Welcome to the first of a three part series, Back to the Future, which explores the complicated reasons behind the continuing regulatory and judicial failure to regulate global financial markets.
Professor of Law at the University of New South Wales, Justin O'Brien writes that the scandal surrounding the manipulation of the London Interbank Offered Rate (Libor) has exposed the ad hoc and inadequate re-framing of global financial regulation, despite significant reform efforts since the global financial crisis.
This is an edited extract of the article, which is available in full here.
On September 29, 2010, the Financial Times published a radical pledge. Seventeen senior financiers in the City of London committed to subjugating the profit motive of trading floors and financial advisors to what was termed “a larger social and moral purpose which governs and limits how they behave”.
Corporate responsibility to society, it was argued, could not be shirked nor delegated by the board and senior management: “Ultimately, it is the responsibility of the leaders of financial institutions — not their regulators, shareholders or other stakeholders — to create, oversee and imbue their organisations with an enlightened culture based on professionalism and integrity. As leaders of financial institutions we recognise and accept this personal responsibility.”
The pledge in the aftermath of the global financial crisis, provided what appeared to be a demonstrable commitment to higher ethical standards. The public commitment was underscored by a major conference the following week at the Mansion House, the official residence of the Lord Mayor of the City of London.
The incumbent, Nick Anstee, termed the pledge a “manifesto” with the capacity to “silence the cynics and the pessimists who doubt the ability of the City to put its house in order.” The symbolic power of both the pledge and the conference framing articulated a tangible corporate responsibility to society. Both were predicated on the acknowledgement that external oversight, no matter how invasive, could not vouchsafe societal protection.
The formulation appeared to transcend narrow legal obligation. It repositioned the corporation as an agent of societal preferences. This, the signatories agreed, was the foundation stone of trust, without which no sustainable market could function. Nick Anstee warned however that failure would inevitably lead to external monitoring.
Three years later, the initiative lies in tatters. It is both ironic and (perhaps) fitting that the pledge’s originator should have been Marcus Agius, chairman of Barclays. He was forced to resign in August this year because of the bank’s complicity in the still burgeoning Libor price manipulation scandal.
The implications of the reputational demise of the Barclays' chairman extend far beyond personal humiliation. As the influential United Kingdom Treasury Select Committee reported in August, “the standards and culture of Barclays, and banking more widely, are in a poor state. Urgent reform, by both regulators and banks, is needed to prevent such misconduct flourishing”.
The societal cost of the break between stated and lived values exposed in the Libor scandal poses a series of fundamental questions. Can corporate culture be regulated? If so, should it? How does one ensure the continuing accountability of regulatory intervention?
The debates that accompanied the passage of the New Deal architecture in the United States are instructive here. The New Deal represented an attempt to shift cultural mores by imposing external restraints on capital market governance.
As with the contemporary manifestation of financial crisis, the designers of the New Deal were forced to confront questions associated with opacity and complexity in the design and marketing of financial products, how to embed restraint and how to define and limit systemic risk.
Despite the similarities in terms of scale, societal impact and bitter partisan judicial and political conflict, there is one fundamental difference. In sharp contrast to the piecemeal reforms of today, the architectural design was based on a fundamental rethinking of corporate and regulatory purpose.
Disentangling the roots of these disputes provides critical evidence as to why the New Deal was so transformational and why current attempts to manage the aftermath of conflict has proved so ineffective.
The review conducted here draws on a series of interviews provided to the Columbia University Oral History Project by James M Landis, a critical architect of the Securities Act (1933), governing new issuance and the Securities Exchange Act (1934), which extended regulatory oversight to existing securities and mandated governance through the establishment of the Securities and Exchange Commission (SEC). He served on the inaugural board of the SEC, becoming its chair following the departure of Joseph Kennedy in 1934.
Culture, compliance and ethics
Trust in our corporations and in our institutions, both secular and religious, is at an all-time low. Across myriad domains and jurisdictions from policing to the media, faith-based schooling to banking, governance failures have blighted individual lives, ruined reputations and, in the case of the global financial crisis, social cohesion.
Irrespective of domain, corporate culpability for individual ethical failures is invariably and inevitably informed by the relative strength or weakness of organisational culture (i.e., the degree to which egregious conduct is informed by a disconnect between stated and lived values).
It is equally dispiriting but nonetheless inescapable that neither commitments to enhanced self-regulation nor strengthened external oversight have proved capable of arresting a decline in the trustworthiness of the financial sector. Indeed, recent legislative innovations have resulted in the design of sub-optimal regulatory structures; sub-optimal, that is, to society if not the financial sector itself, ostensibly the target but ultimately the beneficiary of flawed implementation.
This is particularly apparent in the United States. The Public Company Accounting Reform and Investor Protection Act (2002), designed to enhance audit standards in the aftermath of the Enron and associated scandals, for example, transmogrified into an enormous rent-seeking opportunity for the accounting profession. Equally, the Wall Street Reform and Consumer Protection Act (2010) has facilitated continuing trench warfare between the SEC and regulated entities. Historically, more aggressive enforcement in the aftermath of crisis has proved problematic in changing corporate culture, with ever-increasing fines written off as part of the cost of doing business.
Paradoxically, in the contemporary crisis accusations of “overreach” frequently accompany judicial complaints that a façade of enforcement is being privileged. In cases in which insiders have been brought to trial, juries have been reluctant to convict. At a broader strategic level, judicial scepticism over the SEC’s use (or misuse) of cost-benefit analysis has significantly curtailed the efficacy of its discretionary ability to introduce enhanced standards.
It is equally dispiriting that policymakers have conflated the essential function provided by banking with the security of individual banks, a compromise that because of the maintenance of an explicit “too-big-to-fail” subsidy facilitates risk-taking. Moreover, the complexity of modern finance and globalised, fragmented chains of command governing the production and dissemination of specialised knowledge increases the information asymmetry risk. As a consequence, the risk that the unscrupulous will take advantage of what the economist David C. Rose has termed the “golden opportunities” of deception is increasing. Recent survey evidence from the corruption and anti-money laundering domain confirms this insight.
The annual Ernst & Young global fraud survey, for example, is one of the most detailed snapshots of the bribery and corruption challenges facing multinational corporations. One of its most “troubling” findings is what Ernst & Young terms a growing widespread acceptance of unethical business practices (64% of respondents believe the incidence of compliance failure has increased because of the downturn). The trend is particularly apparent in East Asia (60% of respondents in Indonesia deemed it acceptable to make cash payments to secure new contracts; 36% of respondents in Vietnam suggested it was permissible to misstate financial accounts).
The decline in ethical commitment is traced to a lack of training, and, more significantly, to mixed messages from senior management as to the importance of compliance with Anti-Bribery and Corruption Policies (ABACP). As E&Y concludes, if action is not taken to hold offenders to account, stated commitment to high standards remains an exercise in symbolism. While many reported the existence of sophisticated compliance systems, these were not subject to continuing external testing. Only 33% reported using external law firms or consultants to provide assurance. In a significant finding, 54% of CFOs surveyed had not taken ABACP training, while 52% of all respondents reported that the board was not sufficiently aware of operating risk.
The report concludes, somewhat bleakly, that hard times stretch ethical boundaries. The critical importance of trust in lowering agency and transaction costs, building cooperation and innovation and creating more efficient exchanges has, of course, long been recognised. Without continuing substantial institutionalised commitment to ethical behaviour, however, credible ex ante detection remains implausible.
Compartmentalisation and increasing social distance between market actors and broader society weaken the empathetic foundations of trust. The critical question, therefore, is how to strengthen the restraining forces. Resolution of this conundrum cannot take place without critical reflection on the corporation and its place in society. Corporate cultures do not exist in a vacuum; nor are they mere reactive responses to externally mandated rules.
Instead they reflect the values of the organisation. The emphasis on culture underpins an influential definition of corporate governance provided by the Australian jurist Justice Neville Owen. In his investigation into the 2001 collapse of HIH Insurance, Australia’s scarifying equivalent to Enron, Justice Owen maintained that he was “not so much concerned with the content of a corporate governance model as with the culture of the organisation to which it attaches”.
For Justice Owen, “the key to good corporate governance lies in substance, not form. It is about the way the directors of a company create and develop a model to fit the circumstances of the company and the test it periodically for its practical effectiveness”.
The problem facing regulatory authorities is that that model has lost its legitimacy. The privileging of innovation over security and emaciated conception of responsibility and accountability has led to a profound authority crisis that can only be resolved by reconstituting the social contract governing the operation of global finance.
The extension of the role of the state cannot, however, be considered in a vacuum, nor too can the role played by crisis and contingency in facilitating ideational change.
As with the current crisis afflicting the Anglo-American model of capitalism, the debate in the 1930s on whether, should and how the government intervene was based on a social as well as economic catastrophe in which the gullible and the unwary were beguiled by the lure of instant gratification.
The result was a profound recalibration in which private interests were rendered subservient to societal obligation. Not for the first time in regulatory design, the search for credible reform necessitates going back to the future.
In part two of Back to the Future: How the search for a credible and effective approach to regulatory reform goes back to The New Deal of the 1930s and the work of James M. Landis, US administrator and creator of the Securities and Exchange Commission.
This is an edited extract of an article available in full at the UNSW Centre for Law, Markets and Regulation.