Is Banking Unusually Corrupt, and If So, Why? Posner

One has the impression—no more than that, but it is difficult even to imagine what “evidence” is obtainable that could confirm or refute the impression—that imprudent, unethical, unlawful, and downright criminal behavior is more common in large financial institutions (“banks,” as defined in the next paragraph) than in other, and otherwise comparable, business firms. Much of this behavior occurred during the housing and related credit bubbles of the 2000s and was discovered in the wake of the financial collapse of September 2008, yet much seems to have taken place afterward as well, continuing up to the present with the Libor scandal. 

If the impression is correct, what might account for it? I think the answer lies in the nature of banking, understood broadly as financial intermediation: if A has money he’d like to save and B needs money, then rather than A lending directly to B A might lend to C to lend to B, because C—a bank—is a specialist in assessing creditworthiness. To finance its operations C will need to borrow from A at a lower interest rate than the rate it charges B for a loan. It can minimize the interest rate it pays A by borrowing short term (the shortest-term borrowing being a demand deposit). This both reduces the risk of default to A and offers A continued liquidity; should it need the money it’s lent to the bank, it can get it back on demand. And the bank can maximize the interest rate it charges B by making the loan long term, thus transferring liquidity to B and assuming a higher risk of default. C can increase its expected return across the board by lending to borrowers whom the market rates as risky (this pushes up the market interest rate to such borrowers) but whom C thinks less risky than the rest of the market thinks them. 

The bank’s business model is thus a risky one. Its capital is short term and thus can disappear with little or no notice (a bank run), while its assets (its loans) are long term and may be illiquid and thus hard to sell should the bank need to replace some of its capital. Government deposit insurance can reduce the risk of runs and by thus making depositors’ capital more secure reduce the interest rate the bank has to pay them. Bank regulatory agencies can further reduce the risk of banks’ defaulting by requiring banks to hold cash or cash-equivalent reserves, such as Treasury bonds. 

But risk and return are positively correlated; by reducing risk, government intervention in the banking industry reduces expected return. This is true even at the depositor level: the interest rate that a depositor receives is reduced because the risk of his losing his money is reduced. And at the bank level, deposit insurance is a cost to the bank. The bank may therefore decide to augment its capital base by uninsured borrowing. It may also decide to offset the cost of its reserves (cash on which it receives no return), and amplify the spread between its cost of borrowed capital and its return on investment, by making riskier investments with its borrowed funds than mortgage loans, municipal and corporate bonds, Treasury notes, and other conventional bank investments: it may decide to speculate. 

The tradeoff between increased risk and increased expected return is attractive for two reasons. First, a risk is less likely to materialize in the short term than in the long term: a 1 percent annual risk of default becomes formidable only when projected over a 10-year or 20-year or longer period. A banker who has a high probability of making very large profits for the next 10 years may feel well compensated for taking a small risk of bankruptcy during that period. 

Second, not only a bank’s financial capital but also its human capital is short term; very little financial human capital seems to be firm-specific, judging by the rate at which bankers move from firm to firm. Any firm that has short-term capital is under great pressure to compete ferociously, as it is in constant danger of losing its capital to fiercer, less scrupulous competitors, who can offer its investors and its key employees higher returns. 

Such a business model attracts people who have a taste for risk and attach a very high utility to money. The complexity of modern finance, the greed and gullibility of individual financial consumers, and the difficulty that so many ordinary people have in understanding credit facilitate financial fraud, and financial sharp practices that fall short of fraud, enabling financial fraudsters to skirt criminal sanctions. 

These circumstances make an unregulated banking industry a Darwinian jungle, with bankers as predators and their customers (and each other) as prey, and so may explain why bankers are prone to cut corners—to take excessive risk from a social as distinct from their private standpoint (they like and are compensated for taking risk, remember)—and why banking is a regulated industry (and we have learned from the 2008 crash and the ensuing economic depression the macroeconomic significance of a sound global banking industry). It remains to explain why banking regulation seems largely ineffectual. 

Its ineffectuality is on display in the Libor scandal. Libor (an abbreviation for “London interbank offered rate”) is ostensibly a reliable estimate of the interest rate that leading world banks charge each other for three-month or one-year loans. This rate is important both as an indication of a maximally safe private interest rate and so (like the more familiar “prime rate”) a basis for calculating interest rates to different risk classes of borrowers (“Libor plus 1 percent,” like “prime plus 1 percent”), and as a clue to the health of the banking industry: the lower Libor is, the stronger it signals that banks have confidence in each other’s solvency. 

Libor is not a transaction price; it’s an estimate by the banks participating in the estimation process of what they would charge each other for a three-month or one-year loan. Libor is reestimated daily and on many days many of the participating banks are not lending or borrowing for three months or a year from each other. With the financial crash of 2008 and ensuing reduction in loan activity, banks had fewer and fewer occasions to borrow from each other, so the daily Libor rate became increasingly hypothetical. And since Libor is an index of bank solvency, it was in the interest of the participating banks to “estimate” Libor rates lower than actual transaction rates; and apparently that’s what they did. 

The regulators were aware of this monkey business, but apparently did nothing, continuing a pattern of bank-regulatory laxity of many years’ standing. How is this to be explained? There seem to be four explanations. One is the revolving door: some regulators look forward to a post-governmental career in the regulated industry and fear lest the industry punish them for regulatory zeal by refusing to give them a good job. Another is the political heft of immense banks with their enormous financial resources. Another is the opacity of modern finance. But the most interesting is the complacency about capitalism typified by the attitude of Alan Greenspan, the long-serving chairman of the Federal Reserve Board, and by other conservative economists. Greenspan seems to have believed that competition was an adequate substitute for regulation in the banking industry. Competition often is an adequate substitute for regulation; that was the insight behind the deregulation movement that began in the late 1970s. But it is not an adequate substitute for banking regulation, because of the macroeconomic risks that a collapse of the banking industry can precipitate.

 

Banking is not the only industry that is prone to bankruptcy unless regulated. Another is airlines. Because of their heavy fixed costs, the wild variability of their principal variable cost (fuel), and fluctuations in consumer demand, airlines are constantly on the brim of bankruptcy and often over it. But because the airline industry is small and an airline can function quite effectively in bankruptcy, the industry’s riskiness has no macroeconomic significance. Shareholders lose their investment but the airline keeps flying, though now owned by its creditors, and eventually passes out of bankruptcy. There is no good reason therefore for regulation designed to prevent major airlines from going broke. But when banks get into trouble, their capital starts to vanish, and they can’t function. Credit freezes—and the economy, because it runs on credit, also seizes up. Oddly, few economists seem to have understood modern banking, or its role in the economy. 

The banks resist effective regulation, so far effectively, because their managers are better off with the Darwinian business model, which enables the reaping of short-term profits great enough to compensate—not the country, but the bank’s managers and investors—for an increased risk of bankruptcy.

Comments

[Harlot's Ghost]

I agree that some of the will-to-corruption comes from the fact that the business centers on paying Peter a dime for a certain commodity while charging Paul a quarter for the use of the same commodity. If we accept this idea, however, the bidirectionality of the merchant banking transaction becomes the culprit. The bank is a common scheme expecting profits from the skill and knowledge of the managers - while that skill and knowledge is correctly employed in searching out solid investments, deploying it in searching out investors (bank customers) upends the whole transaction. The recipients of the bank loans become the customers, and the depositors become the commodity - the bank that offers the most attractive combination of risk-acceptance and size of capital "wins." In short, the bank becomes the servant of two masters, and its transactions are therefore not viewed in the context of an ethical duty to one or the other.

[Thomas Rekdal]

Judge Posner offers some sensible speculations on why banking regulation has been (and perhaps continues to be) too lax. To his list I would add one more. Anyone motivated primarily by money is likely to prove smarter, quicker, and more resourceful than those appointed to a regulatory role in the public interest. If banks truly are too big to fail, too big to bail, and too big to jail, more pessimism is warranted about a reliance on regulation. Some of the more cynical (or realistic?) economists have even suggested that the real purpose of regulation is not to fix something, but to lull us into the false belief that it has been fixed (or is at least fixable).

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[Mike]

great post

[David Peterson]

The LIBOR scandal is really just greenmail in my view. The government has written vast amounts of debt, and needs to find someone to pay the bills, but doesn't want to increase taxes. So it is going to find another way to extract money from some unpopular group of people.

I doubt that any bank is complaining that it was charged an inflated LIBOR. They know how this works. It's the nonbanking borrower that is complaining, but no one in that market pays LIBOR anyway. What they pay is a negotiated rate which uses LIBOR as its base. It really doesn't matter what base you use though. A negotiated rate is going to reflect the market, and the bank that sets LIBOR does not control the market.

[NEH]

Most interesting. That the latest Depression is the result of Systemic failures in the Banking and Financial Sectors. Such that there appear to be four causes:

1. The "Revolving Door" problem in the Regulatory agencies, such that "Don't Rock the Boat" is the primary regulatory reason for existence.

2. "Political Heft and Influence" better known as the "K Street" problem. Remember, "we have the best Senators and Congressman money can buy".

3. "Opacity of modern Finance", also known as "Black Banking" and "Creative Accounting".

4. The complacency in the belief of the "Capitalistic System" to self correct itself by open competition. Really? doesn't unregulated competition lead to various unscrupulous actions to beat the competition at any cost?

These four problems clearly look systemic too me and point to a clear lack of supervision both internally and externally. Yet, there appears to be another problem. Such that all of this seems to be operating under a more insidious problem inherent in Law and its application. And that is, the "Spirit and Intent" of the Law has been forced into the back seat by a slavish adherence to the "Letter" of the Law. Which raises the question, "Just what is being taught in the professional schools these days"?

[Elliot Boudin]

This is a great commentary. I agree with the statement that banking is not the only business prone to bankruptcy if not regulated. I would like to see something done in the way of the 4 explanations for why the regulators were allowed to did nothing about the "monkey business".

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[george zeed]

I just can't believe that for any explanation there is a reason that is compelling enough for the regulators NOT to do something to stop the monkey business - a nicer term than I would refer to it BTW.

[TANSTAAFL]

Doggone it, NEH was on a roll with the first three points above, but the fourth is so wrong that it torpedoes the whole lot. Freewheeling Franklin could explain.

[Nicole]

This was a well thought out discussion of the incentives financial intermediaries face.

However as most of the beahviors in response to those incentives, borrowing short and lending long etc., are within the scope of the law I have trouble making the leap to find that corrupt.

[NEH]

affl, Once again... I guess you haven't read the commentary of the Professor and thought about it or tried to put it into perspective. Just jumped on that old worn out and broken down ideological band wagon again. The four points are his, not mine...

[TANSTAAFL]

Uh, wrong again, NEH. In the first place the commentary above is that of the Judge, not the Professor. Second, your four points are your own imaginative distillation of what Posner has to say. And, coming from a experienced traveler on the Alinsky band wagon, the manner in which you paraphrase and interpret Posner's post comes as no surprise.

But please do not blame your fourth point on Posner. Such hatred of capitalism is yours alone. Own up to it.

[Lainaa Luotto]

It is true that interest rate that a depositor receives is reduced because the risk of his losing his money is reduced.Most of the bank for me are not really corrupt,in Finland most of the bank give a good services to their customer one of their services is giving loans and lending.I can say the interest is quite good but i cannot say that there is some corrupt things inside.

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[Gordon Longhouse]

Banking is no more or less corrupt, in general, than any other industry. Banking today especially in the US and UK are systemically corrupt today for a number of reasons.
1. Bankers and other experts have an information advantage over customers. Previously bankers were reluctant to push this advantage to their own short term advantage our of concern that the long term loss of goodwill would be worth more than the short term gain. This is no longer the case: transaction by transaction banking is in; relationship banking is out.
2. Bankers have internalised the whole unregulated free market ideology that says that pursuit of self-interest will be self-corrected by the market and that accordingly there is no reason not to do so.
3. Many, but not all, governments have pursued the chimera of being a world financial centre. Until now at least that has meant putting up a facade of safety and regulation for bankers to hid behind while ensuring that there is no reality to it. London is the leader in this regard. It is no co-incidence -as The Economist would have it- that AIG, JP Morgan and Lehmann Bros did their most nefarious trades in London nor that LIBOR was set in London and was corrupt.
This meant that there was no political will to resist bankers who complained of "exzcessive" intrusive regulation hence no will to engage in intrusive regulation.
3. Unlike an airline when a large bank goes bankrupt it brings a multitude of other businesses and creditors down with it. When an airline goes bankrupt it leaves some stranded passengers. I know whereof I speak as I was stranded when an airline collapsed and am solvent still.
Posner correctly points out that banking is an inherently unstable business: short term liabilities support long term assets. That is why traditionally bankers have tried to look safe, boring and trustworthy. A sound banking system that permits depositors to access their money and be kept safe and borrowers to carry out business safe in the assurance that their borrowings cannot be recalled prior to term without cause is a public good.
Regulators and their political bosses need to recognise this and tell banksters waving campaign contributions to jump in the nearest lake.

[NEH]

affl, Once again... you really don't seem to understand the distinction of sitting on the Bench and handing down Decisions and Dictum as a Judge and developing Commentary on important issues of the time as a Professor. Current or Ex...

As for "ol Saul" he had some interesting things to say and do back in the 60's; just as "ol Smith" and other fellow travelers had to say about the British Corn Laws and the wagons that it was carried in. Although, they're all "old worn out and broken down" in desperate need of repair or replacement these days...

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[Josh Slade]

Gladly, I have just started reading this blog. It is a real education, thank you. Also, I am going to put all of my future earnings in a savings account. It seems that one fix to the problem is the informed investor. If bankers cannot be trusted to wisely invest, then the wise investor will not trust the banker with money. It seems to me that the consumer is in the best position to regulate this industry. There is now way, in the current climate, that I will invest riskily with these types of bankers.

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