Is Banking Unusually Corrupt? 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.

Comments

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The big question is: how much does regulation cost the consumer in medicine, drugs, education, utilities, radio spectrum, insurance, etc.?

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Two things. First, over the past thirty years, banks have experienced a less regulated environment, culimating in the repeal of Glass-Steagall in 1999. Second, the major problem with the banks has been the Principal-Agent problem (see J.P. Morgan's recent $4-6 billion trading loss). There have been too many opportunities for bankers to take excessive risks which can net high compensation when right, but few consequences when wrong. Canadian banks with their more-heavily regulated system, seemed to escape much of the financial crisis.

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[EJUsher]

An unregulated industry that manages large amounts of money would likely attract a greater number unscrupulous individuals who are willing to cut corners than the highly regulated industry that we have today. While the regulation of our financial industry does not foreclose the possibility of financial chicanery, it allows the honest market to function on a day to day basis. If it were unregulated, there would be no trust in the market, or somewhat less trust than there is today. The regulations serve their purpose as a deterrent, but they may be deterring fewer malefactors than they have in the past fifty years.

[J]

I don't see how it follows that regulated industries will attract more people willing to cut corners. Following your drug violence example, the opposite conclusion seems evident to me. Becuase there is no regulation in the drug business (for the poeple who participate in it) those who are willing to be ruthless and use violence to achieve their goals have an edge, so it'll attract drug dealers who are willing to take risks.

[Christopher Calton]

" 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. "~

I'm not sure what this means. If we posit the opposite, the industry would be attracting those who appreciate its laissez-faire nature. That is to say, those who are cutting corners now would be dominating the intersection. We label corrupt those we cut corners, simply because the regulations exist, but with the lack of said regulations the actions would either be at par (where they are now) or more egregious -- albeit without the unappreciated label.

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[Dianne Weiss]

I think that most people would believe so. Like you said, an establishment that holds a massive amount of money would probably attract shady dealings. But some hopefuls would like to think that is is not often the case.

[Terry Bennett]

To the original point, "...because that's where the money is..." I would hope that not all priests are pedophiles, but if a person is already a pedophile, the priesthood makes a darned convenient front.

Banking is literally the money business; it is likely to attract people who like dealing with money. The little kid who loved running his hands through piles of coins may well grow up to be a banker. Those people who have already decided their purpose in life is to amass large amounts of wealth are going to look for more effective ways to do it, and sometimes a bank will make a mistake and send a bear to guard the honey.

In earlier times, bankers were different people: conservative, diligent, circumspect, all the qualities they needed to inspire trust from depositors who were counting on them and not the FDIC. (Some still cheated.) Your banker used to know your business as well as you did. Along came the quants, abstracting out the realities of the product and treating all businesses as machines of cash flow - an assumption that can be expected to fail in the moderate-to-long term. The quantative approach is not necessarily a negative development, but the safeguard that would naturally be in place - specifically, customer skepticism - has been negated. Government regulation has had the effect of leading to more corruption rather than less.

There is plenty of unscrupulous behavior to go around. Madoff was a salesman rather than a banker. Enron employees called up the power plant on a hot day and told the managers to fake a problem and shut down to drive the price up. The housing mess rested on cheating by all participants: banks, realtors, and buyers. On the good side, it's just money - not murder or rape. If we'd skin a few unscrupulous actors alive in the public square every now and then, and if people would go into transactions with their eyes open and possessed of a keen understanding that money is something other people may want badly enough to try to acquire it by deception, I expect this type of problem could be adequately controlled.

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[Jack]

Becker, accidentally? makes the strongest possible case for a tightly regulated FDIC insured banking system, and a much less regulated "investment banking" gambling system with the latter NEVER being bailed out.

"Funny thing" pre-Paulson that Goldman was a 75 year old partnership with its actions guaranteed by all the partner's assets. Today? stockholders and those doing the bailing take the hit.

[Jack]

J. Agreed! Old style banking was hardly attractive to adventurers and buccaneers.