In David Enrich’s The Spider Network, an engaging chronicle of the London Interbank Offered Rate (LIBOR) interest rate-fixing scandal, employees of financial companies such as UBS, Citicorp, Deutsche Bank, HSBC, Rabobank, RBS, Barclays, and several brokerage firms conspire to move LIBOR and its offshoots by small amounts, for the sole purpose of benefiting derivatives traders who profited from the moves. The book implicitly raises a key question for the financial industry, indeed for the entirety of capitalism: Is there an ethical code that must be followed, apart from and beyond the requirements of the law; or is all that is necessary to be ethical merely to adhere to the law? The latter, many would agree, is a very dangerous idea – and therein lies the inescapable dilemma and challenge for capitalism.
In Enrich’s book, attorneys for several of those accused of manipulating LIBOR make the following argument in their clients’ defense and against the prosecution’s case:
The crux of their defense was that the world the prosecution was describing to the jury – a world in which everyone was expected to play by the rules, where transparency mattered, where honesty and fair dealing were sacrosanct – was a fantasy. The financial industry was not a polite, rules-bound, ethical place; it was a no-holds-barred culture where brokers were actively encouraged to manipulate and lie to their clients.
Anyone familiar with the financial industry will know that at many, perhaps most financial institutions, indeed the most profitable ones, the no-holds-barred description of the culture fits better.
At firms like Goldman Sachs, products are designed with the sole purpose of increasing the information asymmetry between product sellers and clients – clients who were sometimes referred to as Muppets, that is, patsies, by Goldman Sachs employees. And the product designers and their sellers are richly rewarded for putting one over on their clients.
At Wells Fargo, pressure on employees to cross-sell new accounts to existing customers was so great that a subculture of employees who added new accounts and account features without customers’ knowledge – and charged them for it – became widespread and well-known within the bank.
At SAC, the hedge fund owned by Stephen A. Cohen, employees of which were convicted of insider trading, pressure to obtain special information about listed companies was so great that one employee could say that “he thought that trafficking in corporate secrets was part of his job description at SAC.”
And at UBS, Enrich says of Tom Hayes, the central character in his book:
He viewed his job as pushing things to the max to make money for his bank. That’s what good traders did – they ruthlessly hunted for tiny inefficiencies and loopholes they could exploit to gain a leg up on rivals or the broader market. Nobody ever told him it was inappropriate – legally, ethically, or otherwise – to lobby outsiders for help on LIBOR. What kept him up at night wasn’t that what he was doing was wrong. It was that he wasn’t doing it well enough.
…He viewed himself as operating within a closed system, facing off against other predatory professionals who were sufficiently sophisticated, and often avaricious, to deserve whatever they got. The perspective of the financial system as a playing field for these competitors, where amateurs were viewed as fair game if they were thought of at all, had been hammered into Hayes since he first set foot on a trading floor. It was a narrow, self-serving view, and its prevalence helped explain why the finance industry was heading for all sorts of trouble.
Two Nobelists in economics, George Akerlof and Robert Shiller, argue in their book “Phishing for Phools” that all of these results of capitalist competition should have been central to economic theory in the first place. In my review[i] of their book, I described their argument as “the exact same free-market process that Adam Smith lauded for doing a great job of satisfying mutual self-interests, also incentivizes scamming. It is not possible to separate the two; they must be part and parcel of the same economic theory.”
How to manipulate LIBOR
LIBOR was set up to be the average rate it cost a group of British, European and American banks to borrow from each other. It was first published in 1986 and overseen by an organization called the British Bankers’ Association, or BBA, which, according to Enrich, had previously been mainly devoted to lobbying for lax regulations on the banking sector. A low-level employee at Thomson Reuters would collect daily from these banks their estimates of how much it cost them to borrow from other banks. Then, after eliminating the highest and lowest of these estimates the Reuters employee would calculate the average of the remaining estimates as LIBOR and report it to the BBA. The BBA, as can be seen in The Spider Network, was extremely lax about policing the authenticity of the estimates that were sent to it.
Not long before that time banks had realized that it would cut down on their lending risk if loans such as mortgages were offered not at a fixed rate, but at a rate that floated with global interest rates. LIBOR quickly became the global interest rate standard, so that tens of trillions of dollars of mortgages and other loans were calibrated to LIBOR.
To compile the average, daily estimates of their borrowing rates were received from numerous banks. The task of creating and sending these estimates was essentially a minor part-time job, usually assigned to a relatively lowly bank employee. In some cases, the employee assigned to the job was someone who was also trading derivatives whose values were dependent on LIBOR. But in many cases, the employee didn’t really have much idea how to estimate the bank’s borrowing cost.
Creating the LIBOR estimate was such a mickey-mouse job that sometimes the employee assigned to it would merely find out what another bank was estimating and copy that estimate. So, if one bank took a lead in estimating LIBOR other banks would often copy it. Furthermore, it was considered allowable for a bank’s estimate to be anywhere within an error band, so that there was considerable leeway to choose the number within that band.
If there was any suspicion that banks were manipulating LIBOR, it was that they were lowballing their estimates to make it look like their borrowing costs were lower than they were, and that they were therefore sounder than they were. But there was much more going on than that.
In fact, a number of derivatives traders found that they could influence the bank employees who sent in their interest rate estimates to LIBOR to shade their estimates in such a way that it would improve the values of the derivatives that the traders held. One of the most prominent among these was Tom Hayes, who worked for a succession of banks including Royal Bank of Canada, UBS and Citibank.
In order to come up with an estimate, the employee responsible for it – who often didn’t have a clue how to do it – frequently relied on the opinions of brokers who, as a service to customers, provided their own estimates of where LIBOR would be moving during the day. Therefore, derivatives traders like Tom Hayes, who already had close relations with the brokers who executed their trades, could influence the brokers to convince the bank employees they dealt with to move LIBOR in a manner that would benefit the trader.
To thank the broker for performing this service, Hayes and others engaged in “switch trades” – pointless cross-trades that undid each other but paid the broker a fat commission going both ways.
Thus, was the LIBOR manipulation process. It continued for a number of years, well past the financial crisis of 2007-2009. Many of those who participated in this process knew at least enough to try to keep a little quiet about it, and a few were disapproving. But Tom Hayes, afflicted with Asperger’s Syndrome, wasn’t quiet about it at all, and seemed not to sense that it was not entirely above board; also, it was so widespread that the “everybody is doing it” mentality prevailed.
Since this benefited the traders and their banks without providing any known societal benefit, and since, therefore, there must have been losers – however difficult it might be to precisely identify them – who trusted the integrity of LIBOR, and lost money to the derivatives traders and their co-conspirators who violated that trust, one would assume that this practice was at least unethical, if not clearly illegal.
Yet it is exactly this kind of unethical and morally bankrupt activity that puts intense pressure on employees in the financial industry to “produce” causes, again and again and again.
Does a free economy undermine a Judeo-Christian moral ecology?
In a thoughtful article, the columnist Ramesh Ponnuru, a senior editor for the conservative magazine National Review and a visiting fellow at the American Enterprise Institute, ponders the question posed in the above subheading. His article’s subtitle concedes his presumably reluctant conclusion: “Capitalism has its flaws, but none of the remedies proposed by its critics on the right would address them.”
Ponnuru’s article chronicles the recent shift in the views of the publication First Things, which Ponnuru characterizes as “a monthly publication that has been the intellectual hub of religious conservatism, and especially Catholic conservatism, for three decades.” According to Ponnuru:
Under its founding editor, the late Father Richard John Neuhaus, First Things was a measured advocate of free markets. Its principal writers did not believe that capitalism was flawless. They argued that it could lead to human flourishing only given the right cultural and political preconditions. It required, could not dispense with, and should be restrained from undermining a virtuous citizenry and the rule of law. But these religious-conservative intellectuals recognized that markets under those conditions could be a powerful force for good: that they had lifted billions from misery. The Catholic theologian Michael Novak was especially influential in explaining that capitalism could be a creative form of community and not just an incubator of anomic individualism.
But now, Ponnuru says, First Things is having second thoughts. Its editor R. R. Reno, according to Ponnuru, says that Novak “underestimated the extent to which a free economy undermines democratic institutions and a Judeo-Christian moral ecology.”
By way of mild rebuttal of Reno’s thesis, which Ponnuru obviously finds partially compelling, he then says:
It is fair to say that, in much of the world, liberating capitalist energies stifled by collectivism is a less urgent task now than in 1982, when Novak’s book appeared. Yet the developed world has not run out of problems, from the persistence of poverty to the affordability of health care, that markets may be able to help us to address. The value of free markets, after all, is not only to liberate entrepreneurs, financiers, and even workers. It is also to discipline them, coordinate their plans, help them meet one another’s needs, and put them in a relation of mutual and uncoerced service.
If the community consisting of Tom Hayes and his co-conspirators in brokerage and banking firms, and their many counterparts who were strewn throughout the financial system are the example of how free markets “liberate financiers” and “help them meet one another’s needs, and put them in a relation of mutual and uncoerced service” – then woe be to free markets. It is, surely, precisely these examples that raised the doubts of First Things and its editor.
If it is true, as Ponnuru’s subtitle states, that the right side of the political spectrum – the one that most vociferously defends free markets – can’t address these flaws, it may fall to the political left, perhaps the (relatively) far left, to define our way out of the capitalist dilemma. The way out could be represented by the views of self-defined socialist Bernie Sanders, who is, according to the Washington Post, the most likely Democratic candidate for president in 2020.
This would not necessarily be a bad thing, in and of itself. After all, numerous countries in Northern Europe have been doing just fine with the kind of social contract that Sanders envisions for the U.S. But with the ideological divisions in the U.S. so deep, and so driven by both moneyed interests and intense passions, it could lead to yet more conflict. Recall how fiercely the Republican Congress and the right-wing media resisted President Obama after his sweeping election in 2008. More of the same, and more vicious, could drive unintended consequences even worse than those that ultimately followed the reaction in 2008-16.
The bad ethics bordering on fraud that can be seen so clearly in The Spider Network – sometimes stepping over the legal line, though that line is by no means clear – may not comprise an isolated incident in the banking sector that needs only a modicum of reform to remedy. It could be a symptom of a deeper and more insidious disease afflicting modern, ethics-free capitalism. The prognosis, and possible remedy, for this disease is one we have yet to develop.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
[i] Confirmed as accurate by Akerlof in personal communications.
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