READ ON TO DISCOVER:
- The “super-citizen” who wields enormous political influence, but can’t be prosecuted
- Why CEOs should maybe yield to CROs (Chief Risk Officers)
- The single factor that could be biggest driver of financial scandals
Andrew W. Lo is the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering. His latest book, Adaptive Markets, examines financial stability and crisis to explain how evolution shapes human behavior and the market at large. David Enrich is the Finance Editor of the New York Times. His first book, The Spider Network, unveils the story of how a math genius, a few outrageous accomplices, and a deeply corrupt banking system ignited one of the greatest financial scandals in history. Both shortlisted finalists for the 2017 Financial Times & McKinsey Business Book of the Year Award, David and Andrew recently sat down to discuss the root causes of financial scandals, and how we can nip them in the bud.
David: How do you reconcile the irrationality of individuals with the rationality of markets?
Andrew: The fact that Dick Thaler, a behavioral economist, just won the Nobel Prize for economics suggests that we’re finally ready to start taking human behavior seriously. One of the things I found fascinating about your book on the Libor scandal is the fact that it wasn’t just one person, it was actually an entire system that contributed to this event. It’s unfortunate that Tom Hayes was singled out as the sole individual that was punished for this, when in fact there were many people involved. We need to start thinking more broadly about human behavior, because it’s not typically one bad actor that causes these financial scandals. There’s something about the system that we have to address, and that has to do with human behavior.
David: One of the biggest takeaways when writing The Spider Network was that individuals might act irrationally, but they are doing things in a framework that actually isn’t that irrational. In a lot of these banking scandals we’ve seen over the past couple of decades, the behavior is inappropriate, but it’s not that surprising, because bankers and traders are paid very well to do very specific things. When someone is incentivized to make a lot of money at all costs, to exploit little inefficiencies in the market, it’s not surprising that they’re going to do exactly that. They’re not compensated based on adhering to certain rules—they’re incentivized to make money at all costs, as quickly as they can.
Andrew: Exactly. Human behavior affects all aspects of the financial system, including regulators. In The Spider Network, you talk about the role of the regulators, first in turning a blind eye, and then afterwards in scrambling to figure out what to do about it. It’s human nature—they respond to incentives just as the traders did. If we want to eliminate these behaviors, we have to think more deeply about how the entire system is put together. Without that 360° view about how these financial crises emerge, we’re never going to be able to break free from them.
David: Well, what’s your view of how to resolve this? Is this simply a question of incentives, is there a market structure issue, a regulatory issue?
Andrew: I think it’s all of the above. The approach I take in my book Adaptive Markets is, first of all, to acknowledge that the financial system isn’t a static, physical, mechanical system. It’s really an organic system, and you’ve got lots of stakeholders reacting to different kinds of incentives. One of the things I suggest is to create the equivalent of a National Transportation Safety Board for the financial industry. The NTSB has no regulatory authority. All they do is put together reports that summarize the accidents—what happened, how it happened, why it happened—and offer recommendations on what we can do to make sure it doesn’t happen again.
David: The NTSB example reminds me of what we saw with the Financial Crisis Inquiry Commission back in 2010 or 2011. They produced a report that you’d think would be extremely dry, but that summer, people were reading it on the beach. It really captivated the public’s attention because people were yearning for some understanding of what had just happened. Having an NTSB-style postmortem on this type of activity—how does that help?
Andrew: I think it helps because it gives us some kind of direction on how to deal with the issue. For example, arresting one person is not going to change this kind of behavior. The incentives that were created for traders to make money, for regulators to look the other way and not worry about these issues until it’s too late, all of those incentives are still in place to this day. Some reforms were made, but not nearly enough. That’s why I think having this narrative is important—it tells us what needs to be done, and what else can be done in order to deal with it.
Based on your analysis of the situation, how many of the issues that created the crisis are still in play, and what do you think the likelihood is that something like this could happen again?
“The fact is that if you don’t change the underlying structure of motivation, you’re not going to change the outcomes.”
David: A lot of it is still very much in play. There’s been an enormous amount of lip service paid over the past nine years to the idea of ethics, good behavior, and forming a culture. [But] the reality is that a lot of this comes down to pay. It’s a little bit different in Europe right now, where there have been much greater government efforts to change the way people are paid. But in the US for the most part, people are largely rewarded for many of the same things. Pay is a little bit longer-term now, and it’s a little bit more in the form of equity that can’t immediately be sold, but traders are still paid based on the profits and loss of their individual or their team’s trading books. They are still rewarded for making as much money as quickly as they can out of clients.
To me, that’s not a healthy lens through [which] to view the financial system. The financial system exists to be a lubricant for the broader economy, and to help efficiently set prices and move money around. [Yet] much of the Wall Street ethos continues to be about finding little inefficiencies to exploit and weaknesses to take advantage of and loopholes to sail through. That is, to me, setting up another round of trouble in the years ahead.
Andrew: The fact is that if you don’t change the underlying structure of motivation, you’re not going to change the outcomes, no matter how much you engage in punitive reactions. I don’t know about you, but I thought that the punishments meted out because of the Libor scandal were pretty mild in comparison to the scale of impact that these behaviors had on stakeholders. When you think about financial misdeeds and the usual litigation that ensues, typically the plaintiffs will calculate damages and ask to be compensated accordingly.
For example, if you engage in securities fraud, the ultimate consequence of securities fraud is, “How much did you damage the public for engaging in fraudulent activity?” Economists will come up with estimates of the damages, based upon the kinds of fraud that occurred. If you did that for the Libor scandal, my guess is that the damages would be in the tens if not hundreds of billions of dollars. Yet when you take a look at the fines that were imposed on these financial institutions, they actually seem pretty mild. Was that your sense as well? How do you look at it?
David: I actually have a slightly different perspective. I agree that the penalties, in the form they were imposed, are not a good deterrent. Some of these big global banks are making several billion dollars a quarter, so paying one or two billion dollars is not going to change that company’s behavior. And more importantly, it’s not going to have a huge impact on individuals’ behavior, whether it’s individual traders, or even the top executives. What’s more important is holding individuals accountable, not so much the institutions—whether that means people lose their jobs, or are arrested and put on trial.
I think the challenge with a lot of these scandals is that it’s very hard to quantify the harm that was done. The manipulation of Libor has the potential to affect anyone in the global financial system that borrows money, or invests in derivatives, or anything like that. To me, the biggest harm of the scandal is not so much in the financial impacts that it had on people or institutions. It was more the damage to the integrity and credibility of the financial system overall, which is intangible but very important.
I mean, any time anyone interacts with a bank, withdrawing money or getting a mortgage or paying for something [with] a credit card, this is all predicated on people having faith in the actors within the financial system. Every time that we have one of these scandals, much less one of these big once-in-a-generation financial crises, it makes it harder for people to trust these institutions. That’s a bad thing for our economy. Frankly, it’s a bad thing for our society, because you want something underpinning a modern economy that everyone can trust, and that’s just not the case here.
The flip side of that is, has that had a real effect on the way markets operate, the way people participate in the markets? I don’t know. I’d be curious to hear your thoughts on that.
Andrew: I think that it has had an impact in the sense that now Libor is not nearly as useful a measure for benchmarking certain kinds of transactions as it used to be. I think you’re right, there is a loss of confidence, a loss of trust, and one of the key aspects of economic growth is a certain trust in the stability of the financial system. Libor was one of the benchmarks that everybody used, and anytime you have a threat to that trust, you’re going to erode the value of the financial system. Because it’s hard to quantify, people sometimes don’t worry about it, but it has an insidious impact on increasing the cost of transactions and slowing down economic growth. It’s not exactly a victimless crime; it’s a crime that affects a large number of people, but imperceptibly at first. It’s kind of hard to pinpoint, and maybe that’s one of the reasons why they didn’t arrest more people. But if you look at the sum total of the damages, I think it’s in the hundreds of billions of dollars, and spread out and hidden in ways that aren’t easily quantified by the typical consumer.
“Culture shapes behavior in ways that are very difficult to model but, without a doubt, have real impact. I think that may end up being the single most important driver of these kinds of scandals.”
David: The interesting thing though is that even in the recent scandals, where it’s been much clearer exactly who was harmed and by how much, the ability of banks, regulators, and prosecutors to hold those individuals accountable has still been really weak. There’s been piecemeal efforts to hold lower-level individuals to account for their actions, and there have been efforts to fire executives, including some CEOs, but in most cases, those guys have walked away with such huge fortunes intact that any deterrent effect that that type of punishment might have [has been] really limited.
One of the things I’m trying to figure out is the degree to which this era of scandal over the past 10 or 20 years has had an effect on the degree to which individuals and smaller institutions participate in the markets. I’d be curious if while you were researching your book, whether that’s something that you encountered at all.
Andrew: You know, only qualitatively, and certainly that has been a big shift since the financial crisis. We have to remember that the financial crisis had a number of different aspects to it. One of them was the Libor scandal that you wrote about, but another one was the Madoff scandal, and another was all of the bad behavior surrounding these mortgages and mortgage-backed securities. There was a host of bad behaviors surrounding the financial system. It’s given finance a bad name, and that is, in a way, the real harm, because there’s a lot of good that finance can do.
Without that narrative of using finance to do well by doing good, we ultimately end up hurting ourselves—we’re cutting our noses off to spite our face, and that’s what really worries me. I think that’s something economists don’t really look at in a serious way. Culture shapes behavior in ways that are very difficult to model but, without a doubt, have real impact. I think that may end up being the single most important driver of these kinds of scandals.
David: I’d been writing about banks for 10 or 15 years before I wrote [The Spider Network], and everyone paid lip service to culture, but there’s no training program. [Everyone] learns through osmosis, picking up cues from their colleagues and their bosses, absorbing the patterns of behavior they see all around them. That stuff spreads, and people always push it a little bit further, until these cultures take on a life of their own. They’re a lot more powerful than most people give them credit for.
It’s also much harder to change. It’s not a question of just paying your penalty or changing CEOs and moving on. It’s about getting into the nooks and crannies of an institution, figuring out how it ticks, and then changing it. That’s part of the reason that there are going to be more of these scandals in the future—because short of tearing down these institutions and starting over, which no one is advocating, it’s very hard to [change company culture].
I agree with you that in the meantime, one of the big casualties of all of this is the respect that people have for Wall Street, and the respect they have for what Wall Street is doing. Because it’s important to have a healthy, vibrant, flexible financial system. It’s important for individuals to be able to borrow efficiently, and for companies to be able to tap the capital markets, and for small businesses to be able to use derivatives. These things are unquestionably good for the economy and good for the country, and yet they’ve been tainted because of this industry’s bad behavior.
Andrew: One of the concerns I have is the fact that we now have a very different financial landscape than we did 50 or 100 years ago. The modern corporation is now much larger and more powerful than ever before. Thanks to Citizens United and other legal opinions, corporations are considered persons, yet they don’t have the same accountability as persons. You can’t put a corporation in jail.
I wonder if ultimately that’s the source of a lot of these issues, because corporations, as persons, wield enormous influence—they can engage in free speech, they can engage in support of political activities. And because there’s now no limit to how much money they can deploy, they have enormous influence on the political system. Imagine creating a super-citizen who’s allowed to engage in all these activities, yet isn’t subject to criminal prosecution. That’s what we’ve created with corporations.
“Corporations are considered persons, yet they don’t have the same accountability as persons. You can’t put a corporation in jail.”
David: Well that’s the issue, right? I certainly agree with your diagnosis of the whole problem. There have been efforts to prosecute companies, it’s just rare. The hallmark case in this regard was the prosecution of Arthur Andersen after the Enron scandal 15 years ago. Arthur Andersen was convicted and went out of business, and that came to be viewed, rightly or wrongly, as a huge mistake. Thousands and thousands of people lost their jobs, the accounting industry was down to four big accounting firms instead of five. And the message that prosecutors took away from that is that we just can’t afford to roll the dice on these big corporate prosecutions.
I think that was a big mistake, and I think it’s a mistake that has started to be addressed in the past several years. There were more prosecutions of subsidiaries of big global banks, if not the parent companies themselves. The question is whether those are done in a way that is deliberately meant to avoid threatening the existence of those companies, and that therefore has less of a deterrent effect. You can attach sharper teeth to this [by] putting fear in the heart of companies that this isn’t a question of a one-time hit to their earnings—it’s a question of whether their equity is reduced to zero, whether the company continues to exist.
Andrew: I don’t know the answer either, but if we acknowledge that human behavior is the root cause of this, that it’s not just one bad actor, but there’s something systemic about these things, then we need an equally systemic approach to dealing with it.
Here’s one example of how to deal with these incentives. Imagine if, in a modern financial institution, we created a law that said, “Anybody that receives compensation above and beyond $1 million a year will automatically become jointly and severally liable for any of the losses that the company suffers from that point forward.”
In other words, it’s turning a modern corporation into a kind of partnership, the way Goldman Sachs was a partnership in the old days. If you did that, every single one of these highly compensated individuals would be extraordinarily cautious about the kinds of risks that their firm was taking. Now, the downside is that you won’t get the large corporations that exist today, because this will automatically limit their size—Goldman Sachs was much smaller before they did an IPO and became a public corporation. It changes the nature of risk-taking to make it more personal, which may well reduce the amount of available capital for supporting economic growth, but the growth under this system may be more sustainable.
David: That’s a fascinating idea. You’re right, that would have a radical, immediate effect on the amount of risk and the culture of these institutions—they would become so much more conservative. That’s a good thing, and also a bad thing, right? I mean, financial institutions exist as intermediaries in the economy because they’re supposed to be taking risk, and you don’t want them to not take risk. That would mean that I wouldn’t get a mortgage, and you wouldn’t get a credit card. The trick is figuring out ways to balance healthy risk-taking from reckless, greedy risk-taking.
Andrew: So here’s another idea that’s part-way there. Let’s look to the human body as a biological solution to the problem of how we balance all of these competing forces. Because, obviously, as human beings, we would love to party all night, but our bodies are designed to start giving us headaches when we end up drinking too much alcohol, and getting tired when we exert ourselves too much. With that in mind, the problem with corporations today is that they don’t have these same kinds of feedback loops.
Imagine if we created a new role for every company called the Chief Risk Officer whose sole responsibility is to prevent the company from taking risks that are outside those parameters set by the board of directors. Imagine if this individual’s compensation plan were designed to reward him or her for reining in the company, not shooting the lights out. And imagine if the Chief Risk Officer reported not to the CEO, but directly to the board, and that the Chief Risk Officer had the power to relieve the CEO of his or her responsibilities if that CEO was taking irresponsible risks. In other words, you create a system of checks and balances that is focused on risk-taking and sustainability.
It might be a kind of healthy conflict, in the same way that we have our own healthy conflicts internally when we’re reaching for that second serving of cake and noticing the size of our love handles.
David: I love that idea. It would be a fascinating human experiment to watch.
This conversation has been edited and condensed. To learn more, visit ft.com/bookaward and follow the conversation at #BBYA17.