A Q&A With Thomas Baxter, General Counsel, Federal Reserve Bank of New York

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.”

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