Why tossing rogue traders in jail and throwing away the key is the only way to police the industry.
- By Helen ThomasHelen Thomas has seen all sides of financial markets, from trading floors to hedge funds, think tanks to parliament, and now blogs sensible market commentary at blondemoney.co.uk and @MarketBlondes.
The sentencing of the trader Tom Hayes for his part in the Libor scandal caused many a sharp intake of breath on London’s Canary Wharf. Fourteen years in prison is, after all, similar to what many murderers serve in the United Kingdom. For some observers, this was justice well served for another greedy banker who prospered as the world’s economy shrank; for others, it was overkill from an overzealous regulator. Even Nick Leeson, the fraudster who brought down Barings Bank in 1995, fell into the latter camp, describing the sentence for Hayes as “a bit heavy.” But it was also necessary.
To be sure, it looks like a punitive sentence, even in absolute terms, for any kind of crime — even more so if we compare it to the 3.5 years that Leeson himself ended up serving. After all, Hayes wasn’t actually one of the Libor submitters who responded to daily telephone calls from the British Bankers’ Association, surveying member banks about where they could borrow funds. But he was a derivatives trader who could have made significant profits based on where the average of that survey fell out — hence his comments, replayed during the trial, which showed him attempting to manipulate the submitters. For example, one phone call recorded him saying, “Mate, can you do me a big favor and ask him if he will set three-month Libor on the low side in the next few days?” He offered perks, such as trips to football matches, to get the submitters on his side.
The rewards for this kind of manipulation were huge. During four years at UBS, Hayes was paid 1.3 million pounds, and in nine months at Citigroup he received 3.5 million pounds.
How did Hayes get away with it for so long? Where were the regulatory authorities? Why were they not aware, and why did they not intervene? Their job is to ensure the markets are free and fair, but clearly they failed here. It wasn’t just Hayes, nor was it just one or two banks, that have been shown to be guilty of manipulation; it’s apparent that corruption in this market was rife.
And the problem doesn’t stop there. The Libor scandal is just a microcosm. The global financial crisis was a failure of regulation on a worldwide scale: the credit rating agencies who stamped their highest AAA ratings onto packaged securities that turned out to be worthless; the central banks that failed to spot the build-up of leverage within banks; the politicians who were happy to take tax revenue from a financial services sector built on an illicit bubble — the list goes on. So could the solution really lie in doling out murderer-style prison sentences for traders?
The answer lies in the incentive structure. In general, traders are not personally liable for making unethical decisions. If they do and are found out, they may be prevented from trading by bodies such as the Financial Conduct Authority in the United Kingdom or the Securities and Exchange Commission in the United States. Yet this has very rarely occurred — in fact, virtually never before the crisis. Just as the regulators let the banks build up high leverage ratios, they also let the banks judge whether to bring a case against their own traders and force them from the Financial Services Register or the Series 7 certification. The trouble is that a bank has little incentive to highlight the failings of one of its own — far better to fire the person, preserve the bank’s reputation, and let the wrongdoer take his or her ethically unsound behavior elsewhere.
This is entirely unlike other professions. Lawyers are routinely disbarred, doctors de-credentialed, and accountants sanctioned for unethical and negligent behavior. It is in the interests of their employers to expose them as a protection against liability. A hospital could be shut down if a negligent doctor is revealed; a law firm or an accountancy firm could lose its reputation. These professions attract business precisely because they stick to the rules. If there were a rogue doctor killing people, a lawyer misrepresenting people, or an accountant defrauding people, their employer would prefer to go to the authorities than to risk going down with them.
Not so for bankers — especially if unethical or fraudulent behavior leads to higher profits. Compared to those other professions, the risk profile is balanced in completely the opposite direction. Risky behavior by lawyers, doctors, and accountants offers little upside for their employers but tremendous potential downside. In banking, it’s the reverse.
The upside for everyone is huge if the risks pay off. The trader gets his million-pound bonus; his managers get theirs; the shareholders receive handsome profits; and, as long as the bank’s share price keeps rising, the regulator often accepts the verdict of the markets and continues to believe it’s a profitable and sustainable business.
On the downside, if a banker goes rogue, what happens? The individual will be fired, but the bank will simply let him go, portraying him as just one bad apple. Remember the case of Jérôme Kerviel, the French banker who apparently managed to lose 4.9 billion euros for Société Générale all by himself? The bank still exists; Kerviel now works for a computer security firm.
So how can we redress the imbalance and the skewed incentives? It’s not politically feasible to limit the upside for traders by capping their pay, even during normal economic times. It’s against free market principles, for one thing. For another, traders can easily move — unlike lawyers, accountants, and doctors, who are typically credentialed in just one jurisdiction — to another country where pay is uncapped.
The other solution is to enlarge the downside, and the only way to do that is to make it personal. Traders can bet billions, but usually the worst thing that might happen — with the exception of the odd Tom Hayes — is that they get fired. Regulators could get tougher, too, by barring any bad banker for life from the register of “approved persons.” But again, unless every regulatory authority around the world operates with the same register, this wouldn’t necessarily end a trader’s career. Prosecution is the only way to target the right person with the right incentives.
Moreover, the threat of prosecution would have to be immediate and dire to reflect the size of the risk to society. The downside risk from unethical behavior is not just for that trader or his bank. As the global financial crisis showed, a breakdown in the system can cause a meltdown that leads to economic oblivion. Even now, eight years after it began, the crisis casts a very long shadow, with millions of people still missing from the labor force and interest rates still at rock bottom simply to keep a lukewarm recovery going.
The fragility of the global economy, paired with the nature of the modern financial system — enormous, complex, yet vulnerable to the actions of a single person — has made incentives targeted at individuals essential. The headlines about Tom Hayes may be shocking. But it’s a shock that the system needs.