Monday, July 23, 2012

Is Banking Unusually Corrupt?

Is Banking Unusually Corrupt? Gary Becker

Financial intermediation was formerly dominated by commercial banks that borrowed short term and lent long term to local and sometimes national businesses. In those days, banking leaders denoted solid, respectable, if not very imaginative, individuals who were the pillars of society. Commercial banks are still important, but modern financial intermediation is dominated by investment banks, mutual funds, and hedge funds that often invest large sums of money in equities, derivatives, and other mainly risky assets, including junk bonds.

Has this change in the nature of modern banking changed also the type of individuals who enter banking toward those who are more likely to be more corrupt and of lower character than the traditional banker? An April 2010 study in The Daily Beast, in partnership with the think tank Transparency International, listed the 17 most corrupt industries. Wall Street/ Securities was in fact number 2, but number 1 was Utilities, and numbers 3-5 were Telecommunications, Construction, and the Media. Traditional banking was among the remaining industries that were mainly other heavily regulated industries, such as mining, insurance, oil and gas, and pharmaceuticals. It is not clear how much weight to give to this and similar studies, but I believe two factors do encourage somewhat more corrupt individuals to enter modern banking.
Highly regulated industries tend to attract some business leaders who are willing to cut corners and try to avoid and evade regulations, and have the regulations changed if necessary, when these methods would greatly increase their incomes. Businessmen who fully conform their behavior to the regulations, and try not to influence the regulations, would have difficulty competing against these other types. Very extreme examples of the effects of extensive regulations are participants in industries that are illegal, including the sale of drugs like crack, or prostitution. These industries are dominated by violence and intimidation of regulators.
Violence is not common in legal but highly regulated industries like banking, but heavy and onerous regulations provide financial incentives to try to avoid regulations through both legal and illegal means. One way around regulations is to encourage the regulators to take a largely laissez-faire approach. Many banking regulators did just that, as Posner indicates, in the years leading up to the financial crisis. Another way is to influence the regulations that get enacted through extensive lobbying of government legislatures and executives. Banking invests a lot in lobbying in Washington and capitals of other countries. Encouraging favorable actions by regulations and favorable regulations themselves do not per se imply that industry leaders are corrupt, but corrupt individuals would be willing to go further and in directions that more scrupulous individuals would not.
In addition to being highly regulated, modern banking invests many billions of dollars. This provides opportunities to earn enormous incomes in perfectly honest and respectable ways, as do the great majority of money managers and bankers. But it also provides huge financial incentives for individuals to cheat their investors, as in the infamous Bernard Madoff version of a Ponzi scheme. These schemes involve paying off some investors with money borrowed from others in ways that appear to provide investors with high and stable returns. They are named after Charles Ponzi, who in 1920 cheated investors on a much smaller scale than Madoff through the use of international postage stamp coupons. Madoff’s scheme cost investors many billions of dollars in what is considered the largest financial fraud in American history.
Management of large amounts of money also induces the entry of some dishonest individuals not only as company leaders, but also at much lower levels, as with so-called rogue traders. These are lower-level individuals who invest unauthorized large amounts for the companies they work for, and where their incomes and employment depend on how well they do. The latest widely publicized example is the “London Whale” trader from the generally well-managed JP Morgan investment bank. He took excessive risks in the market for credit default swaps. These bets went undetected by the leaders of this bank, and ended up costing the bank several billion dollars.
I am not suggesting that the majority of modern bankers are corrupt, for that is patently untrue. However, a highly regulated industry that manages enormous sums of money is likely to attract more than the average number of individuals who are willing to cut corners and violate regulations and laws, and sometimes their own company’s rules, in the attempt to make very large incomes for themselves.

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