Jan 29, 2016 - In particular, the Interest Rate Swap (IRS) scandals have shown the ability that ..... transactions, regardless of their effective sophistication, are.
Global Policy Volume 7 . Issue 2 . May 2016
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Vincenzo Bavoso University of Manchester
Abstract
A number of questions remained unanswered with respect to the regulation of large financial institutions after the global financial crisis (GFC) of 2007–08. Some pressing issues have resurfaced in the context of the recent interest rate swap scandals. These events provided the opportunity to reflect on the wider socio-political agenda that involves the regulation of banks’ -vis societal stakeholders. In particular, the Interest Rate Swap (IRS) scandals have shown the ability that banks behaviour vis-a have to first, innovate and customise complex financial products, and second, limit their legal liability when selling them to investors. This has resulted in a highly unfair balance of powers between financial institutions on the one hand and regulators and financial consumers on the other.
Policy Implications
• • • • •
The behaviour of banks should have regard for social priorities ahead of profit-making activities conducted in the interest of banks’ shareholders and executives. The desired behaviour of banks should be enshrined in statutory regulation. Regulatory changes should enhance the protection of financial consumers. The power of banks to innovate for speculative aims should be curtailed through more prescriptive regulation; this would inter alia curb the problem of information asymmetry in financial markets. The balance of powers in financial markets should be reconfigured together with the role of financial institutions in society.
1. Background The years following the quasi-collapse of the global financial system in 2008 have provided much evidence to contend that the global financial crisis (GFC) is still ongoing. While new regulation was being enacted in the US and in the EU, a new generation of financial scandals was brewing, ready to manifest in rapid sequence. From the Payment Protection Insurance (PPI) mis-selling, through the Libor rigging manipulation, to the Interest Rate Swap (IRS) mis-selling, the list is certainly not exhaustive. Even though these events were generated in the same ‘boom years’ that preceded the 2008 crisis, they highlighted new features and exposed how different sections of society can be directly harmed by the activities conducted by financial institutions. This article focuses on the analysis of the IRS scandals that exploded in the UK and in the US. The opportunity can be [Correction added on 29 January 2016, after first online publication: The Acknowledgement was previously omitted and has been added in the author biography in this current version].
Global Policy (2016) 7:2 doi: 10.1111/1758-5899.12300
taken for a broader reflection on the undesired effects of financial innovation, particularly the ‘over-development’ of derivative products. Moreover, the scandals show the ability that banks have to first, innovate and customise complex financial products, and second, employ contractual terms that limit their legal liability to investors. Unlike previous scandals, the IRS events have directly harmed different social stakeholders, outside the financial services industry. The victims were individuals and small and medium-sized businesses in the UK, and government entities in the US. In both cases, complex derivatives were sold by banks to investors who were not sufficiently aware of the level of risk that they were taking. By highlighting the flawed legal protection that is granted to financial consumers entering into complex derivative contracts (such as IRSs), this article poses two broader policy questions involving financial institutions operating on a global scale. First, it reflects on the role of financial institutions in society, which entails a definition of the social function of financial markets. Second, it looks at the power of banks to innovate, which has made their relationship with both © 2016 University of Durham and John Wiley & Sons, Ltd.
Research Article
Financial Innovation, Derivatives and the UK and US Interest Rate Swap Scandals: Drawing New Boundaries for the Regulation of Financial Innovation
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regulators and societal stakeholders highly unbalanced. This article draws a number of policy lessons from the IRS scandals. It contends that while much of the post-crisis regulation has been well conceived, it is largely piecemeal because it lacks the reformist strength necessary to regulate the behaviour of financial institutions, and align them with socially inclusive goals. It will also be argued that in order to socialise the process of financial innovation towards welfareoriented goals, an institutional shift is needed. This would bring about a much needed redefinition of the relationships between market players, society and regulators. The analysis provided in this article is multidisciplinary. In discussing the IRS scandals, legal sources are used, and in particular cases and reports from the UK and the US. Financial innovation is explained by looking at both economic and legal scholarship, while section 4, in evaluating the effect of culture on the behaviour of financial institutions, draws chiefly from literature in the field of social and behavioural studies. Section 2 provides an initial overview of the problems associated with financial innovation, linking them to the underlying powers of banks; section 3 illustrates the main legal and policy issues that emerged from the IRS scandals; section 4 analyses the main cultural patterns that characterised the IRS scandals and reflects on ways to regulate culture; section 5 concludes.
2. The root of the problem: contemporary financial innovation The process of financial innovation has existed for as long as rudimentary monetary systems can be recalled. The search for novel ways to optimise transactions is ingrained in human societies and is rooted in the desire to foster commercial as well as social relationships. Advancements in financial techniques have allowed the evolution of key functions such as capital allocation, access to capital and the management of risks (Avgouleas, 2015). Historically, new financing techniques and products have facilitated economic growth and fuelled industrial developments (Ferguson, 2008, introduction). The story of contemporary financial innovation however, reveals a different picture. Many of the explanations of the GFC included financial innovation among the main causes (Turner, 2009, p. 14). The Turner review highlighted the explosive growth of the US financial system in the mid-1990s, which gave way to the boom of the structured credit market, and at the same time, to a new array of very complex products. It was believed, Turner explained, that the process of structuring and slicing credit exposures could create value by offering more attractive combinations of risk and return to investors (Turner, 2009). The International Monetary Fund (IMF) reiterated in 2007 that innovation supported the financial system because it facilitated the dispersion of credit risk and in turn broadened credit extension (IMF, 2007). This widespread belief however proved to be misguided once the crisis broke, because the function of credit intermediation that the new products should have performed, was severely © 2016 University of Durham and John Wiley & Sons, Ltd.
compromised by the complexity of the transactions and the obscurity of the products (Turner, 2009, p. 16). Following the GFC, the relevance of recent financial innovation to the real economy has been questioned alongside the extent of its contribution to society. Particularly after the 1980s financial innovation moved towards more rent-seeking and less economic goals, and became detached from welfare priorities (Avgouleas, 2015). In the wake of the GFC, Nobel Prize winners Paul Krugman and Joseph Stiglitz expressed highly critical views about the contribution that financial innovation brought to society. Stiglitz went on to point out that recent innovations were not conceived to enhance the ability of the financial sector to perform its social function (The Economist, 2012a). Questions on the social dimension of this phenomenon lead to a preliminary assessment of the role of financial markets as a whole. It is usually postulated that financial markets represent: (1) a meeting point for buyers and sellers of securities; (2) a means to raise finance beyond bank lending; and (3) a system of efficient capital allocation and capital intermediation (De Haan, Oosterloo and Schoenmaker, 2012, ch. 1 pp. 5–15). The analysis of the IRS scandals in section 3 provides part of the answer to this question and demonstrates that innovated products have undermined the functions of capital allocation and intermediation. Having raised the issue of the social value of financial innovation, the next section will look at the dynamics behind this process and assess whether it encompasses any social concerns. In order to do so, two main questions will be addressed, namely who are the actors behind the innovation process, and why this happens. Who innovates and why Starting from the question as to why financial innovation occurred, the Turner review provided an authoritative explanation of the drives behind it. It clarified that a combination of macro-economic imbalances (between emerging exportled countries and developed economies) and monetary policies (based on low interest rates) fuelled the growth of credit extension, mainly in the UK and in the US. At the same time, the growth of the structured credit market was accompanied by investors’ appetites for yields (Turner, 2009, p. 13–14). It was ultimately investors’ demands for more profitable solutions that pushed towards the creation of new products. Innovation therefore was triggered by clients pushing investment banks to design products that allowed more risk taking but at the same time capped the potential for losses. The innovation of most retail financial products was conducted chiefly by investment banks and more specifically by their research and development divisions. These are generally staffed with science and engineering researchers who design the complex mathematical models that underscore the risk profile of new products (Rajan, 2005, p. 14; The Economist, 2012b). The innovated products introduced in the late 1970s were in fact not simply the result of an evolution, they were invented. A process of design underpinned financial innovation, and science was at the heart of it as a Global Policy (2016) 7:2
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source of creativity, instead of being used as an application (MacKenzie 2009, ch. 4 pp. 68–69). As will be explained later in this section, the element of creativity characterising new derivative products was emphasised by deregulation, particularly by the erosion of differences between derivatives and wagers (traditionally enshrined in the possibility to settle the contract through delivery, typical of the former). As more abstract products were introduced into the market (due to the decreasing element of material value attached to the contract), it became more difficult to establish the nature and quantity of the underlying assets (MacKenzie, 2009, ch. 4 pp. 64–65). In essence, the innovation process has been the offspring of private interests and little concern has been given to issues of market efficiency, financial stability and social welfare. This contention is corroborated by the definition of financial innovation provided by Julie Winkler of the Chicago Mercantile Exchange (known as CME, which since the 1980s is central to global finance for derivatives exchange, MacKenzie, 2008, ch. 6) who highlighted three specific phases. These are: the investigation, where the investment bank establishes whether there is sufficient demand for a certain product; the creation, where the new product is designed contractually with the help of lawyers, and is preliminarily tested on a small section of investors; the validation, which involves feedback from various groups within the CME (The Economist, 2012b). It is interesting to note for the purpose of this enquiry that these three phases do not encompass any test as to the social or economic value of the product or the probable effect that it has on investors. Banks will normally be concerned with the costs of legal compliance that the product entails. However it has been observed that once new products are standardised in the market, their complexity obfuscates the ability of regulators to understand their consequences. Similarly, investors are often led to understate the risks of the products and misprice their actual value, due to persisting asymmetric information and over-reliance on mathematical models (Turbeville, 2013). The process of deregulation that began in the early 1970s with the end of the Bretton Woods, and flowed three decades later into the final liberalisation of over-the-counter (OTC) derivatives, provides much explanation to the phenomenon of financial innovation (Frieden, 2006, ch. 16). It also serves to clarify the dynamics behind it. In the US in particular, deregulation dismantled the infrastructure that had been set up with the New Deal, as a response to the Great Crash of 1929. For the purpose of this discussion, two key regulatory changes need to be singled out. First, the repeal of the separation between commercial and investment banking activities brought by the Gramm-Leach-Bliley Act 1999 gave way to huge financial conglomerates, and enabled them to compete for the more profitable investment business while enjoying implicit government guarantee. Second, the Commodities Futures Modernization Act 2000 removed long-standing legal constraints related to trading in speculative OTC derivatives (the difference between legitimate trading in derivatives and Global Policy (2016) 7:2
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illegal gambling rested on whether it was possible to settle the contract by delivering the underlying asset) thereby giving legal certainty to speculative trading that was previously banned by courts (Stout, 2011; FCIC, 2011, p. xxiv). Similar measures were enacted in the UK, chiefly in the context of the 1986 ‘big-bang’ in financial regulation, where differences between commercial banks and merchant banks were obliterated, and membership to the Stock Exchange was opened to corporate members (Bamford, 2011, p. 176). The Financial Services Act 1986 also exempted investments from the old prohibitions of the Gaming Act 1845, thereby facilitating market practices related to speculative derivatives. At EU level, the European Second Banking Coordination Directive (Directive 89/646/EEC, replaced by Directive 2006/48/EC) enabled European banks to engage in investment-type activities that were not traditionally allowed in deposit-taking institutions. Globally, the trend towards financial liberalisation affected both developed and developing economies since the mid-1970s. This resulted, among other things, in the privatisation of many financial institutions, the deregulation of bank interest rates and reserve requirements, and the rejection of state intervention in the economy. State intervention was particularly halted in credit allocation decisions whereas newly liberalised financial intermediaries could now take new risks in foreign markets (Demirguc-Kunt and Detragiache, 1998, p. 11). As a consequence of deregulation, large international financial conglomerates were able to create customised complex financial products and sell them to investors worldwide. They were indeed incentivised to do so for two main reasons. First, the Basel capital adequacy requirements strongly advocated risk-mitigation techniques (derivatives such as Credit Default Swaps (CDSs)) and reliance on internal risk models. Pillar III of Basel was aimed at complementing minimum capital requirements and supervisory processes through a set of disclosure requisites that allowed market participants to assess the capital adequacy of an institution. To this end, market discipline was deemed fit to supplement regulation by requiring institutions to disclose details of their capital, their risk exposure and their risk assessment (BCBS, 2005). Newly customised derivative products therefore had the intrinsic feature of being opaque because they were based on the risk assessments of the banks themselves, which were not necessarily shared by other market participants. This implied the privatisation of a fundamental component of financial regulation, namely the risk assessment. In essence, innovated products carried an asymmetry of information that allowed the bank designing and marketing them, to maintain a better marginal understanding of the product’s risk, and thus extract rents from other financial stakeholders (Turbeville, 2013; Avgouleas, 2015). Second, as the new large financial conglomerates became the main providers of financial services, a new business model emerged, driven by the pursuit of short-term profits through high-risk activities, and fuelled by flawed market incentives (such as stock options). Banks could now rely on implicit government guarantees even in connection with risky activities which were previously the domain of © 2016 University of Durham and John Wiley & Sons, Ltd.
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investment banks (Jaffer, Morris, Sawbridge et al., 2014, p. 42). Unconstrained moral hazard thus contributed to erode trust in large financial institutions. Changes in culture also aggravated to this process, especially in so far as the traditional ‘relationship banking’ gave way to a sales-driven attitude (Jaffer, Morris and Vines, 2014). The deregulated financial sector that has emerged in the last three decades is fundamentally lacking both democratic legitimacy and accountability (Avgouleas, 2013, p. 77), and it has created institutional imbalances that make its regulation problematic. These deficiencies have significantly impaired the social function of financial markets and more specifically the process of financial innovation. The next section will illustrate this contention through the analysis of the IRS scandals in the UK and the US.
3. The interest rate swap scandals A primer on IRS A swap is a derivative contract whose function is the exchange of two streams of payments between two counterparties. In the context of IRSs, the counterparties agree to exchange interest rate cash flows, from a fixed rate to a floating rate or vice versa, with the latter being linked to a reference rate like for instance Libor. The rationale for employing IRSs is to manage exposures to fluctuating interest rates and obtain a lower interest rate than would be available without the swap. Firms resorting to IRSs desire a type of interest rate structure that can be provided by another firm at a better cost. As an illustration, by swapping the variable interest rate mechanism with a fixed one, a borrower can reduce its exposure to fluctuations and thus the IRS performs a hedging function. IRSs are normally negotiated with a bank acting as seller of the standardised financial product. The resulting contractual relationship presents features that are relevant to this enquiry. First, IRSs include an ‘interest rate cap’ clause designed to protect borrowers against interest rates rising above a certain threshold. This entails that if the variable rate is higher than the fixed rate, the borrower will be credited, while if the variable rate is lower, the borrower will be debited (House of Commons, 2014, p. 3–4). Second, IRSs have a degree of flexibility as regards the amount and duration of the underlying loan, because the swap may either cover only part of the loan or run beyond it. IRSs remain however separate contracts from the underlying loan and must be terminated independently. An earlier termination of the swap will give rise to ‘break costs’ for the borrower, consisting in the difference between the interest rate on the contract and the prediction of the interest rate on the remaining life of the swap. Third, the relationship between banks and borrowers has remained problematic because the former disclaim any role as advisers in the transaction, which entails a strong attenuation of the applicable fiduciary duties (House of Commons, 2014, p. 2; Getzler, 2014). The UK and the US scandals exploded chiefly because of the charges that accrued under the IRSs, with termination © 2016 University of Durham and John Wiley & Sons, Ltd.
costs amounting to up to 50 per cent in addition to the value of the loan. In the postcrisis years the Bank of England and the US Federal Reserve lowered interest rates to record level; this created a very unsustainable situation for borrowers who had entered into IRSs and were left with the choice of either making higher payments under the swap or paying huge ‘break’ costs to exit it. The development of the scandals on both sides of the Atlantic highlighted similar concerns for the way large financial institutions sold complex hedging products to financial consumers. It emerged in particular that, due to conflicts of interests within large banks (pushed by perverse incentives to sell IRSs in connection with loans), clients were not adequately informed about the key features of the products they were purchasing, and did not have sufficient awareness of the risks associated with them. The main legal and policy issues that arose in connection with the IRS scandals will be illustrated in the following sections. It will also be shown that the cost of intermediation between providers and consumers of capital has increased dramatically over the last three decades, despite the fact that capital intermediation should be the central social function of the financial system. This happened because the volumes of trades in derivatives, due to excessive reliance on mathematical models, hindered the quality of information processed into the market and allowed insiders to extract value from the market, at the expense of capital intermediation efficiency (Phillippon, 2011). The UK mis-selling scandal In June 2012 the Financial Services Authority (FSA) unveiled the large-scale mis-sale of hedging products by a number of UK banks. The FSA review confirmed that there had been failings in the way IRSs were sold to investors, most of whom were classified as nonsophisticated (mainly small and medium-sized enterprises). The FSA highlighted that a great percentage of the transactions under review did not comply with regulatory requirements and that this would therefore result in a redress in favour of customers (FSA, 2013). In identifying the main legal issues, the FSA recognised above all the increased product complexity. It argued that IRSs could have protected customers against interest rate fluctuation if they had been properly understood by borrowers and sold to them in the right circumstances. However, the element of speculation and risk intrinsic to IRSs could not be appreciated by non-sophisticated customers (FSA, 2012). Beyond product complexity, a number of sales practices were also singled out by the FSA, namely: (1) poor disclosure of exit or ‘break’ costs on the part of banks; (2) the failure of banks to ascertain customers’ understanding of the underlying risk; (3) sales characterised by banks as nonadvised while they were straying into advice; (4) over-hedging, consisting in the amount and duration of the hedging product not matching the underlying loan; (5) poor corporate governance of banks, resulting in perverse incentives to sell high volumes of IRSs (FSA, 2012, p. 3). Global Policy (2016) 7:2
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These legal issues have been accompanied by broader policy concerns. A first concern pertains to the way courts, by upholding the principle of ‘sanctity of contract’, have allowed large banks to regulate these contractual relationships. The practice included exemption of liability clauses that obliterate the fiduciary protection recognised to the banks’ customers (which meant that no equitable remedy was available to customers). The fiduciary protection is normally limited to individual retail customers (Lloyds v Bundy, 1975). Nevertheless it is argued that in the context of derivative products, their complexity could justify per se the application of a fiduciary relationship because customers’ lack specific expertise to understand derivatives, and therefore depend on the bank’s advice. This line of thinking has however been dismissed by English courts that have traditionally maintained a conservative stance, making it difficult to establish fiduciary duties of banks (Bankers Trust v PT Dharmala, 1996; JP Morgan v Springwell, 2008). More recent litigations involving specific claims of mis-selling have confirmed the reluctance of courts to interfere with the commercial freedom of parties, on the premise of their ability to bargain at arm’s length. This approach has resulted in courts upholding the terms of the contract, under the assumption that they were agreed by parties with equal bargaining power and full understanding of contractual terms (Green & Rowley v RBS, 2013; Kwok v HSBC, 2012; DBS Bank v SanHot, 2013). It has been observed that the attenuation of fiduciary duties in financial markets has become more evident since the 1980s, due to: (1) a combination of legislative changes (such as the Trustee Act 2000 in the UK and the American Uniform Prudent Investor Act 1992); (2) the ideological view that financial markets are better served by rational market-players, liberated by the constraints of legal rules; and (3) the ease with which courts allowed parties to contract out of fiduciary liability (J. Getzler, 2014, p. 202). A second policy concern relates to the advantage that large banks have attained by becoming huge conglomerates as a result of deregulation. This has allowed them to offer a wide range of services to their customers, from the more traditional commercial and retail ones (loans), to more risky, insurance-like products such as derivatives. The mis-selling scandal illustrated a different facet of the too-big-to-fail problem, notably the increase in conflicts of interest within large banks that, pushed by perverse incentives, tied their loans to the sale of hedging products like IRSs. As explained in section 2, this was caused by the consolidation of financial institutions into large mega-banks and by the consequential shift in their business models and sources of earnings (Jaffer, Morris, Sawbridge et al., 2014, p. 42). The US scandal The IRS scandal in the US was linked to a number of bankruptcies of US municipalities that had purchased hedging products in the years before the GFC. The vast employment of IRSs among local governments stemmed from the volatility of interest rates in the post-Bretton Woods era, which pushed public entities to find ways to manage that Global Policy (2016) 7:2
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risk. IRSs represented a way to hedge the risk of both longterm inconvenient fixed rates and variable rates on a bond, which resulted in the inability to predict the correct price of borrowing over a certain time (Bondgraham, 2012). Contrary to what was the case in the UK, the US scandal did not give way to a mis-selling. IRSs played a major role in fuelling the bankruptcies of a number of municipalities who were advised in the pre-crisis years by Wall Street financial institutions on ways to hedge the risks of rising interest rates. In particular, municipalities were advised to purchase structured products in connection with loans or investments that they had entered into to finance large public projects (Bondgraham, 2012). The case of the City of Detroit provides a good illustration of the role of IRSs in leading to unsustainable levels of debt. Detroit became entangled in predatory swap agreements proposed by Wall Street banks to hedge the cost of increasing interest rates (at that time). In particular, IRSs amounting to $1.4bn were entered into to hedge the risk of interest rate rise on bonds that had been issued to fund public pensions (Turbeville, 2013a). Post-crisis monetary policies, however, meant that Detroit, like other municipalities, had lost the bet and had to pay high rates under the swap (Gaist, 2014). Moreover, IRSs had been arranged with huge termination costs leading to local governments having to pay millions of dollars to unwind them. As Detroit became unable to meet payments under the swap in 2009, Bank of America and UBS demanded $400 million in termination fees and the control of some of the City’s revenues – because contractual clauses had allowed the banks to terminate the swap under specified conditions and collect termination payments (Turbeville, 2013a). This led to the paradoxical situation where Detroit was negotiating to pay $165 million to the above banks to terminate the IRS, while offering only pennies on the dollar to unfunded pension obligations owed to retired City workers (Walsh, 2014). As opposed to the UK, where the mis-sale led to an FSA investigation into the practices carried out by major banks, the US regulator – the Securities and Exchange Commission (SEC) – has not undertaken a similar task to date, despite a formal probe requested by the Detroit Emergency Manager (Lichterman, 2014). Nevertheless the events related to the Detroit bankruptcy provided the background to recognise a number of dubious practices carried out by the banks, namely: (1) the banks projected false and misleading information about future interest rates; (2) the IRSs breached the threshold of the City’s legal debt limit; (3) the contractual provision that allowed the banks to pledge the City’s revenue as collateral under specific circumstances was illegal under the Michigan Gaming Act; and (4) the ‘safe harbour’ provision that banks claim under the US Bankruptcy Code (s. 546) were in breach of the Michigan Municipal Finance Act 2001 which was conceived to protect municipalities against predatory financial deals (Gaist, 2014a). Beyond these specific legal issues further questions have arisen that are common to all the municipalities involved in the scandal. The primary concern is the ‘suitability’ of IRSs to the financial needs of local authorities. It has been argued © 2016 University of Durham and John Wiley & Sons, Ltd.
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that municipalities were ill-equipped to appreciate the risks underlying these contracts and their effects on rating agencies downgrades, which in fact occurred in the Detroit case, once the city became unable to meet payments on the swap (Turbeville, 2013a, p. 8). This shows again that the better understanding that banks had of the financial products they were selling put them in a contractual position that allowed them to benefit from asymmetric information and extract rents at the expense of financial consumers. This unbalanced situation has not been mitigated by the application of fiduciary duties (or lack thereof) owed by banks for the advice given to customers. Like in the UK, US courts have largely ostracised the application of fiduciary protection in commercial transactions. As illustrated earlier, the reason for this is that parties in commercial and financial transactions, regardless of their effective sophistication, are deemed to be able to negotiate at arm’s length and therefore protect their own interest through the contract they enter in good faith (Katz v Oak Industries, 1986).
4. The prevailing legal and cultural patterns in international financial institutions The events described in the previous sections highlight a certain modus operandi that has become common among global financial institutions. Section 2 explained that the deregulation process that started in the UK and the US became later a global phenomenon due to pressure exerted by international standard-setters like the Basel Committee and the IMF. The scale of the problem however remained different across jurisdictions for two main reasons. First, the balance of powers in developing economies (such as BRICS) is still characterised by the state maintaining control over financial markets either because the largest institutions are state-owned, or because of the ‘command economy’ that shapes regulation accordingly. Second, the practices that characterised the IRS scandals are rooted in the prevailing culture that has historically permeated Anglo-American financial markets (Williams and Conley, 2014) and that contributes in turn to shaping behaviour at institutional and individual level (Langevoort, 2011, p. 1242). While this section focuses on exploring the origins of these cultural patterns primarily within Anglo-American financial markets, the lesson that can be learned is globally relevant. This is because large financial institutions operate at a global level and their cultural values and practices are exported – to different degrees – into different jurisdictions which are faced with similar regulatory and policy challenges. In light of the initial question relating to the social dimension of financial markets, it is worth noting that financial institutions in the UK (and to a large extent in the US) were historically private in nature and retained that character for a long time. The Bank of England and the London Stock Exchange were private institutions (Ingham, 1984, p. 17) and this has not only shaped the self-regulatory system that characterised the UK financial sector for a long time, but it has also created a legacy that persists today of strong influence of financial institutions over central government and regulators © 2016 University of Durham and John Wiley & Sons, Ltd.
(Gilligan, 2013, p. 29). The historical influence of City professionals over the Crown was rooted in mutual self-interest and in the Crown’s dependence on the City of London to finance its expenditures. These factors contributed to foster a privileged position of the financial sector in society and to create a culture that still emerges today despite many crises and regulatory developments. Eventually, the same cultural and organisational patterns typical of UK financial institutions have been exported to a great degree to New York first and then with less vigour globally (Gilligan, 2013, p. 25). The City’s historical hegemony in the relationship with parliament (and generally with the regulator) is today reflected in a number of features characterising the regulation of financial activities. First, it has been stressed that until the GFC in 2008, the regulation of UK financial services was grounded in a ‘laissez-faire’ approach. This rested on a permissive regulatory model that relied on the ability of firms to police themselves, and in a market-friendly regulator (the FSA) that would restrain from intrusive supervision of market practices (Tomasic, 2008, p. 337). This phenomenon can also be explained with the City’s success in projecting its own interests as ‘public interest’ in matters of financial regulation and more general policy making (Gilligan, 2013, p. 25). The ability to shape perceptions and to exert huge lobbying powers allowed both the City and Wall Street to create cultural norms that have come to be widely accepted within society (Gilligan, 1999) as undisputed dogma (Kahneman, 2012, p. 62). Unfortunately, the policy agenda set by the financial industry has failed to take under due consideration public interest in general, that is the interest of those constituencies outside or at the periphery of the financial sector. Another dimension of this hegemony is the relative immunity of financial circles from penalties and imprisonment (McDonald, 2014). This is evident by looking at how banks and bankers remained virtually unscathed in the aftermath of the GFC. Beyond criminal liability, the analysis of the IRS also shows that courts are reluctant to configure duties upon banks that could lead to their civil liability and to pecuniary sanctions. Huge fines have been imposed on banks in recent years, if only for their failure to comply with conduct rules, a failure that illustrates the ethical culture within banks (McCormick and Stears, 2014). The behaviour of banks in the context of recent scandals, including Libor and the IRS, shows that financial circles feel immune despite violating rules. This attitude stems from the culture at the heart of these organisations, which promotes behaviours that lead to regulatory deviance, and raises basic questions of honesty and ethics (McCormick and Stears, 2014, p. 135). The banks’ culture in other words legitimises behaviours that are not socially desirable and that, in the context of financial institutions, have come to affect a large number of societal stakeholders. Beyond the historical nature of this attitude, behavioural studies have also explained why reckless and risky conducts prevail over prudent ones. Psychological and cultural forces within firms alter the perception of risk and create a bias towards more aggressive strategies. In times of boom especially, this leads to persistence and more risk-taking, Global Policy (2016) 7:2
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eventually overwhelming more cautious strategies (Langevoort, 2011; Akerlof and Shiller, 2009). Risk becomes a self-fulfilling prophecy in times of good fortune which leads to the belief within the institution that there is nothing to worry about (Langevoort, 2011 p. 1242). It also needs to be considered that overconfidence and exuberance in financial institutions were fuelled by the availability of financial products which were thought to provide forms of risk mitigation, namely credit derivatives (Turbeville, 2013). As explained earlier, the insufficient understanding of these products on the part of banks created a cognitive bias (MacKenzie, 2009, p. 178) that was institutionalised in the behaviour of banks and thus led to reckless strategies, namely: spreading unquantifiable credit risk through the system and harming investors. The process of financial innovation that is illustrated in this article is closely interlinked with the privileged position that financial institutions enjoyed historically and particularly in the post-deregulation decades. From a legal standpoint, this has allowed the development of contractual and transactional patterns that at best have no commercial rationale, and often impose costs on society. From a financial perspective, the theoretical models underpinning transactions and products, that banks developed and relied on, also failed to reconcile finance with reality. These provided investors with prescriptive information telling them what to do, rather than descriptive information that may have enabled them to act rationally (MacKenzie, 2008, ch. 3 pp. 87–88). Financial innovation, as analysed in this article, is also the quintessential expression of a culture developed within financial institutions which finds its sole legitimisation in market ethos. In particular, the change in business models post-deregulation led banks to seek earnings from more risky activities, such as proprietary trading in complex derivative products (as opposed to traditional interest on clients’ loans). Increased risk-taking – and also the misallocation of risks created by complex derivatives – caused huge losses that have been borne chiefly by banks’ customers. They were no longer seen as clients whose prosperity banks had to look after, but mere counterparts for banks’ trading (Jeffer, Morris, Sawbridge et al., 2014, p. 51). This culture – specifically the institutionalised culture within investment banks that in turn has come to characterise financial markets as a whole – justifies any form of short-term profit and self-interest strategies for the interests of banks’ shareholders and executives (Ho, 2009, p. 184). This article contends that this culture is generated from institutional imbalances; these have historically allowed financial institutions to pursue strategies (i.e. the sale of toxic products) that do not advance social priorities and do not fit within the essential functions of capital allocation and intermediation. In other words, contemporary financial innovation does not appear to have contributed to the efficiency of financial markets. Can regulation change culture? The discussion conducted in the previous section leads to question whether, and how, the prevailing culture in financial markets (especially in the UK and the US but increasingly Global Policy (2016) 7:2
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globally) can be regulated. The contention in this article is that at present, the postcrisis regulatory infrastructure does not seem to be capable of delivering the necessary regulatory changes (O’Brien, Gilligan and Miller, 2014). A flawed institutional design still permeates financial systems and this is at the heart of the fundamental imbalances, discussed in section 2, between market participants on the one hand and regulators on the other. Much of the post-crisis regulation, despite fixing some relevant aspects of the financial system, is largely piecemeal (Avgouleas, 2012; Buckley, 2014). A relevant example in this sense is the product intervention regime introduced in the US and the EU to enhance investor welfare and financial stability. In the US, the Dodd-Frank Act, title X, established the Consumer Financial Protection Bureau as an independent agency within the Federal Reserve system, to ensure the enforcement of federal consumer laws and the transparency of products. At EU level, with the Market in Financial Instrument Regulation 648/2012 (MIFIR), the European Securities and Markets Authority (ESMA) has powers to temporarily prohibit, or restrict, the marketing and sale of financial instruments that pose threats to investor protection or the stability of financial markets, provided the measure does not have detrimental effects on market efficiency and does not create regulatory arbitrage. These represented potentially excellent measures to curb the power of banks to innovate for speculative aims. Crucially, however, they were not accompanied by a substantial redefinition of the author-vis financial institutions. ity of the delegated agencies vis-a The power of the agencies remains inadequate for a number of reasons (ranging from lack of resources to poorly defined powers) and the institutional imbalance highlighted in the previous section has not been fixed. The private nature of financial markets enabled internal cultural values, which legitimise business patterns that are socially harmful, being sources of social imbalances (O’Brien and Gilligan, 2013, p. xvii). Innovated forms of credit derivatives are prime examples of this phenomenon with investment banks engineering bets so complex that central banks have been unable to classify them or assess their value (Peston, 2013, ch. 3 pp. 86–92). The value of OTC derivatives was in fact largely based on self-referential mathematical models, internally devised by the same investment banks (a problem that has only been partly addressed by the introduction of central clearing requirements in the US and the EU). Similarly, the power of banks to influence regulators was also represented by the regulatory reliance on market participants to develop concepts such as ‘integrity’ in the context of conduct rules. Arguably, this approach has failed to reestablish trust in the financial system after the crisis, simply because a system of self-referential standards is no longer credible (O’Brien, Gilligan and Miller, 2014, p. 117). This article stressed that financial institutions have become central in the economies of most developed as well as developing countries. While it would be highly desirable, a regulatory framework designed to channel financial activities towards economic and social welfare is still missing (O’Brien and Gilligan, 2013, Introduction pp. xxv–xxvi), due © 2016 University of Durham and John Wiley & Sons, Ltd.
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to persisting institutional imbalances. It could be argued that if the institutional structure of the financial system is indeed the problem, then the necessary regulatory changes should start from a new institutional design. In order to promote much needed societal obligations, for instance, the purpose and culture of regulated firms should be institutionalised through regulation and thus generate the desired type of behaviour (O’Brien, Gilligan, Miller, 2014, p. 124). As this is not likely to come voluntarily from market participants, the necessary conduct would have to be imposed by an appropriate form of state intervention (Sants, 2010). A more prescriptive conduct regulation could both institutionalise socially desirable behaviour, and also prevent the formation of a culture at firm level, that is not consistent with social and welfare priorities. A revisited policy framework is therefore the necessary precondition for a new institutional design. The desired regulatory architecture of financial markets is one that should recalibrate the priorities and functions of the financial system in society; this presupposes a rethink of the broad politico-economic dimension of the problem. From a policy perspective, a model of social capitalism should thus be advocated globally, in sharp contrast to the prevailing neoliberal doctrine that prompted the liberalisation of financial markets over the past three decades. As discussed earlier, policy pressure from international standard-setters led to the advancement of the interest of the financial industry over other social stakeholders (Westbrook, 2013, p. 13). The influence of neoliberal orthodoxy on policy making led to believe that a lightly, market-regulated financial system could work well, and that market-players’ greed and selfishness could still give rise to efficient outcomes (Jaffer, Morris and Vines, 2014). This hypothesis led to catastrophic results as evidenced in section 3. A new politico-economic orientation would translate into a more prescriptive regulatory model embedding cultural values – prudence instead of excessive risk-taking for instance – that would be institutionalised at firm level. This type of social order would overhaul the conventional wisdom, that markets should not be impeded by state regulation that is not permissive of market practices. The questions raised in section 2, related to the role of financial institutions in society, are likely to remain open until a holistic redesign of the governance of financial markets is conducted. In the context of post-crisis reforms, there has been a missed opportunity in this sense, given that the nationalisation of failing banks first, and then the repeated scandals revealing the fraudulent conduct of banks, could have served as a springboard for more drastic reforms. This article upholds the view that a drastic redefinition of the relationship between regulators, market-players and society is needed (O’Brien and Gilligan, 2013, p. xxi). This would be the precondition to build a new institutional framework for the regulation of financial markets which would in turn promote new intellectual and normative values. As the current system still rests on flawed policy and institutional foundations – allowing banks to pursue their private interests through speculative innovation and © 2016 University of Durham and John Wiley & Sons, Ltd.
increased risk-taking at the expense of societal stakeholders (Turner, 2011) – it is difficult to envisage regulation that shapes culture and behaviour in financial institutions.
5. Concluding remarks: drawing new boundaries for the regulation of financial innovation This article examines the recent IRS scandals that occurred in the UK and the US and it reflects on the undesired effect that innovated and complex derivative products had on different types of financial consumers. These events showed that banks selling these products extracted rents from investors, due to asymmetric information and flawed legal protection afforded to purchasers of IRSs. The IRS scandals also provided an opportunity to reconceptualise the function of financial innovation and assess the motives that underpin this fundamental function of the financial system. This article observes that contemporary financial innovation is underscored by the private self-interest of market participants, and that the more recent innovation process has lacked any connection with the real economy. This contention leads to critically analyse the dominant culture and behaviour in financial institutions and to assess whether regulation can change culture and foster more socially inclusive behaviour among market participants. From the above consideration, this article suggests that a paradigmatic shift is needed to regulate behaviour in financial institutions and recalibrate their role in a socially desirable dimension. As explained, this shift has not occurred post-GFC. Unlike what happened in the US with the New Deal in the 1930s, lawmakers in the US, the UK and the EU have missed the opportunity to redesign the architecture of financial markets. The degree to which culture can be regulated by imposing constraints on capital market activities has been largely underexplored as well as the more fundamental balance between private interests and social obligations. Furthermore, as the GFC manifested a crisis of authority, a new institutional design should have drawn new boundaries for the operations of financial institutions. As put forward in section 4, a more prescriptive conduct regulation could shape behaviour and therefore impact on culture at firm level. This article submits that a redefinition of the role of financial institutions in society is needed; this should be accompanied by an adequate design of the regulatory and supervisory infrastructure, whereby the designated authorities should be equipped with sufficient power and legitimacy to oversee the industry and impose behaviour. Such new arrangements would have profound implications at different levels, namely political, theoretical and judicial. At a practical level, the most immediate consequences would be a tighter definition of activities that can be conducted by financial institutions. In light of what was said in the introduction, the functions of capital allocation and intermediation would be guaranteed and in this sense the process of financial innovation would be channelled towards economic and social goals, by constraining the power of private actors Global Policy (2016) 7:2
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to design new products. While this approach may prima facie represent an obstruction to the ongoing global integration of financial markets, it is contended that it would be the necessary compromise to achieve the much needed shift towards more sustainable and socially responsible financial markets.
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Author Information Vincenzo Bavoso, Lecturer in Commercial Law, School of Law, University of Manchester. I am thankful to the Leverhulme Trust for funding part of the time spent conducting this research. I also thank the members of the Tipping Points Project at Durham University for helpful discussions and encouragement, and the two reviewers for very constructive comments on a previous draft of this article. Errors remain my own.
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