Regulation

Why Incompetence in Banking is Worse than Greed


By Professor Boudewijn de Bruin, Professor of Financial Ethics, University of Groningen, The Netherlands (01/09/2015)

We call it the global financial crisis today. But in 2008 it was only called the credit crunch or subprime meltdown. US observers may have seen the intensity of the events a bit clearer then, and some may have experienced a greater sense of urgency to act. But to many Europeans the collapse of Lehman Brothers in September 2008 still felt far away, ‘American’, and unlikely to have consequence here.

 

Some European bankers and policymakers were wiser fortunately. By the end of 2008 the Dutch Bankers Association, for instance, set up a commission to write a report about the restoration of trust in the financial sector. The report contains exceptionally concrete suggestions, many of which have in the meantime found their way into law. In fact, it contains something that has gained the Dutch some fame: a Hippocratic oath for bankers. In the Netherlands, almost all bank employees now have to swear an oath, pledging that they will make their clients’ interest their central professional concern, and that they will uphold the reputation of the banking profession.

 

As measured by the respected Edelman Trust Barometer, trust in banks amounted, in 2008, to 69 per cent in the US, 47 per cent in the UK, and 56 per cent in the Netherlands. Last year, these figures were 46 (US), 32 (UK), and a dramatic 26 (the Netherlands). Safe to say the oath has not brought what was promised.

 

It is a platitude to say that finance needs trust. But the irony is that the more often this platitude is rehearsed, the more likely we lose sight of what is much more important – trustworthiness. When bankers and policymakers clamour for trust, they seem to think that it is the citizens who are to blame for the crisis, as they have stopped trusting the industry. But if you want to be trusted, you first have to make sure that people have good reasons to trust you. To be trusted, you need to be trustworthy.

 

It is clearly difficult nowadays to find bankers and other finance practitioners trustworthy. Libor manipulation, Forex trading, insider dealing, tax evasion – the amount in fines that banks have paid since 2008 for these and similar illegal and unethical activities is hard to fathom, and a week does not go by without a new scandal.

 

In The Wolf of Wall Street, Martin Scorsese’s 2014 film, Jordan Belfort is initiated into the rites of brokering. His senior asks whether he knows what fugazi means. Belfort’s answer: ‘Fugazi. It’s fake.’ Belfort knows that brokers don’t work for their customers, but fake their work for their own gain only.

 

This film is far from unique in blaming banker’s greed for the worldwide financial chaos. Banker bashing is about as popular as complaining about the weather, at least in my country. In a recent book on Ethics and the Global Financial Crisis, I have argued, however, that we should not waste all our energy on attacking banker’s greed. This is of course not a recommendation to believe that greed is good. But as the subtitle of the book says, incompetence is worse than greed.

 

To see why, let me outline a simple view of trust and trustworthiness. Why would you trust your doctor? To begin with, you would need to believe he or she is motivated to do the job. You would not trust a doctor who is more interested in money than patients. But the correct motivation alone is not enough to trust a doctor. Your doctor has to have competence as well. A doctor who is unable to give a diagnosis or perform a surgery because of lack of knowledge or experience is not trustworthy.

 

This shows that motivation and competence are equally important for trustworthiness. But when it comes to banking, most commentators are only interested in motivation. In Swimming with Sharks, Dutch Guardian journalist Joris Luyendijk tells a lucid and informed tale about life in the City of London, based on innumerable interviews with bankers and other financials. One myth he does not bust, though: the myth about banker competence.

 

From the many examples of incompetence I discuss in the book, I have chosen one to discuss here. It is concerned with the credit rating agencies. Return to 2007, before the crisis started. The quants – financial mathematics whizzkids – were widely applauded for their work on complex derivatives, including mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Many of these instruments received top-notch ratings from the credit ratings agencies at the time. Yet today they are often considered junk.

 

Did the agencies make mistakes? For ratings of corporate bonds, their track record is rather good. But structured finance is a wholly different business. This should not be so difficult to see. In 2008, around 64,000 structured finance products got the highest possible rating of triple A. At the same time, only 12 companies in the world were triple A. This should make one think twice before treating them similarly.

 

Lloyd Blankfein, CEO of Goldman Sachs, uses this example in an argument about risk management: many finance firms were too dependent on the credit rating agencies, and did not carry out their own risk management. It was outsourced to institutions that were not competent to do the job.

 

The rating agencies certainly deserve blame for the highly inadequate ratings of structured finance instruments. They could have done much better had they used better mathematical models and more reliable and diverse qualitative data. For a long tim Moody’s would not even use the simplest data about individual mortgages in their MBS ratings.

 

But what about those who used the ratings? In an article in European Financial Management, economist Phillipe Jorion shows how a lack of critical thinking and careful analysis at UBS led the bank to treat the triple A rated tranches of structured securities as if they had yield curves normally associated with triple A corporate bonds. How can that be? How can something be riskless and give a yield much higher than Libor? Had UBS employees forgotten the most fundamental principle of finance, the correlation between risk and return? Jorion does not  mince his words, writing that the bank’s risk management system was ‘flawed’.

 

Many more examples could be given. But what can we do about incompetence? First, commentators should stop thinking of banks as populated by greedy geniuses. Bankers are not all greedy, and neither are they geniuses, and it is high time that the general public learns this lesson.

 

Many financial institutions have spent large amounts of money on initiatives to change ethical culture. There is little scientific evidence supporting such decisions: cultures do not change quickly, and a piecemeal engineering approach, where small steps are taken incrementally, has much to recommend.

 

But secondly, a better way to spend the money would be to increase competence. This is not merely knowledge of finance. It is also critical thinking skills. Bankers should learn to spot the differences in reliability of data. They should know the limitations of their knowledge. They should be encouraged – incentivized, if you wish – to seek advice when needed. And they should be invited to use evidence-based methods, just as in such professions as medicine and engineering. To build a trustworthy financial sector requires building competence. We have ignored that for too long.