The crisis shows moral capital is in secular decline

And still the revelations come. Leading banks pay yet more record fines for egregious behaviour ranging from sanctions-busting to facilitating tax evasion. Their involvement in rigging markets now extends beyond Libor, the rate at which banks lend to each other, to foreign exchange and the gold market. It appears to be a pervasive rather than occasional phenomenon. Even when they have been shopped, they do not give up. UK banks, we discover, have been underpaying compensation for mis-sold payment protection insurance.

All this corporate wrongdoing is combined with immense personal enrichment and a paucity of prosecutions of people at the top. How are we to make sense of this bizarre concatenation of events, in which the financial system appears to have become an ethics-free zone?

One fruitful way to look at it is to think of the financial system as having, at any given moment, a stock of moral capital. This complements an insight of economist John Kenneth Galbraith. In his book on the 1929 crash he argued that there is always an inventory of undiscovered embezzlement, which he called the “bezzle” – in other words, negative moral capital. When markets ride high the bezzle increases. Come the recession people become more suspicious, audits become more penetrating and the bezzle shrinks.

Galbraith described a cyclical phenomenon. Yet events since the latest financial crisis suggest that there is also a structural component to changes in the moral capital stock. In the corporate sector, and especially in banking, there has been an adverse step change in ethical values. One reason is the ineptly named “shareholder value revolution”, whereby a paternalistic corporate capitalism was replaced by a capital market pressure cooker in which senior executives were required to deliver progressive rises in short-term earnings. A second change was the move to performance-related pay and incentives tied to equity values.

In banking this bred a more transactional culture in which profits and personal rewards came increasingly from gaming the system. The globalisation of capital flows in the absence of an international regulator provided banks with ample opportunity for regulatory arbitrage, whereby questionable business could always be diverted to weaker jurisdictions.

At domestic level banks have shaped their business to minimise regulatory capital requirements. The great boom in securitised mortgages – the focal point of systemic risk and fraud in the crisis – reflected the lower capital requirements on mortgage-backed securities relative to those on conventional mortgage lending. At a personal level bonuses took precedence over virtually everything, including the customer.
As long as incentives are at odds with ethical requirements, common decency will be a minority pursuit. Scandals are inevitable. And as the gap between bankers’ pay and that of executives outside the financial system grows ever wider, business leaders lose moral authority, and the case for enlightened capitalism is devalued. There are honest people in banking. But it has become a less comfortable place for those with a strong moral conscience.


If this notion of a secular depletion in the moral capital stock in finance is right, attempts to instil ethics by refining incentives – however necessary and well meaning – will not be enough. In a mature industry in which the return on assets has been stagnant for years and higher equity returns have been achieved only through leverage and excessive risk-taking, heavy reliance on bonuses and equity-related rewards is an absurdity. Any significant rebuilding of the moral capital stock will have to come largely as the byproduct of structural change to make banking more like a utility.

Equally necessary is a retreat from the obsession with punishing corporations rather than senior executives. The supposed justification is that companies can be made to transform their culture and prevent future crimes. Much window-dressing results. Slapping huge fines on banks is potentially a more dangerous game. If the fines are big enough to do material damage, the resulting hit to bank capital may be a systemic trigger. Many innocent shareholders and employees will be the victims. If the fines are immaterial, they are pointless.

Jed Rakoff, the US district judge, argues that going after the company is technically suspect because you should not indict a company unless you can prove that some managerial agent of the company committed the alleged crime; and if you can prove that, why not indict the manager? He also sees it as morally suspect because punishing innocent employees and shareholders for crimes committed by unprosecuted individuals seems contrary to elementary notions of moral responsibility.

Modestly refining the carrots and using the wrong sticks is a poor formula for rebuilding the moral capital stock. There has to be a more radical way.


John Plender


Fonte: FT