Moral hazard – lite and strong

I have always been a believer in the screw-up theory of history (and particularly of disasters) rather than of the conspiracy theory of history (disasters).  The financial crisis that has engulfed the world certainly offers massive evidence for the importance of screw-ups – errors, mistakes, misunderstandings, singular stupidity verging on idiocy, misjudgements and missed opportunities.  I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance – of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours.

Three representative examples:

(1) UBS agrees to pay $780m (£548m) in fines and to turn over a yet-to-be-determined number of US customer names to the US government as part of a settlement in which the Swiss bank admitted it helped thousands of clients evade taxes.  I don’t understand why a bank that systematically and over many years promotes, aids and abets tax evasion, tax avoidance and tax fraud should be allowed to continue to exist.  Why aren’t all those involved stamping license plates?  Surely, these are criminal as well as civil offences?

(2) Bernie Madoff runs a $50 bn Ponzi scheme over many decades, right under the noses of the regulators in one of the two financial co-centres of the universe.  It is possible Bernie Madoff was the only crook involved.  Possible, but unlikely.

(3) Why is Barclays sufficiently desperate to avoid even partial UK government ownership, that it is willing to accept £7 billion of capital from the Middle East at a price well in excess of what was available from the UK Treasury?  Is this not a clear breach of the fiduciary duty of the management and the board? Why is Barclays now even actively considering selling one one of its crown jewels, iShares, rather than accepting a public sector capital injection when this was on offer?  Could it be related to the fact that Barclays runs one of the world’s largest ‘tax efficiency’ units, which it does not wish to be subject to closer scrutiny by a shareholder who is supposed to speak for the British tax payer?

On March 17, 2009, Barclays Bank obtained a court order banning the Guardian from publishing documents which showed how the bank set up companies to avoid hundreds of millions of pounds in tax. The gagging order was granted by Mr Justice Ouseley after Barclays complained about seven documents on the Guardian‘s website which had been leaked to the Liberal Democrats’ deputy leader, Vince Cable.

I am sure there is some legal peg that Mr Justice Mousey can hang this gagging order on, but to me this is an extraordinary interference with the freedom of the press and the public’s right to know something that is clearly of significant public interest.  I tend to forget that justice and the law are two quite unrelated concepts.

The internal Barclays memos showed executives from SCM, Barclays’s structured capital markets division, seeking approval for a 2007 plan to sink more than $16bn into US loans. Tax benefits were to be generated by an  elaborate circuit of Cayman islands companies, US partnerships and Luxembourg subsidiaries.

These documents were leaked to Dr. Cable by a former employee of the bank, who also wrote a long account of how the bank works.  It included the following telling paragraphs: “The last year has seen the global taxpayer having to rescue the global financial system. The taxpayer has already had a gun put to their head and been told to pay up or watch the financial system and life as we know it disappear into a black hole.

“It is a commonly held view that no agency in the US or the UK has the resources or the commitment to challenge SCM. SCM has huge amounts of resources, the best minds rewarded by millions of pounds. Compare this with HMRC [Her Majesty's Revenue & Customs] recently advertising for a tax and accounting expert with the pay at £45,000.”

“Through the use of lawyers and client confidentiality SCM regularly circumvents these rules, just one example of why HMRC will never, in its current state, be up to the job of combating this business.” ...

Financial nonfeasance, misfeasance and malfeasance thrive on opaqueness, complexity and lack of transparency

Another reason why banks (although quite willing to take the King’s shilling in the form of guarantees for assorted assets and liabilities; indeed Barclays is considering joining the UK government’s asset protection programme) may be reluctant to accept the state as a major shareholder is the more intense scrutiny of what the bank has on its balance sheet that this is likely to imply.

It is clear that  the vast majority of the large border-crossing banks are continuing to exploit every accounting trick in the book to avoid recognising the marked-to-market losses on their dodgy assets.  With most banks cursed with paper-thin equity cushions in relation to their assets, a more intense, let alone a quasi-forensic scrutiny of the balance sheet by a nosy expert paid for and acting on behalf of the government shareholder could easily precipitate a move from partial to full state ownership and thence into insolvency and an orderly restructuring or liquidation.

Too many bank insiders have exploited their monopoly of information and the control it bestows on them, to enrich themselves by robbing their shareholders blind.  There has been a spectacular failure of corporate governance.  Boards have foresaken their fiduciary duties.  Surely, even the liability insurance taken out by board members ought not to shelter those who are guilty of, at best, such willfull negligence and dereliction of duty?  Where are the class actions suits by disgruntled shareholders? Where are the board members in handcuffs?

Now that there is no meat left on the shareholder drumstick, the rogue managers and employees are going after a piece of the really juicy bird – the ever-patient tax payer.  I hope they choke on it.

Moral hazard refers, in insurance parlance, to a situation where the likelihood of an insured event occurring can be influenced by the insured party, without the insurer being able to observe accurately the actions of the insured party that influence the outcome. So anything that creates incentives for excessive risk taking, like limited liability and investments in toxic assets that benefit from leverage in the form of non-recourse lending by the Fed, would create moral hazard in the insurance sense of the word – moral hazard lite.

What we have seen and continue to see in much of the border-crossing financial sector, however, is a rather more literal form of moral hazard: a lack of morals in some key participants in the financial system dance causing major hazards to the financial well-being of millions of powerless victims.  Corrupted morality putting at risk genuine, wealth-creating financial intermediation, innovation and risk-taking. This is moral hazard strong.

Finance is one of the great social inventions of humanity; the division of labour and specialisation in effort and activity that are at the root of all prosperity depend on it.  It makes me sick to see an entire branch of human endeavour brought into disrepute by the actions of a relatively small (but still far too large) number of masters of the universe.  There will have to be a reckoning, and not just in the court of history.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website