The Common Link in Failures and Scandals at the World's Leading Banks
| Publication year | 2012 |
I. INTRODUCTION
While the roots of recent institutional failures run deep, this past northern summer has revealed substantial compliance, risk management, and governance failures at major international banks at an unprecedented level. The exposure of a new wave of scandals at JPMorgan Chase and Co., HSBC Holdings plc, and Standard Chartered Bank plc, and the panel-member banks under transatlantic investigation for the manipulation of the London Interbank Offered Rate (LIBOR) points to systemic governance failures that also call into doubt the structural integrity of current models of financial regulation. Taken together, they suggest that both regulated entities and their regulators face a profound legitimacy and authority crisis. The causes of the problems facing the banking industry and its regulators, while complex, share a common theme. They derive from a failure to integrate what we term the five core dimensions of internal and external oversight: compliance, ethics, deterrence, accountability and risk (CEDAR).
In the aftermath of the crisis, there are pressing reasons to revisit the fundamental purpose of corporate governance and financial regulation and to evaluate to what extent the reform agenda addresses the revealed limitations of current and proposed frameworks. It is in the interest of both the regulator and the regulated that one has substantive conceptions of compliance, rather than mechanical conceptions that are easily transacted around. It is in their common interest for there to be warranted commitment to ethical standards rather than a stated aspiration that lacks the granularity to be enforceable. Likewise, only effective deterrence can assure public confidence, which necessitates demonstrable internal capacity and willingness to police and punish deviance. This, in turn, augments accountability, without which confidence cannot be assured. Ultimately, the goal of internal governance and external supervision through financial regulation is to reduce risk. This can only be vouchsafed, however, by evaluating the extent to which all five dimensions are integrated within an overarching design that encompasses mandate, corporate or bureaucratic process, and use of discretion. The CEDAR matrix serves, therefore, both a diagnostic and an evaluative function across mandate, process, and the use of discretion.
The first dimension of CEDAR is compliance, which includes the notion of compliance risk. Compliance risk is defined as "the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities."(fn1) Parliamentary and congressional investigations into the recent banking scandals have shown that in each case compliance risk was exacerbated by globalized institutional structures that were too big to manage internally and too big to regulate externally. Against this rubric both the internal compliance paradigm and external deterrence strategies of enforcement are inherently unworkable. In the United States for example, where threats of criminal prosecution are hollow and breaches are routinely sanctioned by financial regulators through negotiated settlements,(fn2) there has been little incentive for such "systemically important financial institutions"(fn3) to implement a robust compliance program that extends beyond symbolism. Given the amount of repeat offenders, there is scant evidence to suggest that negotiated settlements encourage any meaningful behavioral change. Indeed, an influential New York district court judge, Jed Rakoff, argues that these agreements privilege the "facade of enforcement."(fn4) In the United Kingdom, the situation is even more problematic given the failure to hold any individual accountable.(fn5) Trust, which is the foundation of banking and its regulation, has in consequence and for good reason evaporated.
But ascertaining who or what is responsible for these banking scandals, who should be held accountable, and more fundamentally, how the oversight model could or should be redesigned remains exceptionally problematic. The core and unresolved issue pivots on purpose, both for the corporation and for the market in which it is nested. As Edward Mason famously noted in 1960, "[t]he fact seems to be that the rise of the large corporation and attending circumstances have confronted us with a long series of questions concerning rights and duties, privileges and immunities, responsibility and authority, that political and legal philosophy have not yet assimilated."(fn6) The passage of time has demonstrated not only the sagacity of this insight, but also its particular relevance to the financial services industry.
Some have argued that the rapid expansion of financial services in recent years has disproportionately benefited the industry itself.(fn7) Proponents of this narrative advocate structural changes, such as reimposing the Banking Act of 1933,(fn8) also known as the Glass-Steagall Act,(fn9) or implementing a strict-form ban on proprietary trading under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).(fn10) Others blame weak regulators.(fn11) This privileges a familiar regulatory capture narrative.(fn12) It notes the failure of central bank officials and government regulators to respond to patent misconduct that is, in some cases, exposed years prior to the commencement of official investigations.(fn13) As with all compelling narratives, each is plausible. What is lost, however, is perhaps an even more disturbing reality. While most of the scandals have excised the "rotten apples" deemed responsible, it could well be the case that it is actually the "barrel that is the cause of the problem."(fn14) If so, then no amount of structural tinkering alone will be sufficient: one cannot solve normative problems with technical measures alone.
Should one rely on rules alone, there is the demonstrable danger that they will be transacted around; likewise, a reliance on principles lacks application in circumstances in which the actors have no conceptions-or very limited and emasculated conceptions-of what those principles are.(fn15) What needs to be mapped and tracked, therefore, is the extent to which rules and principles interact within specific epistemic communities of practice, whether they are professional, corporate, or regulatory. This in turn forces reflection on the question of culture, a recurring motif in the report of the United Kingdom Treasury Select Committee on the LIBOR price-manipulation scandal.(fn16) It is an issue initially raised but since then quietly buried by senior regulatory figures in the United Kingdom in the immediate aftermath of the Global Financial Crisis.(fn17) However, this Article argues that both the root cause of the crisis and the route to restoring trust and confidence is to be found in ascertaining how to regulate culture across mandates, processes, and use of discretion.
Part II identifies the internal and external failings of four of the most recent global banking scandals within the CEDAR matrix. Part III discusses the regulatory challenges faced when compliance serves no practical function and the consequent material risk to market integrity. This Article concludes by suggesting that it is unsustainable for regulation to be decided, implemented, and monitored at a national level. Global oversight has become an imperative to reduce the conflicts of interest that may create profitable industries, but not socially beneficial ones.
II. RECENT CASE STUDIES
On May 10, 2012, JPMorgan disclosed a "surprise" trading loss of at least $2 billion.(fn18) The loss was linked to a complex hedging strategy based on synthetic credit default swaps made by traders in London on behalf of the New York-based chief investment office (CIO).(fn19) According to the chief executive officer, Mr. Jamie Dimon, "the losses emerged after the firm tried to reduce that position and unwind the portfolio."(fn20) In the immediate aftermath of the disclosure, JPMorgan shareholders saw about $30 billion of market value obliterated.(fn21) The control failures at JPMorgan were not the consequence of rogue traders operating in a niche market far removed from the corridors of power (the "rotten apple theory"). The traders were executing a strategy on behalf of the CIO. Its function was to "hedge the bank's exposure on loans and other credit risks to corporations, banks, and sovereign governments."(fn22) Nothing could be more central to JPMorgan's risk management, yet it appeared to be operating out of control. Unraveling how and why this occurred is instructive about the difficulties associated with conflating compliance with risk management. Moreover, it also highlights multiple ex post and ex ante accountability failures within the bank itself and with its regulators where confusion reigned over just who was responsible for monitoring risk and whether the global nature of the operations fatally undermined any meaningful capacity to regulate.
The first signs of problems had surfaced a month prior, on April 6, 2012. The
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