital (valued at £43,066m).

As we know, the value of these assets do fall and when they do, the repercussions for other stakeholders are dramatic. The table below presents a stakeholder analysis of the top 6 UK banks from 2001-2009. It presents the cumulative average gains for the state (tax income received and direct bailout expense) for shareholders (capital gain/loss and dividends) and for the workforce (staff costs) across the five institutions.  The bailout figures do NOT include the bailouts of Northern Rock (£25bn, 14 Sept 2007) and Bradford and Bingley (£42bn 29 Sept 2008); or emergency loans to HBOS & RBS October 2008 (totalling £62bn); or special liquidity scheme/credit guarantee scheme (£500bn in total); or asset guarantee scheme 24 Feb 2009 (£325bn). The shareholder figure is for total capital gains/losses and dividend payouts and does not measure returns to shareholders owning shares in 2001. So this figure, if anything, understates the diverging fortunes of different stakeholders.

It would be difficult to credit those bankers at the heart of the leveraged, CDO boom ‘talented’ by these graphs, even if they do have an impressive record of educational attainment. In the same way that I would struggle to justify the same term myself if, despite any apparent intelligence and skill, I chose only to teach my students through the medium of mime and blew my departmental budget on powerful hallucinogens which led me to perform demented shamanic rituals on the ashes of my unmarked exam scripts. Talent must be recognised in a particular context, and if the results disappoint then you have to raise serious question about whether those skills are appropriate for that industry, whether high pay is merited, and whether we should be thinking of these people as ‘talent’ at all.

If talent should be judged by performance, and performance is disappointing, how do we explain the endurance of high pay norms then? It may simply reflect two key industry features: i) the revenue earning capacity (NB not profitability) of an industry or field and ii) the number of other charges and claims on that revenue stream. The best paid UK academic will always command a lower price than the best paid UK banker, not because the banker is better in some market for abstract talent, but because a university has an externally imposed revenue ceiling (student quotas, the resources available from funding bodies etc) and a range of administrative, teaching and research costs which mean claims on revenues are distributed amongst the many rather than concentrated amongst the few. Similarly, a graduate with an engineering or physics PhD will be differently remunerated depending on the industry in which he or she chooses to work. Those skills may add equal value in manufacturing or finance, but they will be more generously remunerated in finance because there are a relatively smaller set of claims on that quantum of revenue. The central claim of our 2006 book still stands: high pay is a function of position, not necessarily talent. The real reason elite bankers are paid so much is because they are a small group of interconnected individuals close to a big till.

This ‘big till’ and its attendant high pay norms are a dead weight loss. A dead-weight loss refers to a situation where an implied subsidy or some other distortion leads to an allocative inefficiency. It is usually used by neo-classical economists to describe the distorting effects of taxation, minimum wages etc on a free market. It has even been used by bah-humbug-ers to describe the net losses of gift-giving at Christmas. But here it could be used to describe the effects of a bailout guarantee on the unit value of elite labour. Bank bailouts have had two effects. First they have kept banks on life support and allowed the continued payment of high fees to elite workers, when by rights banks should be cutting costs and writing down debt. Second, with QE, central banks have reduced the costs of capital to banks, allowing them to ramp spreads on their outstanding and future loans – thus providing funds to both recapitalise and maintain pay norms, while passing on costs to their customers (as well as taxpayers and the public sector). This would not happen in any other distressed business, where the workforce would immediately bear the brunt of adjustment.

The big till is underwritten by government and central banks. But what are the social returns? The social dividend is limited by problems of insider claims and opportunity costs. On the former, for example, the generally accepted view of the mutual fund industry is that actively managed funds pay more for their stock pickers than those passive funds who simply buy the index, but that active funds underperform passive funds (eg Gruber 1996). Further studies suggest that net returns to investors are negatively correlated with a fund’s expense levels, which are generally higher in actively managed funds (Carhart 1997). In purely economic terms, this means that talent is overpaid on a marginal cost basis: the skill of active stock pickers may allow the fund to generate superior gross returns, but they incur higher costs from transactions, information and pay, so that net returns to investors are lower. Put in the language of ‘claims’, this is the same as saying that any benefits which might accrue from more accurate stock picking are captured almost entirely by insider talent working within actively managed funds. The same may also be true of activities like high-frequency trading which involve eye-watering sums spent on algorithm-builders, code-writers and telecoms infrastructure which improve latency by milliseconds and give traders manning the war machines of finance fleeting advantages. Returns on individual trades may be marginally higher, but those gains are largely claimed by insiders within the bank. Outcomes for markets are as yet unclear because it is open to all kinds of socially useless wargaming, while returns to investors appear modest and may disappear quickly. And, as Knight Capital’s investors can attest, it may leave your capital exposed to unforeseen software malfunctions and other unanticipated interactions in complex systems – the likes of which Charles Perrow has discussed.

If the higher returns that accrue from modest or superior performance are captured by a small number of insiders, then we need also to think about opportunity costs. That is – if those skills were applied to another area of the economy, would they improve the national economy relatively? If, rather than spending their time writing code for high frequency trading, the same skilled engineers and mathematicians developed new software for high tech manufacturing or green technologies or some other high skill, technology intensive industry, would they produce more jobs, more spin-off activities, more economic multipliers etc? I have no data or study to answer this question (and it is a complex one because HFT clearly creates its own demand for high-tech telecommunications investment), but my hunch is that on balance, they may well do. Skilled workers would undoubtedly be paid less in other non-finance industries, even if their net economic contribution were greater. Is high pay in finance therefore more a market distortion rather than a sign of an efficient market for talent?

It seems that the ‘market for talent’ metaphor is inappropriate when explaining high pay in banking. Activity performance by any measure has been poor, which suggests that whilst these individuals clearly have skills, they cannot be considered ‘talent’ in many instances. Similarly high pay is only possible because the industry is heavily subsidised and operates in a permissive, lightly regulated environment. Their talent is not ‘bid up’ due to its scarcity nor its transformative power. Even at the peak of the boom surveys like that conducted by Deloitte found that only very small numbers of CFOs within financial services claimed there was an ‘inadequate’ supply of talent (defined as “high potential individuals likely to excel in finance”). With such a thing in mind, perhaps the role of the banking institution is not to put a ceiling on elite bankers pay, but rather to put an implicit floor under it by sanctioning certain high risk, high volume, low return activities and creating positions which allow a select few insiders to value skim for considerable personal gain?

Stanley

“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 SalzReview@barclays.com”.

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

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 18^th 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 16^th, 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 29^th 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

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.

Stanley