Editorial: Moral Cents recently encountered arguments against teaching Finance and Ethics in MBA finance programs, and has rebuttals.

Benefit Corporations: Corporations can choose social and environmental good over profits without fear of legal repercussions from shareholders, by incorporating as Benefit Corporations. We may be witnessing a slow cultural (r)evolution, supported by the law, as corporate goals shift from pure profit maximization to producing social and economic good.

Corporate Social Responsibility (CSR) in China: The CSR situation in China. An interview with Mr. Li Weiyang, CSR Director of the State Grid Corporation of China.

Cross Country Examination of Executive Compensation: What is the state of executive compensation in the U.S, the United Kingdom, and South Korea?

A Neuromarketing Analysis of Financial Predation: Here is a neurobiological model that studies how predation influences trust and cooperation between predator and victim.

Mortgage Electronic Registration Systems (MERS): What are the fiduciary obligations of MERS in the U.S. housing crisis?

Hong Kong’s Housing Game: The economic (in)justice of the housing market in the Hong Kong Special Administrative Region (SAR).

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1. Rebuild the middle class

2. Invest in infrastructure with savings from winding down overseas wars

3. Invest in and reform education

4. Extend unemployment insurance

5. Cut taxes for the middle class (those earning less than $250,000 year)

6. Increase taxes on the wealthy (those earning more than $250,000 a year)

7. Cut taxes for small businesses that hire veterans

8. Cut taxes for companies in the US and give additional relief to companies that relocate manufacturing and research and development to the US. Discourage off-shoring.

9. Use tax credits to encourage research

10. Preserve Social Security and Medicare as a public programs

11. Support workers’ rights

12. Raise minimum wage and index to inflation

13. Maintain new regulations to restrain financial malfeasance

14. Streamline outdated regulations

15. Ensure free and fair trade

(From: Democratic Party Platform 2012)

Analysis

Like the G.O.P.’s 2012 finance platform, the Democrats’ finance platform contains no new ideas. In that sense, the two political parties are similar. The Democrats’ finance platform’s big idea is to rebuild the middle class. To fulfill this grand objective, the finance platform is made up of familiar, piecemeal measures for which Democrats are known – investing in education, preserving government programs (just make them more efficient), and giving government help to those in need. The lack of new ideas from either party is not a revelation, but confirmation of the status quo is still dispiriting. Like those of their opposition, the ideas from the Democrats’ finance platform are from the last century. These ideas do not seem to account for evolved economic and financial realities. Bold, inventive thoughts are absent in the platforms of both parties.

Yet, in theory, the two platforms offer a choice of governing principles to voters – the same choice as in the past, but a choice nonetheless. In the practice of government, it seems pragmatism, compromise, and syntheses (from which new ideas do arise) are not currently on the voter menu.

On the issue of ethics in finance, the G.O.P. finance platform ignores the role of ethical failure in the financial crisis (this near catastrophic event also is given scant acknowledgement). Apparently, for the G.O.P. there is no problem of ethics deficiency in the financial domain (but plenty of moral laxity in the social sphere, of course). At least the Democrats acknowledge that a lack of ethics contributed to the financial crisis. Unfortunately, their main solution to ethical failure is to promulgate regulations to keep financiers in line. The Democrats do not recognize the unintended consequences of financial regulations some of which lead to ethical problems. Indeed, the same refrain of, “home ownership is an achievable dream for all Americans” seems cut and pasted from past Democratic platforms. The push for home ownership and laws in pursuit of that goal led to ethical failures at Fannie Mae and Freddy Mac and their eventual financial demise.

Both political parties in the US need to realize ethics education in finance achieves Democratic and Republican principles. For Republicans who purport to value free markets and individual achievements, people can choose to act ethically, on their own, if they have a sound moral compass. This is self-driven regulation, sans government rules. For Democrats, ethical behavior is more likely if an individual is embedded in an ethically oriented milieu. In other words, the culture and community must foster ethical acts and virtuous people. Thus, ethics and ethical behavior in finance are self-driven but community supported.

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2. Reduce personal and corporate taxes.

3. Constitutional amendment requiring a super majority for any tax increases

4. Reduce federal spending using a tripartite test for every federal activity, and thereby,

5. Reduce the size of big government

6. Rein in union power

7. Audit the Federal Reserve Bank and make it more transparent

8. Enforce free trade by pushing trading partners to open their markets to US goods

9. Stop China’s unfair trade and currency policies

10. Aggressively support small businesses

11. Promote private-public infrastructure development

12. Retain FDIC guarantees on bank deposits but increase banks’ capital requirements ensuring no more future bailouts

13. Repeal Dodd-Frank. Instead pursue, “Reasonable practical oversight of financial institutions, [and] practical safeguards for consumers”, but still,

14. Moratorium on all regulations until existing ones have been reviewed

15. Give citizens control over their Social Security accounts

(From: G.O.P. Platform 2012)

Analysis

First, there are no new ideas. These fifteen positions on finance and economics have been part of the GOP world-view and action plan since the last century. Economic and financial ecosystems have changed. Empirical evidence from finance over the past decade may require new ideas for new contexts. For instance, the tone of the GOP platform suggests free markets are, without exception, good. The party continues to want light to no regulations (little is said about regulating banks after repealing Dodd-Frank). This position ignores the evidence provided by the 2008 financial crisis and the 2000 dotcom crisis. Markets are not efficient. There are market failures and there is market manipulation.

Second, the GOP platform, not unexpectedly, speaks in broad, general terms. There are few details. For instance, reduce big government. Who can disagree? However, the tone of the GOP platform suggests government, without exception, is bad. The implication is government and labor unions distort free markets making markets inefficient. However, the platform is silent on other factors that distort free markets.

Private sector interference also can distort free markets. Unethical private sector activities such as the manipulation of LIBOR (London Interbank Offer Rate) distort the free market price of money. Cronyism and non-independent boards of directors distort the market price of executive compensation. Corporate corruption such as Enron’s distorts free market forces.

Third, the platform is largely anodyne. Yes, we do not find disagreeable ideas like free markets, less government, and a balanced federal budget. However, if the GOP had included something new and creative in its platform, such as, say, “promote ethics in markets, because ethical failure is probably the single most perilous cause of financial market collapse”, voters would probably sit up and pay more attention.

Next Week: The Top 15 points of the Democratic Party Finance Platform

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Dr. Kara Tan Bhala recently delivered a lecture on, “Ethics in Finance: Its Desolate History and Its Fruitful Future” at the Heidelberg Center in Santiago, Chile. Proyecto ACCESO was a sponsor of the event and kindly provided a video of the lecture. This talk was also given at KAIST Business School in Seoul, Korea. KAIST is one of the first business schools to make “Ethics in Finance” a required course for MBAs who are pursuing a concentration in finance.

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William (Bill) Black is a lawyer, academic, author, and a former bank regulator. He developed the concept of ‘control fraud‘, in which a business or national executive uses the entity she controls as a ‘weapon’ to commit fraud. Black was a central figure in exposing Congressional corruption during the Savings and Loan Crisis. Black is the author of, among others, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. He is a columnist for the Huffington Post and writes on financial and political fraud and (legal and illegal) corruption. Black is currently an Associate Professor of Economics and Law at the University of Missouri-Kansas City in the Department of Economics and the School of Law. He was the Executive Director of the Institute for Fraud Prevention from 2005-2007 and previously taught at the LBJ School of Public Affairs at the University of Texas, and at Santa Clara University.

Instead of a competition in laxity, we want to introduce a competition in integrity

TRAVIS STRAWN:  In your opinion, have the problems with the financial industry that led to the economic crisis been resolved?

WILLIAM BLACK: No

TS: Why do you think that is so?

WB: Because I think the fundamental causes were not addressed.

TS: And the causes being?

WB: The fundamental causes as I see it are: we have created intensely criminogenic environments, and we have done this through a combination of the three D’s: deregulation, de-supervision, and de-facto decriminalization.   And we have created the criminogenic environments through modern executive compensation.

TS: What do you think remains to be done on those issues?

WB: Well in some sense everything, because not very much was done on any of those things.   Take the de-facto decriminalization. There still are no prosecutions of any of the elite criminals that drove the crisis. In terms of de-supervision, in general the people that screwed up as regulators were promoted, as opposed to being replaced by vigorous supervisors.  In terms of reregulation there’s been some, obviously the Dodd-Frank bill, but it doesn’t address the key factors producing the criminogenic environment, so I don’t think it will solve the problem. Indeed we continue to be strong supporters overall of the race to the bottom theory of regulation, typically with the city of London in finance, in which we have to “win a competition in laxity”. That’s the dynamic that produces an aggressions dynamic in which bad regulation drives good regulation out of the marketplace. That ends up being very criminogenic and of course we have one candidate [Mitt Romney] saying he is going to repeal all of Dodd-Frank if he is elected.

TS: What do you think of the Dodd-Frank financial reform bill as a means to regulate the financial industry in general and about the Volker rule against proprietary trading in particular?

WB: Well, I have gone through my overall view of Dodd-Franks so I will concentrate here on the Volker rule. I have written some things recently on the Volker rule that will give you more of my views in the context of the current JP Morgan losses. I think the Volker rule is a very good rule. If you look under liberal, conservative or libertarian principles, there is no reason why the systemically dangerous institutions (these are the institutions treated as too big to fail), should receive both an explicit federal subsidy through deposit insurance and a much larger implicit subsidy from the treatment of too big to fail.  This treatment allows them, in the words of the very conservative authors of “Guaranteed To Fail” (Guaranteed To Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White) to bring a gun to a knife fight.   There was nothing free about the markets because of the role of these implicit federal subsidies.   Financial derivatives are overwhelmingly traded by a very few banks, all of them systemically dangerous institutions, so all of them received these double subsidies. I can’t think of any public policy reason, on liberal, conservative, or libertarian grounds that would say we should be subsidizing those kinds of gambles. Gamble is the best term of course, because regulators still haven’t solved the agency problem with regard to derivatives. The agency problem probably explains why there is no more Merrill Lynch as an independent entity. What people forget about this crisis is that the biggest entities were also the entities that not only created the most of what we call the “green slime”  (toxic financial derivative instruments) but actually ate their own cooking to a far greater extent than people understand. This, I argue, is primarily because of agency problems where corporate officers have perverse incentives to create fictional income by having bad loans.

Jamie Dimon recently got this one correct at least in the loan context, but it applies to many derivatives as well. If you don’t underwrite these derivatives, they produce tremendous short-term fictional income and longer-term real losses. That is the fundamental agency problem because the officers are still paid overwhelmingly on the basis of short-term results so it’s a sure thing mathematically that if you buy these really bad assets it will report a record income in the short-term and that record reported income will lead to extraordinary bonuses. You can walk away wealthy – this is the meaning of the title of Akerloff and Romer’s famous article in 1993 “Looting: The Economic Underworld Of Bankruptcy For Profits[i].” The firm crashes but the officers walk away wealthy having looted the place – alas Merrill Lynch for example.

The fact traders can get away with fraud is what has really changed in the modern era– that’s the de-facto decriminalization of fraud.

TS: And this is, you think, like control fraud?

WB: This is control fraud. Systemically dangerous institutions together with subsidies completely distort competition. You make markets dramatically inefficient and you encourage the officers to engage in gambling. The gambling is going to cause destruction ultimately, of many financial institutions.

That’s the good news.   My view is that control frauds can do something far worse.  They can hyper inflate bubbles which cause really bad financial crises, recessions or depressions.

TS: And you are saying instead of gambling on it, it is a sure thing because they have the insurance backing, the taxpayer backing?

WB: No the implicit subsidy means that you can borrow more cheaply. Too big to fail really means, operationally, the institution doesn’t fail but when it does fail, we bail out general creditors and even sometimes subordinated debt and even sometimes equity.  But mostly we bail out general creditors. That means since general creditors are implicitly protected against loss by the federal government, such institutions can borrow more cheaply.  And that gives them a competitive advantage. As I said earlier, that competitive advantage distorts competition and is the written equivalent of bringing a gun to a knife fight. All the wonderful stuff about efficient markets and such dies at that point.

The second point is that the bail outs produce what neoclassical economists fixate on, which is moral hazard. There is gambling of course, when traders take excessive risk. If they win really big they will do very well but if they do poorly they may cause $50billion in losses. But they walk away from the losses and maybe pay a hundred thousand dollars. The risk is asymmetric. Conventional economists focus on this asymmetric risk and call it gambling. I am saying, “well no”, because that’s an inferior option typically. Why gamble when you have a sure thing? Economists like Akerloff and Romer write about fraud being the sure thing. Virtually nobody cites Akerloff and Romer’s paper ignoring the possibility of fraud. Conventional economists focus entirely on gambling and that doesn’t comport with the facts. Gambling assumes massively irrational behavior on the part of the officers. If you are  willing to believe traders would be willing to gamble and destroy the entire firm then why should you not be willing to believe traders will choose to commit fraud, a sure bet to winning big, especially if they can get away with it. The fact traders can get away with fraud is what has really changed in the modern era– that’s the de-facto decriminalization of fraud.

TS: Because of Dodd-Frank and the higher capital requirements of Basel lll, the banks seem to be adjusting to a new business model.  Do you see the financial sector shrinking in terms of their cumulative earnings as a percentage of national GDP, perhaps back to the early 1980’s level? 

WB: No, it would be very good if they shrank the efficiency conditions for a middle-man. Investment banking is a middle-man enterprise after all. Finance is supposed to be lean and mean and not to have enormous profits. It is simply supposed to serve the real economy. In fact the financial sector has become parasitical in the real economy. It takes vastly too much wealth.

Higher capital requirements are in general a good thing. But you can’t count on them because, you know, capital is simply an accounting residual and what we’ve been saying is people can easily distort the asset valuations.  In other words accounting fraud is the weapon of choice in the financial sphere so we always urge, from a regulatory, criminology and economic standpoint, that you should not rely primarily on reported capital asset protection because it is so easy to manipulate.  That said, the parade of horribles Jamie Dimon raises, such as not being able to raise capital, and the subsequent disappearance of banking, are ridiculous.

TS: Is it too late to put the genie back in the bottle in regards to the financial industry?  Will finance return to its original function of being the means to channel money from investors to companies?

WB: Left to its own devices no, it will not return to its original and appropriate function.  It will remain really to some degree, crony capitalism and that is going to be very bad for the world.

Can we put the genie back in the bottle?  Yes, but it will take the Supreme Court to strike down Citizens United to have any realistic chance.

…in my more upset moments I refer to business school, the modern business school, as a fraud factory.

TS: What do you think is the relationship between ethics and regulation?

WB: Well, regulation when it’s done right is putting regulatory cops on the beat.  Regulators’ primary function is to prevent an aggressions dynamic, in which bad ethics by people in the business produces competitive advantage. This advantage drives good ethics out of the market place. We should be focused very much on ethical behavior and indeed one of the interesting things is conservatives, in general, love the broken windows theory.  In fact if they know anything about criminology, probably the only thing they know is the broken windows theory. This theory says that long before you deal with really serious crimes it is essential that the ethos of the overall community cracks down on relatively minor unethical acts that tend to weaken community.  To be consistent, conservatives need to apply the same logic to white-collar crime. The broken window theory works a lot better in white collar crimes than in the blue-collar context because we do away with having just minimum levels of ethics. Instead we are going to aim for a high ethical plane. Instead of a competition in laxity, we want to introduce a competition in integrity.  That would be a very different approach.

TS: Did business and financial education contribute to the economic crisis?

WB: Yes, business and financial education contributed to the economic crisis. Michael Jensen, who has of course turned against his Frankenstein creation of compensation for executives in modern finance, says that executive compensation has produced a profoundly unethical system. Jensen cites survey evidence which shows it is common for CFOs to be willing to take actions that are unethical and uneconomic. Jensen says this is what people are learning in business school  – how to employ unethical techniques. So in my more upset moments I refer to business school, the modern business school, as a fraud factory.

TS: U.S. stock markets are experiencing particularly low volumes of trading.  Is this an indication of the lack of trust Main Street has for Wall Street and will this situation of declining trust get even worse?

WB: Yes, there has been a reduction in the number of Americans willing to participate in the stock market. This goes back at least to Enron and WorldCom days. During the tech boom more Americans invested directly. Obviously they had investments through their pensions but it became much more common for regular middle-class Americans to have their own individualized stock portfolios. It is because of these recurrent crises that people quite rationally do not trust the markets very much.  And indeed this is perhaps part of the reason why you have economist after economist talking about the mystery, the alleged mystery, of the equity premium which is supposedly too high.

TS: Do you think there is a political-financial-media nexus that strongly supports the current status quo in finance?

WB: Yes. I have been dealing with business media for 27 to 28 years. Business media was never strong during that 28 year period and it has weakened considerably. It is very common for them to recycle press releases from the industry. Prestigious papers like the New York Times, basically want access to the top folks in finance. The price of access is self-censorship. Thus, business media can be a little critical but it cannot really fundamentally question the system.

TS: Do you think there is a big difference from 27 [28] years ago to now?

WB: Not huge, but business media was not strong 28 years ago and has fallen from a low point.

TS: What is your opinion about the Occupy Wall Street movement and will it last?

WB: My opinion is the movement has been very helpful because empirically, the number of media references to inequality went up dramatically. A number of us and certainly I believe, that rapidly increasing inequality is one of the major problems in America and in a number of other nations. If the Occupy Wall Street movement did nothing else but highlight inequality, that would be a really good accomplishment.   It is a really interesting movement in that it really doesn’t have leaders and it doesn’t really have an agenda. There is an enormous question of what will become of it. If Occupy Wall Street continues to exist it won’t be the same entity because it will have to develop some degree of leadership and greater programmatic issues.  However, it has already been a useful movement. It may spawn other alternatives approaches as well.

TS: Do you think there will be more criminal prosecutions for those connected with causing the economic crisis?

WB: I think they have to indict someone before the election but I think that indictment will be token.

TS: Do you have any idea who you think they would actually indict?

WB: I think they’ll indict one of the entities selling loans to Wall Street, possibly to Fannie and Freddie. They will do so under the aegis of this new working group that’s looking at securitization. They will look at false reps and warranties that were made and perhaps indict one or two of those entities. My guess is that the entities indicted will not be the big guys. They won’t indict Citicorp for example, despite the testimony given to the Financial Crisis Inquiry Commission about Citicorp’s false reps and warranties on hundreds of billions in sales.

TS: How do we get finance workers to behave and think more ethically?

WB: Right now we incentivize finance workers to do the wrong things.  There is a famous quotation from Frank Raines, who the Business Roundtable in a wonderful case of irony, made its spokesperson to the media in response to the Enron [and] WorldCom series of scandals. BusinessWeek asked him, “Hey, Frank why do we have all these frauds?”  He says that “it’s the money” and he summarizes, and this will be an almost exact quotation, “if you wave enough cash in front of people even good people will do bad things.”  So right now we systematically incentivize and reinforce the worst conduct by the officers and directors, from the most senior level through many of the most junior levels. You can’t create an intense incentive system that encourages people to do the wrong thing and then have somebody preaching, you know, come in and say [laughs] “you should do the right thing, you should do the right thing.”

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The Institute wishes to thank Mr. William Black for his insights and graciousness.

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The list of the month’s charges, convictions, sentences, and ethical lapses run as follows:

1. Barclays Bank fined US$450 million for manipulating the London interbank offered rate (Libor); other top tier banks are being investigated and more charges are likely to follow. Libor is set daily and is a key benchmark rate.  Messing with it is like messing with your interest payments or interest earnings, without your knowing.

2. Rajat Gupta, the former global head of McKinsey Consulting, convicted of insider trading. He gave material, non-public information (the definition of insider trading) about Goldman’s activities to Raj Rajaratnam (already serving an 11-year prison term for insider trading). Gupta leaked information to Rajaratnam on three occasions in 2008, one of them was when Goldman’s board approved Warren Buffett’s $5bn investment in the bank.

3. Allen Stanford, former billionaire and owner of Stanford International Bank in Antigua, was sentenced to 110 years in prison for running a $7 billion Ponzi scheme. He stole money from investors to finance an extravagant lifestyle in the Caribbean.

4. Philip Falcone, a once lauded hedge fund manager of Harbinger Funds, has charges brought against him by the Securities and Exchange Commission (SEC) for using customer funds to pay his taxes, manipulated markets and gave favorable treatment to certain clients. The SEC charges that Falcone fraudulently obtained $113.2 million from a hedge fund he advised and misappropriated the proceeds to pay his personal taxes.

5. Peter Madoff, the brother of the infamous Bernard Madoff, pleaded guilty to conspiracy. He helped Bernie to perpetrate the largest investment fraud in U.S. history. Investors are thought to have lost $20 billion in principal in the Madoff fraud.

6. Tai Nguyen, the president of an investment research firm Insight Research LLC, pleaded guilty to insider trading. Nguyen admitted to sharing material non-public information with hedge fund manager Samir Barai and a former analyst at Steven A. Cohen’s SAC Capital Advisors, Noah Freeman.

7. Bob Doll, Chief Equity Strategist of BlackRock Inc and a regular on CNBC, retires after his funds’ board of directors learn the investment models used for Doll’s funds were never proprietary but instead based on other firms’ models.

Libor is a core, sacrosanct number in finance

The most egregious case and the one that hits at the heart of finance and our lives is the manipulation of Libor rates by top tier banks. Libor should be an inviolable pillar in financial markets. It is the key benchmark rate at which banks borrow from each other. It is the reference rate for about $350 trillion of financial products, from sophisticated products such as interest rate swaps to commonly used products such as credit cards. Mortgage rates, savings account rates, home equity rates and a host of other interest rates a modern capitalist economy uses are based off Libor.

The rate is set daily by asking the world’s leading banks their cost of borrowing. Everyday, the rate-setting banks give their estimates of how much it will cost them to borrow in 10 currencies for 15 different lengths of time. The top and bottom rate are discarded and an average is calculated from the remaining rates.

Barclays and other suspected banks submitted artificially low Libor numbers to help other divisions in these banks make money. Specifically, traders of interest rate derivatives asked colleagues to submit false information in order to boost trading profits. When the rate submitting colleagues acquiesced and gave false Libor estimates, the derivatives trader sent an email: “Dude, I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.” Britain’s Financial Services Authority (FSA) tracked 257 messages asking for Libor and its yen and euro equivalents to be altered. These emails paint a tawdry picture of banking. Submitted rates also were manipulated to give the appearance that everything was fine for Barclays during the financial crisis in late 2007 and 2008.

In other words, Libor, a number on which nearly everyone depends, and the veracity of which almost everyone trusts, was falsified. For profits. By a few banks. John Authers of the Financial Times, describes the manipulation of Libor rates for self-interested purposes as, “grotesque ethical failures”.

The logic of ethics education in finance

While there has been unethical behavior in finance in the past (and will be in the future), the pace, frequency, and easy acceptance and acceptability of unethical acts in finance has increased over the years. Most unethical acts also are illegal and as we have seen in the financial crisis, starting with the fall of Lehman Brothers, their consequences ripple through the global financial system.

As a result of these acts, the financial system froze and needed rescue, people lost jobs and homes, cities went bankrupt, and the Euro’s existence is threatened. Most notably, the public’s faith and trust in financial markets has fallen dramatically. First, the public has lost trust in the U.S. stock market. In March 2012, the average daily volume in equity shares was 6.59 billion shares a day, the lowest level since December 2007. Second, the public has lost trust in financial institutions. Gallup published a poll on June 27^th that shows Americans’ confidence in banks has fallen to a record low of 21%. These are the percentage of Americans saying they have a “great deal” or “quite a lot” of confidence in U.S. banks. It is a well-known and accepted fact that markets run on trust which is, not coincidentally, a moral value. Without trust, markets wither.

In other words, unethical acts have consequences.

Logically, to stop people from doing unethical acts, we must make sure they choose to do ethical acts. It follows that it is important to teach ethical reasoning and the major frameworks of ethics in addition to portfolio theory and options pricing when teaching finance. It also is essential to instill an ethical culture in the money industry. Especially in the money industry because recent psychological research finds that having money or even just thinking about money makes people more likely to be unethical. If a culture places greater value on integrity (of the system and of the individual) than on profits (performance bonuses), then one is less tempted to cheat or manipulate Libor rates.

Free Markets Plus (Ethics)

Thus, if we agree one of the causes of the financial crisis is a lack of ethics, then surely a solution to the problem of getting finance to function properly is to ingrain a greater sense of and sensitivity to ethics in the financial industry. Ethics is not the solution but a solution. For in order to right finance other factors such as risk assessment and regulation need to also improve. Risk assessment models always will be flawed and wanting. Regulations cannot carry the full burden of monitoring finance. There always will be financial innovations that cannot be foreseen by regulators, who to some degree are fighting the last battle.

Free market proponents want as little regulation as possible. Free market proponents call for self-regulation. One of the oldest and surest ways of individual self-regulation is by using a sound moral compass to act ethically. Ethics in finance is not something we should ignore or dismiss.

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The foundation of the current paradigm rests on the assumptions that economic agents are rationally self-interested and focused solely on the pursuit of maximum profit. These neo-classical economic assumptions help simplify the world for the purpose of econometric modeling.

Alas, over the last six decades, these economic assumptions metamorphosized into values. In other words, the assumptions became the ethic – we should be self-interested and we should pursue profit maximization. How often do we hear these values espoused by business, financiers, and politicians of certain persuasions? Let us not forget these values transmuted from mere assumptions.

The current paradigm of finance has served humanity well in that it has delivered material growth and prosperity. The paradigm has served humanity ill in that it has promoted an impoverished value system, designating people as “factors of production”. The two values of selfishness and maximizing profit ultimately lead to a commitment to thoughtless growth, for the sake of growth.

The call for a new economic paradigm is spreading as the Great Recession/Contraction rolls on. Robert Skidelsky and Edward Skidelsky write in their recent article, In Praise of Leisure, that the current economic system has two defects:

The first defect is moral. The banking crisis has shown yet again that the present system relies on motives of greed and acquisitiveness, which are morally repugnant…Second, the crisis [has shown that] our financial system is inherently unstable.

The Skidelskys recommend, as does this Institute, to bring together insights from economics and philosophy (moral and political). “Economics for the sake of its practical influence, philosophy for the sake of its ethical imagination. It’s time to revive the old idea of economics as a moral science, a science of human beings in communities, not of interacting robots.”

We must realize this vision of ourselves as robots and factors of production is relatively new, borne from twentieth century economics. Aristotle, Adam Smith, and John Maynard Keynes believed wealth to be a means to an end – the good life – and not an unsatisfiable end in itself.

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Seven Pillars Institute had the pleasure and honor to be an invited delegate to the Qatar Law Forum (http://www.qatarlawforum.com/) held in Doha, Qatar from 4-6 May 2012.

The focus of the Forum was change in the Middle East and current challenges in global finance. Over 400 leaders in law from 60 jurisdictions attended the Forum. Chief Justices present included those from the Supreme Courts of Bangladesh, China, England & Wales, Egypt, the Maldives, Libya, Qatar and Rwanda. The Panel on the Arab Awakening had senior representation from Egypt, Libya, Tunisia, Turkey, and the United Nations, and several of the panelists were active participants in the revolutions in their home countries. Overall, speakers hailed from Azerbaijan to the Americas, Australia to Pakistan, and India to Malaysia, from the New York Fed to the World Bank, and from the International Chamber of Commerce (ICC) to the International Court of Justice (ICJ). Distinguished law professors from 20 universities attended, together with the leaders of more than a dozen national or international bar associations.

Of particular interest to the Institute was the Panel on The Role of Ethics and Law in Finance. Thomas C. Baxter, Jr., General Counsel and Executive Vice President, Federal Reserve Bank of New York, was among the panelists. Mr. Baxter is one of the foremost authorities in the world on Banking Law. With experience through many financial crises, his advice is highly sought and respected.

What follows are answers from Mr. Baxter to four questions posed to the Panel by Sir William Blair, Justice of the Queen’s Bench in London. Those answers reflect the personal views of Mr. Baxter, not those of the Federal Reserve Bank of New York, any other part of the Federal Reserve System, or the United States government. The Institute has provided minor formatting and editing, but not changed the substance of the answers. The answers, while publicly presented at the Forum, are not intended as a polished article.

Question 1:

In terms of the debate on ethics and finance, what are the core problems to have been identified by the global financial crisis?  

First let me say that my remarks today are my personal remarks, and should not be taken as the official position of the Federal Reserve Bank of New York, or any component of the Federal Reserve, the central bank of the United States.

My position as chief legal officer of the Federal Reserve Bank of New York gave me a unique perspective on the crisis.

(1)       Many of the crisis events I experienced up close and personally.

(2)       Many I was a part of – following, as well as I could, Chairman Bernanke’s direction to do “whatever it takes, within the bounds of the law, to restore financial stability.”

I want to make some threshold observations.

(1)       I do not believe that people who work in finance are less ethical than people who work in other professions, like the arts or law or medicine.

(2)       I do not believe that the financial services industry is ethically challenged any more than other industries, like airlines or hospitality or petroleum.

(3)       I do not believe that residents of places like New York City and London are less ethical than residents of St. Louis or Doha.

(4)       I do believe that there needs to be careful study of the root causes of the crisis, and that such study will reveal a problem that is much more complex than ethically challenged people working in a corrupt industry.

(5)       Let me offer you three of the root causes – and underscore that I am limiting myself to three. There are more.

1^st Cause:        Misaligned Incentives

The key driver here is compensation.

•  If you pay people by the number of loans rather than the loans’ quality, they will make a lot of poor loans.

2^nd Cause:       Risk Management Failures

There were colossal mistakes regarding the assessment of risk, the pricing of risk, and the managing of risk.

•  The people at Lehman who went long on commercial real estate at the wrong time.

• The people at AIG who wrote CDS [Credit Default Swaps] on CDO’s [Collateralized Loan Obligations] without thinking through how much cash AIG would need to put up when the CDO’s lost value because of the subprime problems and AIG itself was downgraded.

•  The people at Bear Stearns who thought funding in the repo market would always be available

3^rd Cause:       Complexity of Modern Financial Engineering

• A machine called securitization created demand for fuel.

• The fuel for this “machine” was not oil but loans.

• The demand for loans worked as a kind of accelerant to the way that many loan officers were compensated. They made more loans, made more money, and fed the machine. Similarly, the people running the machine made more as it ran hotter and faster.

Question 2:

In terms of changes in market behavior, can this sufficiently be achieved through the markets themselves and through available legal strategies? Are there limits in this regard?

I worked for Chairman [Alan] Greenspan, a highly intelligent person, for whom I have the greatest respect. However, even he admitted recently that markets are not fully capable of regulating themselves.

We must continue to do the hard work of law and regulation. We need law and regulation to govern securitization. I concede that it would be nice to have very ethical people running securitization businesses too.

We need to upgrade the game with respect to risk management. Having very ethical people is, again, a nice to have – but we need the expertise first.

If we reward the wrong kind of behavior, can ethics overcome a monetary incentive? My heart wants to think so, but my experience tells me it just won’t be enough. I think we need to create the right kind of incentives. Risk and reward should be tied to each other. In this regard, the partnership model that is so pervasive in Islamic finance succeeds, in my view, because it gives all the key players a stake in the enterprise.

Question 3:

If there are limits, can culture and ethics help to fill the gap?

Yes, an ethical culture and ethics are important. We should encourage financial institutions to put in place internal governance procedures that take into consideration ethical impacts of transactions and products and how they might impact the reputation of the institution.  In the end, it is the reputation of the financial institution that is the franchise – without it, there will be no confidence, and the loss of confidence is the beginning of the end.

We should encourage financial institutions to include reputational risk among the key risks to the franchise. Damage to reputation from perceived unethical practices can adversely affect the financial institution in the same way as a material financial risk. Banks have introduced supervisory committees to oversee new products to ensure these produces do not involve ethical breaches. They have also, with some incentive from their supervisors, introduced committees to evaluate the reputational and other risks associated with large, complex structured transactions.  However, some caution is advised in the employment of such committees. Using committees may help make for more informed decision making, but they might also have the unintended affect of diffusing responsibility and eliminating  individual responsibility. The old caution “when everyone is responsible then no one is responsible” fits some experiences that I have had with committees.

Our goal should be for financial institutions to achieve a virtuous uplifting cycle that includes law, culture, regulation, and ethics.

Question 4:

Is it possible through regulation to alter and mold the culture and ethics of financial market practice, in a way that goes beyond aspiration?

Law and regulation and culture and ethics should reinforce each other. They should work together. When supervisors look at new products, they should consider the role of ethics, culture, and reputation in developing these products. [In other words, there should be a virtuous cycle.]

When reviewing the minutes of “new products committees” and “large structured transactions committees”, supervisors make sure ethical issues are discussed. However, I do not put too much stock into what is said about ethics in these minutes.

Forget the minutes that say blandly, “The ethical considerations of this transaction were considered.” Instead, ask, “Was there a highly profitable financial transaction or product that this institution turned down because of ethical considerations? There should be one! At least one! When the answer is yes, we will have reached the Promised Land. We are not there yet.”

*          *          *

The Institute thanks Mr. Baxter, and Mr. Justice Blair, for their insights and graciousness.

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From our vantage point at Neosho Capital, the European sovereign debt crisis is actually a symptom of two larger, more intractable, issues: the inherent difficulties of governing a federal entity and the perennial national and cultural tensions that have defined Europe for at least the past 2,000 years. It is our belief that while the short run problems caused by excessive sovereign indebtedness will eventually pass (at some point, either the debt is repaid, or it is in default), we believe Europe faces two longer-term issues that will likely persist over the coming decades, perhaps centuries.

The Symptom: The immediate question is whether Greece, and possibly Italy, Spain, Portugal, or Belgium or some combination thereof, will default on their sovereign debts. Despite the application of many bandages over the past two years, Greece continues to bleed and the possibility of a default this quarter looms ever larger. With some €14.5 billion bonds maturing on March 20 and a further €22 billion maturing before year-end combined with German and French leaders facing elections in which voters have little desire to pony up further funds to save the Greeks, something has to give, and soon.

Of Greece’s €350 billion national debt, €206 billion is held by private entities while the EU, the IMF, and the European Central Bank hold the remaining €144 billion. Of the €206 billion, about 60%, or €124 billion, is held by “big banks” who, as members of the Institute of International Finance (“IIF”), a few months ago agreed to a 50% reduction in the face amount they were owed in return for concessions from the Greeks on asset sales and fiscal austerity. We note that the debt held by the EU, IMF, and ECB is not part of this 50% “haircut.” We do not know the rationale for the EU, IMF, and ECB refusing to agree to a reduction in the principle of their own Greek debt holdings. Perhaps they will not insist on being paid back at all, or, more likely, they consider it perfectly acceptable for private entities to take a hit, while they have the power to insist of full repayment. Regardless, the goal of the 50% haircut on the remaining €206 billion is to reduce the remaining indebtedness to 120% of Greece’s GDP in 2020, supposedly a level that Greece can sustain.

Complicating the proposed 50% haircut solution is that it is estimated that 40%, or €82 billion, is held by hedge funds and other distressed debt speculators, most of whom have insured themselves against a Greek default with the purchase of credit default swaps (“CDS”). These CDS holders will only receive their insurance payments if Greece actually defaults, i.e. Greece fails to repay the contractual amounts owed on time and in full. If the creditors holding these CDS voluntarily agree to receive less than the contracted amount, the CDS will not pay out.1 This explains why the non-IIF Greek debt holders did not participate in the 50% haircut agreement of last autumn. As long as they have confidence that their CDS counterparties will pay out, they would be foolish to accept anything less than full repayment from the Greeks. Essentially, they are betting that the prospect of the Greeks defaulting is an unacceptable outcome to the Greeks, the EU, the ECB, and the IMF, and that those latter three or some combination thereof will pay the bill for the Greeks.

Another possibility is that the Greek government will “end around” the intransigence of the rump of uncooperative debt holders by unilaterally inserting what is called a “collective action” clause in its outstanding debt. Such a clause states that if some significant majority (60% or more) of the debt holders agree to a change in repayment and other terms and conditions, such terms are binding on all other debt holders. The problem with this involuntary solution is two-fold: first, the possibility that those debt holders not agreeing to these terms have ground to take their cause before the European Courts for Human Rights on the grounds that property rights are human rights under the European Charter; and, second, that a small minority of Greek bonds were not issued under Greek law, but under Swiss and English law, both of which contain parri passu provisions (meaning that all bondholders must be treated equally), which is a problem if the bonds held ECB, IMF, and EU are not subject to the 50% haircut imposed or agreed to by other Greek bondholders.

A last, and rather major, complicating factor is the growing sense in Greece that an outright default would be preferable to living under the levels of austerity required to remain in good standing with the EU, the ECB, and the IMF. Unemployment has gone from 13% just last year to 19% this year, with estimates that it will rise even further to 21% in 2012. Rates of homelessness, suicide, crime, and HIV are all up by large amounts. Further adding to the difficulties of Greece keeping its bailout commitments to the EU, ECB, and IMF is the fact that Greece’s largest labor union, GSEE, which represents about 2 million workers, has said it will not renegotiate its wage contracts and that the 2 extra months of salary, i.e. GSEE members get paid for 14 months of work per annum, are not on the negotiating table. Further, Greece has promised to sell off a massive €50 billion worth of state assets — including €25 billion in real estate — but has so far only raised a total €1.56 billion under that program. Defaulting would relieve them of the need to meet this commitment and spare them selling off public stakes in gas, refinery and mining companies, land on the islands of Rhodes and Corfu, a northern highway, 39 regional airports and 12 harbors.

Why does a Greek default matter? They have renounced their debts on several occasions over the past 170 years, so yet another self-declared “jubilee” should come as no surprise.2 The obvious problem a Greek default creates is that it would, one, wreck some of Europe’s largest banks and create a financial panic spurred on by ETF, HFTs, and a sensational press, two, it would undermine the credibility of the EU, IMF, and ECB, and render all their efforts, expenditures, and promises up to this point null and void, and, three, it raises the possibility that Portugal, Italy, Spain, and Ireland (and that order is deliberate) would default on their sovereign debts. Their increased risk of default raises their borrowing costs, which further increases the odds that they default on their debts. In short, it begins a vicious, downward spiral, the end to which is hard to predict, as we saw from the collapse of Lehman Brothers in 2008.

We view a Greek default, whether outright or via the “collective action” clause, as probable at this point and that the best the EU, ECB, and IMF can manage is to make the default and its aftermath as orderly as possible.3 After all, the damage to Greek creditworthiness whether their failure to pay in full is formally called a “default” or not, has been done. The sovereign debt window effectively is closed to them for the near future: either they must pay unbearable levels of interest in issuing new sovereign debt, or no one will buy it, if it can be issued at all.

The Chronic Illness of Federalism: Moving beyond the arrogance of the present and the immediate problem of a probable Greek default, we now turn our attention to the wider problem in Europe: the federal nature of the European Union and its constituent parts. We on this side of the Atlantic should be very aware of the problems of federating multiple sovereign states into a cohesive, effective, and unitary state. Ever since the Continental Congress of 1774, on through to the Articles of Confederation, and now the current Constitution of the United States of America, the United States has grappled with the core question confronting any regime where two or more entities share power: “Who is in charge here?”4

Even defining “Europe” is a problem: is it the 38 nations occupying the westernmost portion of the Eurasian continent starting at the west coast of Ireland and stretching eastwards to the borders of Russia, the 27 member states of the European Union5, or the 17 nations whose national banks comprise the European Central Bank and the Euro? In the instance of the current European sovereign debt crisis, we are talking about a combination of two of these subsets: the European Union and the European Central Bank. The graphic below maps out the disparate nature of European economic and political integration at this time.

By contrast, the U.S. federation suffers only from two levels of substantial political power (State and Federal) combined with a unitary central bank, the Federal Reserve. Thus, the permutations of mischief and dispute are more limited than the situation confronted by Europeans. The ongoing problems presented by the European patchwork federation are two-fold: first, there is practical political problem of the absence a central authority with the ability to impose a solution on its member states, and second, there is the economic problem of sharing a common currency and debt ratings across states with such disparate fiscal policies, social security systems, levels of economic development, demographics, and attitudes about capitalism.

The confusing and ambiguous nature of European federalism has certainly contributed to both the underlying crisis (the over-leveraging of individual nations and the lack of oversight) as well as the piecemeal and ineffective nature of the solutions offered and implemented over the past two years. Some (Merkel of Germany and Sarkozy of France) argue that the way to solve these problem is through the grant of more power to the E.U. and tighter integration, while others (David Cameron of the U.K.) argue that it was the over-centralized nature of the EU which has brought Europe to this crisis point.

The Nature of the Beast: We believe this centralization versus decentralization argument will continue to rage on, regardless of the outcome of the Greek debt crisis, because of the lack of cultural coherence across Europe and because of the history of conflict across Europe. Underlying both the symptom of sovereign debt defaults and the problem of the current form of European federalism are the historic and ingrained cultural, religious, and linguistic differences between, and often within, European nations. Europe’s record of intra-national warfare over the past 2,000 years is unmatched in terms of its consistency and longevity starting with the rise of the Roman Empire and its conquest of Brittania, Gaul, Germania, Hispania, and Illyrium. We note that the trend, up until recently, was for bloodier and bloodier conflicts involving not just armies, but civilian populations and ever wider geographic areas. We need only look back a few decades to find that two of the deadliest, if not the deadliest, wars in human history took place on European soil.6

While we are now 67 years removed from the last major conflict on European soil (with the exception of the relatively contained Balkan conflict of the 1990’s), significant intra-European differences and historic enmities remain as the primary impediment to the creation of a united Europe. To grasp how divided Europe is in practical terms, we need only view the chances that a currently unemployed Spanish construction worker would move to Germany to seek work: 0.1%.7 This compares to U.S. job mobility between States of 3% per annum, or 30 times greater than the European rate of annual mobility. While European travel quite freely and frequently between countries, actual emigration to take up permanent residence in another EU country remains an extremely rare thing.8 Intra-European geographic mobility is essential for the success and prosperity of the EU for two reasons: first, the creation of a true “European citizen” would be a symbol of European integration and the demise of the old hostilities, and, second, job mobility is important in labor market efficiency and ongoineconomic prosperity.9 Clearly, this has yet to happen, regardless of the creation of a common European passport.

Closer and more effective European integration will not be a reality until more cross-border and permanent migration occurs between European nations. The speed with which the primary movers in the E.U. (the Germans, the French, and the Italians) wished to both integrate economically and culturally outstripped the ability of their respective populaces to make that dream a reality by moving from one language and cultural region to another.

Is the dream of a truly unified and peaceful Europe over? We think not, as it has been a dream as far back as the Roman Empire (Pax Romana), on through to Victor Hugo and Winston Churchill. However, it is mostly likely several decades, if not a century or more, away from reality. Nonetheless, the “peaceful” portion of the unified Europe dream has been a reality over the past six decades and this alone is an enormous accomplishment.10 Given our collective ability to destroy whole cities in an instant, thanks to nuclear weapons, perhaps Europeans and all of us should view the price this debt crisis as a bargain compared to the inestimable and horrific costs of yet another war in Europe.11

Bottom Line: In sum, here is what guides our current thinking in managing our portfolios in light of the current European debt crisis.

First, the Greeks simply are not able to repay their debts and many of their creditors have a genuine interest in seeing them default. In fact, while some consider the Greeks already in default, we believe that a default (whether outright or by Greece unilaterally declaring new terms) is likely to occur in a matter of weeks. Indeed, we wonder if a Greek-declared default is not the desired result of the leaders of the EU, ECB, and IMF since it then places the blame squarely on the Greeks, versus the ineffectual actions of those three bodies.

Second, a declared default will undoubtedly cause a massive sell-off in stock and bond markets around the world, and gold and commodities will experience significant increases in their prices as investors make their flight to safety. Central to the scale and persistence of this crisis will be the credit default swaps: the ability of their underwriters to meet their obligations. If the capital backing these credit default swaps is adequate, we believe this panic will be temporary in its impact. If, as in the Lehman Brothers crisis, the underwriters of these credit default swaps have underestimated the likelihood of a default and failed to hold the capital needed to back their obligations, the situation could cascade into another late 2008 panic.

Third, the problems in Europe run much deeper than sovereign over-indebtedness and that the current structure of the European Union and the Euro currency are flawed by virtue of their prematurity. While a free trade zone makes tremendous sense, as existed under the European Community in the pre-Euro days, a currency union stretching across the continent north to south and east to west is untenable given the economic differences between the Euro’s constituent nations.

Finally, while we believe that there will be a reduction in the number of nations participating in the Euro, rather than a scrapping of the entire currency, we believe that even in the event of the complete demise of the Euro that “core” Europe would continue to remain a prosperous region. After a period of adjustment, the return of the Deutschmark, Franc, Peseta, Lira, Schilling, and Guilder would not herald an economic apocalypse and that the creation of value would continue within and between European states, no matter how that value was denominated.

Chris Richey

Neosho Capital LLC

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1 Fitch Ratings has stated publically that even the voluntary 50% haircut deal is a “default” by their definition, so Greece is already in “default” on the IIF-portion of the €206 billion of debt, whether or not the hedge fund and other non-IIF Greek debt holders agree or not to the 50% haircut deal. Greece Monkeys Around, Will Default in March, Investment News, January 17, 2012.

2 According to the Old Testament (Leviticus 25:10-13), every 50 years, slaves were freed, foreclosed property was returned to its original owners, and all debts absolved.

3 The only alternative at this point appears to be the ECB and IMF taking the hit on their portion of the Greek debt, a move they are reluctant to make since it raises the possibility that the Italians, Spanish, Irish, and Portuguese would follow suit and a terrible precedent would have been set.

4 The battle within U.S. federalism continues to this day: the U.S. Supreme Court will hear arguments in March, 2012 over the constitutionality of the Patient Protection and Affordable Health Care Act of 2010 aka “Obamacare” with 26 U.S. States as the plaintiffs claiming that the U.S. Government overstepped its Constitutional boundaries in key provisions of this law. Such State governments versus Federal government Supreme Court battles are perennial events.

5 Even within the European Union, there are subsets of control which play important roles in the resolution of the current crisis: the European Commission, which proposes and implements EU policies, the Council of the European Union, which represents the national governments in certain capacities, the European Council, consisting of the heads of state of the 27 member countries, and the European Parliament, which consists of 626 legislators elected from each of the member countries.

6 For references, peruse the list of European wars: http://en.wikipedia.org/wiki/List_of_conflicts_in_Europe. It is a long list. The only good things to come out of WWI and WWII was the fact that the right side won in each of them.

7 Labor Market Mobility in a Transatlantic Perspective, Conference Report, European Foundation for the Improvement of Living and Working Conditions, 2008

8 A good deal of intra-European worker migration is temporary and, often, illegal. As an anecdote, we point to Michael Lewis’ new book on the current economic crisis, Boomerang: Travels in the New Third World, in which he tells the story of car park attendants noticing that dozens and dozens of cars remained parked, permanently, in the car park at Dublin Airport. It turned out these were cars purchased using Irish bank loans by Polish construction workers who had simply abandoned them on the way back to Poland in the wake of the Irish economic bust when construction work evaporated.

9 In fact, the EU declared 2006 to be “The European Year of Workers’ Mobility”.

10 We also note that the all 38 European nations have enjoyed tremendous freedoms since 1989 and the fall of the Berlin Wall, accomplished without a single shot being fired.

11 In previous decades and centuries, intra-European tensions of this nature would almost certainly been accompanied by threats of the mobilization of armies. We note that the disarmament of Europe after the World War II was largely possible because of the U.S. military presence in Europe, paid for by the U.S. taxpayer. To the extent that the Europeans are not rattling sabers in this debt crisis, it is largely because they have no sabers to rattle.

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