Armageddon option for misbehaving banks

12 February 2013, Newspaper: Issue 837

In a few days' time, mankind will come as close as it has in more than a hundred years to finding out what happens when a big lump of rock crashes into the Earth at high speed.

An asteroid known as 2012 DA14 is scheduled to miss us by just 20,000 miles. That sounds like a fair margin, but in astronomical terms it is a hair’s breadth.

At about 150 feet across, the asteroid would probably make quite a mess if it did hit us. But it’s not big enough to cause what scientists call an extinction event like the one that put paid to the dinosaurs.

It’s not unlike the fines being meted out to banks for manipulating Libor. The numbers are big and scary. But ultimately you wonder what they will achieve other than a temporary crater in the banks’ share prices.

Clearly the fines aren’t changing behaviour. So how big would they have to be to achieve the desired effect? And is there a more effective – and more drastic – deterrent that regulators might wield in future?

Wrong target

When it comes to preventing asteroids from wiping out modern civilisation or preventing banks from wiping out economies, it’s worth having early warning systems to flag up the dangers. Regulators have put a lot of pressure on banks to tighten up their control systems.

But if we assume that things will always slip through even the most robust checks – and, given the imbalance between the rewards on offer and the chances of getting caught, that is probably a safe assumption – then you need to have a back-up.

The recent Libor settlements highlight the weaknesses of the current approach. The first problem is the apparently arbitrary way in which the fines are calculated.

Does the fact that UBS’s Libor fines were more than three times as much as those of Barclays mean that it had made three times as much in ill-gotten gains, that its behaviour was three times as bad or that it went on for three times as long? Or is it just that its lawyers are three times worse?

The second problem is that as the numbers get bigger they begin to lose their impact. Until recently a fine of a few hundred million dollars was quite a big event; now it looks like a reward for relatively good (or less bad) behaviour. And if a few hundred million doesn’t sound like it will do the trick, how much will? A few billion? Ten billion?

The ever-increasing numbers underline the ineffectiveness of fines and the fact that they punish the wrong people. A £1bn fine on a bank is paid, of course, by shareholders and not by the senior management or the individuals responsible for the misbehaviour in the first place.

The UK government may claim that the RBS fines will be paid out of bonuses, but it is hard to see how shareholders have not been damaged by the fine.

Yes, there is some knock-on reputational damage for the firm and its senior management. Yes, a few senior people are chosen (seemingly at random) to fall on their swords, and the bank might be forced to implement some costly remedial controls.

A few individuals who were directly involved might face severe “internal disciplinary proceedings”. Who knows, one or two of them might even go to prison. But overall, the cost of misbehaviour falls squarely on shareholders or, when things go really badly wrong, on taxpayers (or, in the case of RBS, on both).

A big part of the problem is that the legal structure of most companies separates and limits the liabilities of directors and shareholders from the company itself.

In his book The Corporation, lawyer and academic Joel Bakan argues that corporations are “pathological institutions” for whom breaking the law is a simple exercise in cost-benefit analysis, because they are legally programmed to pursue their own self-interest.

The paradox is that when a corporation does break the law, it is virtually immune from punishment because it has “no soul to be damned and no body to be kicked”. Instead, it is easier to kick the shareholders.

Armageddon out of here

Surely it would be more effective to go after the directors of a bank, the individuals involved in misbehaviour and their managers, or even the bank itself (as distinct from its shareholders).

This is harder than it looks. Company directors have strictly limited liability and they would need to be criminally stupid as well as criminal for a strong enough case to be made against them. Unsatisfying as it may seem, incompetence, ignorance and over-optimism in the boardroom are not criminal offences.

The authorities are also reluctant to go after too many individuals, mainly because of the high costs involved. While companies are often happy to settle an investigation (with other people’s money), individuals tend to fight tooth and nail because they have far more at stake. It could take years for the cases against a dozen or so traders to work their way through the system.

Combine this with the high burden of proof required for a successful individual prosecution, and the authorities can only really go after a handful of the most obvious cases.

Of course, this leaves the unpleasant sense that most of the individuals involved will get off with little more than a slap on the wrist.

An alternative approach could be for regulators to lower their sights. Individuals work in the financial markets under a licence extended to them by regulators.

In the same way that this authorisation is granted, it can be withdrawn – temporarily or permanently – with a lower burden of proof than is required for a criminal prosecution.

If individuals thought there was a realistic chance that if they misbehave they might not only lose their job but also their career, it would be a far stronger deterrent than any fine on the shareholders of the bank they work for.

Regulators could also take the same approach with the banks. Withdrawing the regulatory licence under which a firm operates – temporarily or even permanently – would act as a powerful new deterrent.

Regulators withdraw the licences from small firms all the time. Scaling this up to even a small brokerage firm, let alone a global bank, would be fraught with problems, but western regulators could learn from their Japanese counterparts, who frequently suspend or ban brokers and banks from specific markets. Indeed, they are considering just such a ban for RBS.

Finally regulators could use the nuclear option of corporate prosecution. This approach raises the bar even higher but it has been encouraging to see deferred prosecution agreements – a “lite” version of corporate prosecution – being applied in the Libor settlements and finding their way into UK law later this year. Corporations, it seems, are not immune to prosecution after all.

These agreements, which encourage banks to accept liability and put them on probation for a fixed period of time, are the regulatory equivalent of a near miss by an asteroid.

Corporate prosecutions represent the full on impact of a decent-sized asteroid. Sooner rather than later, a bank might just find out what that feels like.

• This article was first published in the newspaper on Monday February 11, 2013

You might also like