standard Financial Crime, Corruption and the Global Financial Crisis: What is the role of regulation?

A multidisciplinary public workshop took place at Durham University early this summer entitled, ‘Financial Crime, Corruption and the Global Financial Crisis: What is the role of regulation?’ hosted by IHRR and the Global Policy journal. The event was facilitated by Professor Timothy Clark (Durham Business School) and Dr Eva-Maria Nag (Global Policy). It was well-attended by postgraduate students, staff and members of the greater North East community, including a practitioner from the financial services sector. The aim of the event was to provide a multidisciplinary investigation into what leads to financial crime in the financial sector, and why punishment is often not enforced, especially within the context of the 2007-08 banking crisis and the subsequent financial crisis in Europe, the US and throughout the world.

Researchers from history, social science and law presented at the event providing unique perspectives on multiple aspects of financial crime and regulation. Researchers from the Tipping Points project who presented were: Professor Ranald Michie (History), Dr Matthew Hollow (History), Dr Philip Garnett (Anthropology and Business School (University of York)) and Dr Vincenzo Bavoso (Law). They were joined by Dr Or Raviv (School of Government) and Professor David Wall (SASS).

No crime, no punishment

Prof Michie and Dr Hollow kicked off the event with their presentation on the history of financial scandal in the UK from the Victorian period onwards. Victorian bankers were seen as respectable and quality individuals in contrast to how bankers are often viewed today, especially in the press.  Prof Michie emphasised that during the Victorian period there were in fact financial crimes committed, namely theft of deposits by bankers, but that they often got away with it at first. This changed after the fall of Overend, Gurney & Company in 1866, which failed with huge losses. The bank directors at Overend Gurney converted the bank to a Limited Liability Company (LLC) in 1865 making them not liable for its failure.

After this event other bank officials found guilty of theft, false accounting and similar crimes were publicly hung, discouraging others from engaging in the same criminal practices. It took 50 years to devise a solution to criminality in the British financial sector. Prof Michie argued that there are lessons to be learned from the Victorians in using the law to deter financial scandal and crime. Matthew continued the presentation on how the UK entered a period of relative financial stability surviving the 1929 Wall Street crash, but a number of frauds still took place namely in shadow banking.

A shadow bank is a company that functions similar to a bank in that it provides loans, takes deposits and provides other financial services that banks do, but is not part of the banking system. A building society is an example of a shadow bank. Accounting procedures were less strict at this time with many frauds attributed to false accounting. Dr Hollow also talked about rogue financiers who promoted joint stock enterprises and took risky strategies by taking out large loans for buying out other banks and corporate takeovers. Numerous examples of false accounting also come from the building society sector in the 1960s and 70s. This was mainly due to the fact that regulations were less strict than with banks and ‘there were fewer auditing requirements with building societies’, said Hollow.

Prof Michie continued that the Bank of England acted as an unofficial regulator of the banking system. Prior to regulations in 1979 there was a balanced system of self-regulation and state intervention. While a small number of big banks that dominated the financial sector were expected to regulate themselves, this changed after 1979 when the financial sector was liberalised. The banking system became highly competitive and ‘the large banks were making as many risky decisions as the fringe banks’, said Michie. Ranald concluded that the Victorians learned individual responsibility for preventing fraud, however, the banking sector has changed since then. Crimes, if they are identified as such, go unpunished because it is no longer a matter of individual responsibility, but corporate responsibility. Are we back to a state of ‘no crime, no punishment?’, asked Michie and Hollow.

Interest rate swap scandals

Financial innovation has played a large role in financial scandal in recent years, not only in the case of the 2007-08 banking crisis, but in the bankruptcies of small to medium businesses in the UK and US. Dr Vincenzo Bavoso presented his research on a financial innovation, in particular on Interest Rate Swap (IRS) or ‘swap’ for short. An IRS allows a borrower to adjust and manage fluctuating interest rates, while an investor could speculate on IRSs by gambling on whether the rates would go up or down. Banks in the UK sold swaps with loans, sometimes not allowing the customer to purchase a loan without an IRS. The problem for borrowers and investors is that if the loan was terminated the IRS could continue. In the UK the scandal became a case of ‘misselling’ because banks did not adequately inform their customers of the terms and risks of an IRS. In the US these financial products were central to the bankruptcies of municipalities such as Detroit, MI and Jefferson County, AL. Goldman Sachs, who was a key player in the 2007-08 banking crisis, and JP Morgan, advised them that investing in IRSs was the best hedging strategy for controlling interest rates. However, when interest rates were lowered in 2008 due to the banking crisis, unsustainable payments were made on the swaps causing government bankruptcies.

Dr Bavoso argues that these scandals involving the creation of innovative financial products have resulted from the emergence of large and powerful private companies that resist regulations and promote behaviour that leads to breaching the law. Moreover, financial scandals in innovated financial markets are a result of excessive risk-taking and cultural exuberance. One key question explored in this paper is whether regulation can change that prevailing culture in financial markets and institutions, especially given the lack of democratic legitimacy of some regulators at the international level. Dr Bavoso continued that financial institutions and markets need to be seen from a social perspective, especially regarding the greater impacts they have on society, and that different regulatory goals were needed, focused on prevention. Currently none of the phases of financial innovation account for public interest in any way. Since investors are usually interested in financial products that can give them better cash flows and allow them to take more risk, their values appear to be at odds with that of society.

After the crisis

Dr Or Raviv argued in his presentation that it is not so much the problem with the regulations in place, but the lack of enforcement and punishment of the financial sector. Or said while no arrests were made for causing the financial crisis ‘there has been a dramatic criminalisation of the protest movement’, for speaking out against the structures of power they blame for allowing the global financial crisis to take place. ‘Bankers are happy for the problem to be with regulation, because it is therefore not their problem that the financial crisis occurred’, said Raviv. He argued that changing the regulatory frameworks distracts from the problem at hand that must be dealt with through ‘enforcement, compliance and supervision’. Market actors largely evaded regulatory rules, so they couldn’t be criminalised. Exploiting regulatory loopholes within the financial system is known as regulatory arbitrage, where companies relocate part of their business to more favourable geographic areas.

Dr Raviv also presented examples of important differences in financial regulation in the US and Europe. The sub-prime mortgage crisis in the US couldn’t have taken place in Europe because of laws in place that prevented a bank from revealing private information about their customers to a third party, but banks in Europe would find other ways to lend more money in other ways through regulatory arbitrage. Banks went to the AIG (American International Group) to purchase products called ‘credit default swaps’ to hedge their risk if the loan was unpaid, but would allow them to keep the asset. In reality AIG was unable to insure banks if their mortgages went under because they didn’t set aside money to pay out. However, Dr Raviv did highlight examples of how enforcement is being taken more seriously in the financial sector. The number of investigations into financial crime has grown by 50 per cent in comparison to 2011-12, but he said that research in this area is problematic because little public data is available. There currently needs to be more information in the public domain to better understand the scale of enforcement that has taken place.

Regulatory challenges of e-crime

Prof David Wall presented on a recent challenge for regulation through online theft that are global in nature and hidden to victims that they steal from. David gave the example of a ‘perfect e-crime’ where 49p was taken from each person’s account in the entire world. Since the amount stolen individually is so low it wouldn’t justify prosecution because it wouldn’t be in the public interest. The crime could be committed using a malware script that included terms and conditions that would make it technically legal, but Prof Wall cautioned that for the curious ‘it shouldn’t be tried at home’. Although the crime is small, the money adds up and suspicious transactions are monitored by banks and law enforcement officials alike. E-crime often tends to be small and low impact, but it at least costs millions in losses. In the case of banking it is difficult to say how much of a problem e-crime poses because banks will often not report these crimes to the police as it reflects badly on their public image. E-crime is also ubiquitous in that it can happen anywhere at any time with some researchers claiming that it ‘democratises crime’ as potentially nearly anyone could commit virtual robberies or frauds.

In response to e-crime Prof Wall argued that it is incompatible with the criminal justice system and that it’s non-routine nature is outside of the police experience. What’s needed is strategic intelligence for small thefts in order to find the individuals who are committing these types of crimes, instead of making more laws. Similar to elite financial crimes committed by bankers, enforcement is key to bringing cyber criminals to justice.

Financial regulation meets complexity

Computer scientist and biologist Dr Philip Garnett introduced how the global financial system could in some cases be too complex to regulate because of the knock-on effects regulation has on the system as a whole. In complex circumstances regulation may in some cases have no effect on the financial system whatsoever. Instead of focusing on individual parts of a system, complex systems theory sees the system as a whole and that the sum of its parts can have emergent effects that may be too difficult to predict. In the case of a banking crash it could be that the banking system is moving along a particular trajectory over a long period of time and regardless of what regulation is put in place will continue until the system fails. Dr Garnett called this ‘waiting to fail’ and there may be good reasons to think that financial systems may behave in this way especially in light of historical bank data. ‘It’s possible that the 2008 crisis came from nowhere, you could make post-hoc justifications for why a crisis might have happened but it’s really difficult in a complex system to actually define causality’, said Garnett. If the current financial system has indeed failed completely it is very unlikely that it could be reversed. In banking history in the UK regulatory measures came and went without having much effect on the systematic decline of the financial sector in the 19th century.

One of the most difficult things about modelling complex systems is that it is extremely challenging to say how a certain system will behave in reality. In response to a question about whether or not financial systems are actually that complex because for so long many continued without failure, Dr Garnett said that globalisation has been a key factor in making financial systems more complex in the first place. In the past mostly nationalised banking systems may have been easier to control through regulation, but because of globalisation it has become far more unpredictable and riskier. So what kind of regulation is needed to govern a global financial system that is too complex for us to understand?

Dr Garnett suggested two potential approaches from complex systems theory. One way is make the financial system less complex and simplify it so it is more likely to be regulated and possibly less likely to fail. The problem with doing this on a global scale of course is that it would demand a simple set of rules that everyone would have to follow. Not only is this unlikely but would still fail to address the problem of complexity because even a system governed by a simple set of rules has emergent properties. Another perhaps more likely scenario is to have a financial system that is ‘complex-adaptive’ meaning that it is self-regulating and responsive to what is happening outside of it. If such an approach were taken to regulating the global financial system banks could account for what their neighbours were doing and understand how their actions would feedback into the system. This could lead to a more stable financial system but companies would have to be responsible for their own stability. ‘This approach may offer a way to build a complex adaptive approach that takes some of that regulatory requirement out of the hands of the system itself, in order for it to persist and prosper’, said Garnett.

The presentations were followed by lively, interactive discussion with contributors that addressed the role of complexity in finance and how it could be regulated in the future, amongst other topics presented.

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