It is a mystery why bankers earn so much

John Gapper in The FT

In the libel suit he brought in 1878 against John Ruskin, the Victorian painter James McNeill Whistler was asked under cross-examination how he justified charging 200 guineas for a painting of a London firework display that took him two days to finish. “I ask it for the knowledge of a lifetime,” Whistler declared. 

Investment bankers explain their bonuses in the same manner, although the rewards for mergers and acquisitions advisers are rather greater than for most painters. Goldman Sachs will be paid $58m by 21st Century Fox for its advice on Fox’s planned $71bn asset sale to Walt Disney (and the bank stands to gain another $47m for financing the remainder of Fox). 

They are remarkable paydays — today’s dealmaking boom is the most rewarding time in history to be a global M&A banker. It is especially lucrative for those in the top league of advisers who run many auctions. An individual with the ability to shepherd nervous boards of directors past the pitfalls and a reputation for squeezing the best prices can name his or her fee. 

But what exactly do they do for the money? When asked this question, they turn sheepish and talk vaguely about the art of persuasion rather than the science of valuation. The secret to a bulging “success fee” is less to obtain the best possible deal than to make the chief executive and the board believe they got it. That is not the same thing, particularly in the long term. 

The M&A adviser’s job has three qualities that put its practitioners in a powerful bargaining position over their own pay. First, the stakes are very high. One former banker compares it to a surgeon explaining his or her charges as a patient is being wheeled into the operating theatre. The latter needs to have the best possible professional and is in no position to quibble. 

Going through an M&A auction can feel like being operated upon for directors who have not experienced it before. Shareholders and the media lurk, ready to condemn any slip-up (the latter risk is why public relations consultants get paid so much as well). There is plenty of subterfuge and bargaining over details, any of which could unexpectedly prove fatal to the outcome. 

Second, advisers are paid with other people’s money. That is especially true when a company is being sold — the overall price including the fees is going to be picked up by the acquirer, so what difference does a few million make? Even when the client is an acquirer, boards of directors whose personal reputations are at stake are not digging into their own pockets to pay. 

Through one end of the telescope, the fees even look small. The average fee for selling a company worth between $10bn and $25bn is about 0.3 per cent, and can cover years of unpaid work. Bankers claim they are cheap compared with property brokers, who may charge several percentage points for selling a house. As ever, the best way to make money is to be around a lot of it. 

Third, M&A advice is a black box. There is plenty of technical skill in structuring a transaction such as using acquisitions to change tax domiciles. That is bundled with access to the bank’s contacts with potential bidders in various countries and presented as a whole by one adviser to the board. The senior banker’s tone of voice conveys a mixture of financial advice, human judgment and comfort. 

The last is the most valuable. In theory, M&A advice could be unbundled into different tasks, and more of the technical work done by machines, but boardrooms only have space for a few people. They are crowded enough by companies’ baffling habit of hiring several banks to advise on big deals and paying them $20m each, which one adviser calls “ludicrous”. 

The fee rises exponentially for an adviser in the room where a deal happens. This accounts for the prosperity of advisory boutiques such as Centerview Partners and Evercore, founded by corporate financiers who built their reputations at banks including UBS and Lehman Brothers. The power of a global advisory elite is exemplified by tiny and highly rewarded banking “kiosks” such as Robey Warshaw. 

Global investment banks sniff at the ability of a few experienced individuals to charge similar fees to them, without bearing the same costs. “The boutiques are full of guys cashing in at the end of their careers and they get a bit of a free ride,” says one adviser at a big bank. In the M&A business, relationships have enduring value. 

But hiring the best cosmetic surgeon in the world does not make cosmetic surgery a good idea. Deals can be brilliantly executed at the time without adding to a company’s long-term value and many are unwound — often with the help of the same advisers — when a chief executive leaves. “Companies pay far too much to advisers. It’s really not worth it,” says Peter Zink Secher, co-author of The M&A Formula. 

The success fees of advisers should be more closely tied to whether the deal succeeds long after it has closed and they have moved on to the next one. Whistler won his libel suit against Ruskin for having accused him of “flinging a pot of paint in the public’s face”, but was only awarded damages of a farthing. Even artists can push their luck.

Mullah vs Allah

There’s nothing the Modi government can do if the opposition doesn’t want him to

Jawed Naqvi in The Dawn

INDIA’S opposition parties must quickly deal with two problems ahead of the next election. One stems from an irrational fear of Prime Minister Modi, of what tricks he might have up his sleeve and so forth to outsmart the opposition in 2019. This problem is rooted in low self-belief and a battered self-esteem, which by habit doubts the hugely positive ground reality.

The other problem the opposition must overcome is the addiction of some, not all, to the gambling casino that a group of croupiers has turned Indian elections into. The croupiers use everything they have — tantric amulets, charms, horoscopes and the inviolable right to throw the dice — to turn their political quarries into addicts and junkies. The croupiers took a call one day that Narasimha Rao would save the country. They were applauded by punters like Harshad Mehta and cheered by the gang that destroyed a dilapidated mosque to change the discourse from issues important to the people.

The croupiers took the view another day that Sonia Gandhi was a foreigner hence not entitled to lead India. Then they decided that Modi was just right for the country. The casino runners have already reaped more than they invested in the 2014 campaign. And yet, the croupiers run the establishment, which currently is a right-wing establishment. Sadly for them though, the soul of India resides on the left. This is not lazy ideological bumpf but the plain truth, beyond the grasp of TV channels and social media.

What constitutes India’s left and right? If anyone’s agenda is to stop the suicides of farmers they cannot be right wing. If the agenda is to stop the loot of the banks, which were nationalised to prevent them from looting the people, farmers mostly, it cannot be right wing. The constitution in its spirit is a leftist document. It harnessed the spirit of socialism and secularism even before the two words were added in the preamble. Defend it and you are through.

So what’s the antidote to the right-wing establishment the croupiers favour?

A recent answer, a compelling one, may lie in New York. The primary defeat last week of top-ranking House Democrat Joe Crowley at the hands of a 28-year-old political rookie named Alexandria Ocasio-Cortez can be and has been replicated in India. It started in recent memory with Arvind Kejriwal and flourished with Jignesh Mewani and Hardik Patel. It can only consolidate into a great force if Rahul Gandhi and H.D. Kumarswamy forget about seat arrangements and focus on saving the country from an obscurantist establishment. Ocasio-Cortez defied the croupiers, and Indian opposition parties can easily replicate her feat.

We are told that Modi has imposed his rule in blood-drenched Kashmir to influence the course of the coming elections. That’s the fear the best of my liberal and leftist friends have expressed. Will there be a televised stand-off on the borders? Anyone can see the steady evidence to the contrary — from Churchill to Manmohan Singh — that wars don’t win elections while peace often fetches electoral dividends. With all the images of body bags flashed on TV during the Kargil collision, Atal Behari Vajpayee barely scraped through in the 1999 polls, leaving his claims of military victory somewhat undermined.

Vajpayee’s BJP secured 23.8 per cent of the vote, pointedly below its 25.5pc in 1998. Worse, it suffered its biggest setback in electorally crucial Uttar Pradesh. The BJP won only 29 of the state’s 85 parliamentary seats, down from the 57 seats it won in the pre-Kargil contest of 1998.

In the United States, Bush Jr gained an embarrassingly narrow lead over John Kerry despite the claims of victory in Iraq and Afghanistan. Besides, Vajpayee never explained what president Clinton meant when he claimed in an address to the Indian parliament that it was the US that saved the day for India by pummelling Pakistan with a diplomatic démarche served on an utterly perplexed Nawaz Sharif.

Row back in time. While Vajpayee’s vote percentage had dropped despite televised jingoism, in Pakistan, the Kargil goof-up required a military coup to mask the embarrassing endgame. And those who have won popular support since were parties who promised peace with India. It was the same with the Mumbai terror strike. In 2009, shortly after the carnage, amid calls for revenge, Manmohan Singh won his second consecutive term without lifting a finger. It was the Indian people’s less-discussed endorsement of his understated, phlegmatic response to Pakistan. This the croupiers and their in-house media will not discuss.

Instead, the blue-turbaned prime minister headed off to Sharm al-Sheikh to agree on a comprehensive path to peace with his difficult and troubled western neighbour. When Singh lost in 2014 after 10 years in office, it was on account of a weakened control on his own coalition partners.

Therefore, editorial writers and worried experts who warn of a Modi plot in the recent events in Kashmir need to calm down. There’s nothing the Modi government can do to win in 2019 if the opposition doesn’t want him to. The ground reality in India has changed from the day he defeated a divided opposition.

The coming together of arch rivals Mayawati and Akhilesh Yadav in Uttar Pradesh has shown that the opposition holds all the aces. Even in Srinagar, if the National Conference and Peoples Democratic Party can bury the hatchet and invite the Hurriyat to work out a durable end to the self-wounding bloodbath, there is nothing that Modi or his hawkish advisers can do to take the initiative from them. The blood of innocent lives will not go waste if Kashmir can find a solution that undermines the croupiers and elevates the chances for a battered and abused region to join the global quest for peace and justice.

An Insignificant Man - Arvind Kejriwal

Would basic incomes or basic jobs be better when robots take over?

Tim Harford in The Financial Times


We all seem to be worried about the robots taking over these days — and they don’t need to take all the jobs to be horrendously disruptive. A situation where 30 to 40 per cent of the working age population was economically useless would be tough enough. They might be taxi drivers replaced by a self-driving car, hedge fund managers replaced by an algorithm, or financial journalists replaced by a chatbot on Instagram. 

By “economically useless” I mean people unable to secure work at anything approaching a living wage. For all their value as citizens, friends, parents, and their intrinsic worth as human beings, they would simply have no role in the economic system. 

I’m not sure how likely this is — I would bet against it happening soon — but it is never too early to prepare for what might be a utopia, or a catastrophe. And an intriguing debate has broken out over how to look after disadvantaged workers both now and in this robot future. 

Should everyone be given free money? Or should everyone receive the guarantee of a decently-paid job? Various non-profits, polemicists and even Silicon Valley types have thrown their weight behind the “free money” idea in the form of a universal basic income, while US senators including Bernie Sanders, Elizabeth Warren, Cory Booker and Kirsten Gillibrand have been pushing for trials of a jobs guarantee. 

Basic income or basic jobs? There are countless details for the policy wonks to argue over, but what interests me at the moment is the psychology. In a world of mass technological unemployment, would either of these two remedies make us happy? 

Author Rutger Bregman describes a basic income in glowing terms, as “venture capital for everyone”. He sees the cash as liberation from abusive working conditions, and a potential launch pad to creative and fulfilling projects. 

Yet the economist Edward Glaeser views a basic income as a “horror” for the recipients. “You’re telling them their lives are not going to be ones of contribution,” he remarked in a recent interview with the EconTalk podcast. “Their lives aren’t going to be producing a product that anyone values.” 

Surely both of them have a point. A similar disagreement exists regarding the psychological effect of a basic jobs guarantee, with advocates emphasising the dignity of work, while sceptics fear a Sisyphean exercise in punching the clock to do a fake job. 

So what does the evidence suggest? Neither a jobs guarantee nor a basic income has been tried at scale in a modern economy, so we are forced to make educated guesses. 

We know that joblessness makes us miserable. In the words of Warwick university economist Andrew Oswald: “There is overwhelming statistical evidence that involuntary unemployment produces extreme unhappiness.” 

What’s more, adds Prof Oswald, most of this unhappiness seems to be because of a loss of prestige, identity or self-worth. Money is only a small part of it. This suggests that the advocates of a jobs guarantee may be on to something. 

In this context, it’s worth noting two recent studies of lottery winners in the Netherlands and Sweden, both of which find that big winners tend to scale back their hours rather than quitting their jobs. We seem to find something in our jobs worth holding on to. 

Yet many of the trappings of work frustrate us. Researchers led by Daniel Kahneman and Alan Krueger asked people to reflect on the emotions they felt as they recalled episodes in the previous day. The most negative episodes were the evening commute, the morning commute, and work itself. Things were better if people got to chat to colleagues while working, but (unsurprisingly) they were worse for low status jobs, or jobs for which people felt overqualified. None of which suggests that people will enjoy working on a guaranteed-job scheme. 

Psychologists have found that we like and benefit from feeling in control. That is a mark in favour of a universal basic income: being unconditional, it is likely to enhance our feelings of control. The money would be ours, by right, to do with as we wish. A job guarantee might work the other way: it makes money conditional on punching the clock. 

On the other hand (again!), we like to keep busy. Harvard researchers Matthew Killingsworth and Daniel Gilbert have found that “a wandering mind is an unhappy mind”. And social contact is generally good for our wellbeing. Maybe guaranteed jobs would help keep us active and socially connected.

The truth is, we don’t really know. I would hesitate to pronounce with confidence about which policy might ultimately be better for our wellbeing. It is good to see that the more thoughtful advocates of either policy — or both policies simultaneously — are asking for large-scale trials to learn more. 

Meanwhile, I am confident that we would all benefit from an economy that creates real jobs which are sociable, engaging, and decently paid. Grand reforms of the welfare system notwithstanding, none of us should be giving up on making work work better.

Protect the NHS – but don’t protect it to death

Harry Quilter-Pinner in The Guardian

 

The NHS, as portrayed at the opening of the 2012 London Olympics. Photograph: Julian Simmonds/REX/Shutterstock




Dancing doctors, uniform-clad nurses and children jumping on hospital beds. There are very few countries that would include a celebration of their healthcare system in the opening ceremony of the Olympic Games. But this was the sight that greeted the millions who tuned in at the start of London 2012. After all, as former chancellor Nigel Lawson said: “The NHS is the closest thing the English people have to a religion.”

Now the country will once again celebrate the NHS, as it turns 70. And so we should. Across the globe, 400 million people still don’t have access to essential healthcare services. Thanks to the NHS, no one in the UK faces this injustice. It is there for us all – regardless of race, sexuality, gender or financial means – at our times of greatest need.

But we must also take this opportunity to stop and reflect. How good is the NHS? What do we want for its future? And what do we need to do to make it better?

A new report attempts to answer some of these tricky questions. It shows that, despite the rhetoric, in many ways the NHS is deeply average. In the authors’ words “the NHS performs neither as well as its supporters sometimes claim nor as badly as its critics often allege”. Shockingly, it finds that if you suffer from cancer, a heart attack or a stroke in the UK, you are more likely to die early than in other developed countries. 

This reality jars with a national perception of the NHS as world leading. Some will jump on this as an opportunity to call for radical change: perhaps a shift to a social – or even a private – insurance model. This would be a mistake. Fundamentally, the NHS is sound: its “free at the point of need” principle ensures that getting ill doesn’t mean getting poor. Moreover, there is strong evidence that it is more efficient than its marketised equivalents in the US and Switzerland.

Money is part of the answer as to why the NHS underperforms, compared with other systems. We spend less on healthcare than most other countries of a similar size and income level: just 9.7% of GDP compared with around 11% in both Germany and France. It should not come as a surprise that with average levels of funding come average levels of care. Theresa May’s recent “birthday present” – a long-term funding settlement for the NHS worth an additional £20bn a year by 2023 – will start to address this, though many predict that it will not be enough in the context of a growing and ageing population.

But money alone is not the solution: the NHS also suffers from a lack of reform. In places where the NHS has embraced best practice it is undoubtedly world leading. Stroke care is a good example. In 2010, London went from 34 hospitals treating stroke sufferers to just eight new centres of excellence. This has resulted in 400 lives saved per year across the capital. There have been attempts to replicate this nationwide. But in too many areas these changes, which involve consolidating services into fewer, more specialist centres, have been opposed by both the public and politicians. 

There are similar debates about moves to embrace new technologies in the NHS. The evidence is clear that artificial intelligence and robotics could fundamentally transform health and care. The government recently announced funding to help save 30,000 lives a year through technology-enabled diagnosis of cancers. But all too often, people see data-sharing as a breach of privacy and the rise of robotics in the NHS as an attempt to cut costs.

In some ways, this reluctance to embrace change is unsurprising. We all have a strong emotional and cultural attachment to the NHS. We are understandably protective of it. And many see the NHS as the last vestige of an endangered postwar consensus. They are fearful that it will go the same way as the rest of the welfare state, becoming watered down, outsourced and underfunded.

But in looking to protect the NHS there is a real risk that we end up “killing it with kindness”. All change is not bad change. As Lord Darzi’s recent review of the NHS has made clear, “high-quality care is a constantly moving target: to stand still is to fall back”. This would not only be a travesty for those who suffer as a result; it would also fuel the arguments its critics. When the great reformer, William Beveridge, proposed the creation of the NHS during the second world war, he was focused not on protecting existing achievements but on embracing the future. On its 70th birthday, it is vital that we do the same again.

How to get away with financial fraud

Dan Davies in The Guardian


Guys, you’ve got to hear this,” I said. I was sitting in front of my computer one day in July 2012, with one eye on a screen of share prices and the other on a live stream of the House of Commons Treasury select committee hearings. As the Barclays share price took a graceful swan dive, I pulled my headphones out of the socket and turned up the volume so everyone could hear. My colleagues left their terminals and came around to watch BBC Parliament with me.

It didn’t take long to realise what was happening. “Bob’s getting murdered,” someone said.

Bob Diamond, the swashbuckling chief executive of Barclays, had been called before the committee to explain exactly what his bank had been playing at in regards to the Libor rate-fixing scandal. The day before his appearance, he had made things very much worse by seeming to accuse the deputy governor of the Bank of England of ordering him to fiddle an important benchmark, then walking back the accusation as soon as it was challenged. He was trying to turn on his legendary charm in front of a committee of angry MPs, and it wasn’t working. On our trading floor, in Mayfair, calls were coming in from all over the City. Investors needed to know what was happening and whether the damage was reparable.

A couple of weeks later, the damage was done. The money was gone, Diamond was out of a job and the market, as it always does, had moved on. We were left asking ourselves: How did we get it so wrong?

At the time I was working for a French stockbroking firm, on the team responsible for the banking sector. I was the team’s regulation specialist. I had been aware of “the Libor affair”, and had written about it on several occasions during the previous months. My colleagues and I had assumed that it would be the typical kind of regulatory risk for the banks – a slap on the wrist, a few hundred million dollars of fines, no more than that.

The first puzzle was that, to start with, it looked like we were right. By the time it caught the attention of the mainstream media, the Libor scandal had reached what would usually be the end of the story – the announcement, on 27 June 2012, of a regulatory sanction. Barclays had admitted a set of facts, made undertakings not to do anything similar again, and agreed to pay finesof £59.5m to the UK’s Financial Services Authority, $200m to the US Commodity Futures Trading Commission and a further $160m to the US Department of Justice. That’s how these things are usually dealt with. If anything, it was considered quite a tough penalty.

But the Libor case marked the beginning of a new process for the regulators. As well as publishing their judgment, they gave a long summary of the evidence and reasoning that led to their decision. In the case of the Libor fines, the majority of that evidence took the form of transcripts of emails and Bloomberg chat. Bloomberg’s trading terminals – the $50,000-a-year news and financial-data servers that every trader uses – have an instant-messaging function in addition to supplying prices and transmitting news. Financial market professionals are vastly more addicted to this chat than teen girls are to Instagram, and many of them failed to realise that if you discussed illegal activity on this medium, you were making things easy for the authorities.

The transcripts left no room for doubt.

Trader C: “The big day [has] arrived … My NYK are screaming at me about an unchanged 3m libor. As always, any help wd be greatly appreciated. What do you think you’ll go for 3m?”

Submitter: “I am going 90 altho 91 is what I should be posting.”

Trader C: “[…] when I retire and write a book about this business your name will be written in golden letters […]”.

Submitter: “I would prefer this [to] not be in any book!”

Perhaps it’s unfair to judge the Libor conspirators on their chat records; few of the journalists who covered the story would like to see their own Twitter direct-message history paraded in front of an angry public. Trading, for all its bluster, is basically a service industry, and there is no service industry anywhere in the world whose employees don’t blow off steam by acting out or insulting the customers behind their backs. But traders tend to have more than the usual level of self-confidence, bordering on arrogance. And in a general climate in which the public was both unhappy with the banking industry and unimpressed with casual banter about ostentatious displays of wealth, the Libor transcripts appeared crass beyond belief. Every single popular stereotype about traders was confirmed. An abstruse and technical set of regulatory breaches suddenly became a morality play, a story of swaggering villains who fixed the market as if it was a horse race. The politicians could hardly have failed to get involved.

It is not a pleasant thing to see your industry subjected to criticism that is at once overheated, ill-informed and entirely justified. In 2012, the financial sector finally got the kind of enemies it deserved. The popular version of events might have been oversimplified and wrong in lots of technical detail, but in the broad sweep, it was right. The nuanced and technical version of events which the specialists obsessed over might have been right on the detail, but it missed one utterly crucial point: a massive crime of dishonesty had taken place. There was a word for what had happened, and that word was fraud. For a period of months, it seemed to me as if the more you knew about the Libor scandal, the less you understood it.

That’s how we got it so wrong. We were looking for incidental breaches of technical regulations, not systematic crime. And the thing is, that’s normal. The nature of fraud is that it works outside your field of vision, subverting the normal checks and balances so that the world changes while the picture stays the same. People in financial markets have been missing the wood for the trees for as long as there have been markets.

Some places in the world are what they call “low-trust societies”. The political institutions are fragile and corrupt, business practices are dodgy, debts are rarely repaid and people rightly fear being ripped off on any transaction. In the “high-trust societies”, conversely, businesses are honest, laws are fair and consistently enforced, and the majority of people can go about their day in the knowledge that the overall level of integrity in economic life is very high. With that in mind, and given what we know about the following two countries, why is it that the Canadian financial sector is so fraud-ridden that Joe Queenan, writing in Forbes magazine in 1989, nicknamed Vancouver the “Scam Capital of the World”, while shipowners in Greece will regularly do multimillion-dollar deals on a handshake?

We might call this the “Canadian paradox”. There are different kinds of dishonesty in the world. The most profitable kind is commercial fraud, and commercial fraud is parasitical on the overall health of the business sector on which it preys. It is much more difficult to be a fraudster in a society in which people only do business with relatives, or where commerce is based on family networks going back centuries. It is much easier to carry out a securities fraud in a market where dishonesty is the rare exception rather than the everyday rule.

 

Traders at Bloomberg terminals on the floor of the New York stock exchange, 2013. Photograph: Brendan McDermid / Reuters/REUTERS

The existence of the Canadian paradox suggests that there is a specifically economic dimension to a certain kind of crime of dishonesty. Trust – particularly between complete strangers, with no interactions beside relatively anonymous market transactions – is the basis of the modern industrial economy. And the story of the development of the modern economy is in large part the story of the invention and improvement of technologies and institutions for managing that trust.

And as industrial society develops, it becomes easier to be a victim. In The Wealth of Nations, Adam Smith described how prosperity derived from the division of labour – the 18 distinct operations that went into the manufacture of a pin, for example. While this was going on, the modern world also saw a growing division of trust. The more a society benefits from the division of labour in checking up on things, the further you can go into a con game before you realise that you’re in one. In the case of several dealers in the Libor market, by the time anyone realised something was crooked, they were several billions of dollars in over their heads.

In hindsight, the Libor system was always a shoddy piece of work. Some not-very-well-paid clerks from the British Bankers’ Association would call up a few dozen banks and ask: “If you were to borrow, say, a million dollars in [a given currency] for a 30-day deposit, what would you expect to pay?” A deposit, in this context, is a short-term loan from one bank to another. Due to customers’ inconvenient habit of borrowing from one bank and putting the money in an account at another, banks are constantly left with either surplus customer deposits, or a shortage of funds. The “London inter-bank offered-rate” (Libor) market is where they sort this out by borrowing from and lending to each other, at the “offered rate” of interest.

Once they had their answers, the clerks would throw away the highest and lowest outliers and calculate the average of the rest, which would be recorded as “30-day Libor” for that currency. The process would be repeated for three-month loans, six-month loans and any other periods of interest, and the rates would be published. You would then have a little table recording the state of the market on that day – you could decide which currency you wanted to borrow in, and how long you wanted the use of the money, and the Libor panel would give you a good sense of what high-quality banks were paying to do the same.

Compared with the amount of time and effort that goes into the systems for nearly everything else that banks do, not very much trouble was taken over this process. Other markets rose and fell, stock exchanges mutated and were taken over by super-fast robots, but the Libor rate for the day was still determined by a process that could be termed “a quick ring-around”. Nobody noticed until it was too late that hundreds of trillions of dollars of the world economy rested on a number compiled by the few dozen people in the world with the greatest incentive to fiddle it.

It started to fall apart with the onset of the global financial crisis in 2007, and all the more so after the collapse of Lehman Brothers in 2008, when banks were so scared that they effectively stopped lending to each other. Although the market was completely frozen, the daily Libor ring-around still took place, and banks still gave, almost entirely speculatively, answers to the question “If you were to borrow a reasonable sum, what would you expect to pay?”

But the daily quotes were published, and that meant everyone could see what everyone else was saying about their funding costs. And one of the telltale signs that a bank in trouble is when its funding costs start to rise. If your Libor submission is taken as an indicator of whether you’re in trouble or not, you really don’t want to be the highest number on the daily list. Naturally, then, quite a few banks started using the Libor submission process as a form of false advertising, putting in a lowballed quote in order to make it look like they were still obtaining money easily when, in fact, they could hardly borrow at all. And so it came to pass that several banks created internal message trails saying, in effect, “Dear Lowly Employee, for the benefit of the bank and its shareholders, please start submitting a lower Libor quote, signed Senior Executive”. This turned out to be a silly thing to do.

All this was known at the time. There was an article in the Wall Street Journal about it. I used to prepare PowerPoint slides with charts on them that had gaps for the year 2008 because the data was “somewhat hypothetical”. Even earlier, in late 2007, the Bank of England held a “liaison group” meeting so that representatives from the banks could discuss the issue of Libor reporting. What nobody seemed to realise is that an ongoing fraud was being committed. There was a conspiracy to tell a lie (to the Libor phone panel, about a bank’s true cost of funding) in order to induce someone to enter into a bargain at a disadvantage to themselves. The general public caught on to all this a lot quicker than the experts did, which put the last nail in the coffin of the already weakened trust in the financial system. You could make a case that a lot of the populist politics of the subsequent decade can be traced back to the Libor affair.

Libor teaches us a valuable lesson about commercial fraud – that unlike other crimes, it has a problem of denial as well as one of detection. There are very few other criminal acts where the victim not only consents to the criminal act, but voluntarily transfers the money or valuable goods to the criminal. And the hierarchies, status distinctions and networks that make up a modern economy also create powerful psychological barriers against seeing fraud when it is happening. White-collar crime is partly defined by the kind of person who commits it: a person of high status in the community, the kind of person who is always given the benefit of the doubt.

In popular culture, the fraudster is the “confidence man”, somewhere between a stage magician and the trickster gods of mythology. In films such as The Sting and Dirty Rotten Scoundrels, they are master psychologists, exploiting the greed and myopia of their victims, and creating a world of illusion. People like this do exist (albeit rarely). But they are not typical of white-collar criminals.

The interesting questions are never about individual psychology. There are plenty of larger-than-life characters. But there are also plenty of people like Enron’s Jeff Skilling and Baring’s Nick Leeson: aggressively dull clerks and managers whose only interest derives from the disasters they caused. And even for the real craftsmen, the actual work is, of necessity, incredibly prosaic.

The way most white-collar crime works is by manipulating institutional psychology. That means creating something that looks as much as possible like a normal set of transactions. The drama comes later, when it all unwinds.

Fraudsters don’t play on moral weaknesses, greed or fear; they play on weaknesses in the system of checks and balances – the audit processes that are meant to supplement an overall environment of trust. One point that comes up again and again when looking at famous and large-scale frauds is that, in many cases, everything could have been brought to a halt at a very early stage if anyone had taken care to confirm all the facts. But nobody does confirm all the facts. There are just too bloody many of them. Even after the financial rubble has settled and the arrests been made, this is a huge problem.

 

Jeffrey Skilling and Sherron Watkins of Enron at a Senate commerce committee hearing in 2002. Photograph: Ron Edmonds/AP

It is a commonplace of law enforcement that commercial frauds are difficult to prosecute. In many countries, proposals have been made, and sometimes passed into law, to remove juries from complex fraud trials, or to move the task of dealing with them out of the criminal justice system and into regulatory or other non-judicial processes. Such moves are understandable. There is a need to be seen to get prosecutions and to maintain confidence in the whole system. However, taking the opinions of the general public out of the question seems to me to be a counsel of despair.

When analysed properly, there isn’t much that is truly difficult about the proverbial “complex fraud trial”. The underlying crime is often surprisingly crude: someone did something dishonest and enriched themselves at the expense of others. What makes white-collar trials so arduous for jurors is really their length, and the amount of detail that needs to be brought for a successful conviction. Such trials are not long and detailed because there is anything difficult to understand. They are long and difficult because so many liars are involved, and when a case has a lot of liars, it takes time and evidence to establish that they are lying.

This state of affairs is actually quite uncommon in the criminal justice system. Most trials only have a couple of liars in the witness box, and the question is a simple one of whether the accused did it or not. In a fraud trial, rather than denying responsibility for the actions involved, the defendant is often insisting that no crime was committed at all, that there is an innocent interpretation for everything.

In January this year, the construction giant Carillion collapsed. Although they had issued a profits warning last summer, they continued to land government contracts. It was assumed that, since they had been audited by KPMG, one of the big-four accounting firms, any serious problems would have been spotted.
At the time of writing, nobody has been prosecuted over the collapse of Carillion. Maybe nobody will and maybe nobody should. It’s possible, after all, for a big firm to go bust, even really suddenly, without it being a result of anything culpable. But the accounting looks weird – at the very least, they seem to have recognised revenue a long time before it actually arrived. It’s not surprising that the accounting standards bodies are asking some questions. So are the Treasury select committee: one MP told a partner at KPMG that “I would not hire you to do an audit of the contents of my fridge.”

In general, cases of major fraud should have been prevented by auditors, whose specific job it is to review every set of accounts as a neutral outside party, and certify that they are a true and fair view of the business. But they don’t always do this. Why not? The answer is simple: some auditors are willing to bend the rules, and some are too easily fooled. And whatever reforms are made to the accounting standards and to the rules governing the profession, the same problems have cropped up again and again.

First, there is the problem that the vast majority of auditors are both honest and competent. This is a good thing, of course, but the bad thing about it is that it means that most people have never met a crooked or incompetent auditor, and therefore have no real understanding that such people exist.

To find a really bad guy at a big-four accountancy firm, you have to be quite unlucky (or quite lucky if that was what you were looking for). But as a crooked manager of a company, churning around your auditors until you find a bad ’un is exactly what you do – and when you find one, you hang on to them. This means that the bad auditors are gravitationally drawn into auditing the bad companies, while the majority of the profession has an unrepresentative view of how likely that could be.

Second, there is the problem that even if an auditor is both honest and competent, he has to have a spine, or he might as well not be. Fraudsters can be both persistent and overbearing, and not all the people who went into accountancy firms out of university did so because they were commanding, alpha-type personalities.

Added to this, fraudsters are really keen on going over auditors’ heads and complaining to their bosses at the accounting firm, claiming that the auditor is being unhelpful and bureaucratic, not allowing the CEO to use his legitimate judgment in presenting the results of his own business.

Partly because auditors are often awful stick-in-the-muds and arse-coverers, and partly because auditing is a surprisingly competitive and unprofitable business that is typically used as a loss-leader to sell more remunerative consulting and IT work, you can’t assume that the auditor’s boss will support their employee, even though the employee is the one placing their signature (and the reputation of the whole practice) on the set of accounts. As with several other patterns of behaviour that tend to generate frauds, the dynamic by which a difficult audit partner gets overruled or removed happens so often, and reproduces itself so exactly, that it must reflect a fairly deep and ubiquitous incentive problem that will be very difficult to remove.

By way of a second line of defence, investors and brokerage firms often employ their own “analysts” to critically read sets of published accounts. The analyst is meant to be an industry expert, with enough financial training to read company accounts and to carry out valuations of companies and other assets. Although their primary job is to identify profitable opportunities in securities trading – shares or bonds that are either very undervalued or very overvalued – it would surely seem to be the case that part of this job would involve the identification of companies that are very overvalued because they are frauds.

Well, sometimes it works. A set of fraudulent accounts will often generate “tells”. In particular, fraudsters in a hurry, or with limited ability to browbeat the auditors, will not be able to fake the balance sheet to match the way they have faked the profits. Inflated sales might show up as having been carried out without need for inventories, and without any trace of the cash they should have generated. Analysts are also often good at spotting practices such as “channel stuffing”, when a company (usually one with a highly motivated and target-oriented sales force) sells a lot of product to wholesalers and intermediaries towards the end of the quarter, booking sales and moving inventory off its books. This makes growth look good in the short term, at the expense of future sales.

Often, an honest auditor who has buckled under pressure will include a cryptic-looking passage of legalese, buried in the notes to the accounts, explaining what accounting treatment has been used, and hoping that someone will read it and understand that the significance of this note is that all of the headline numbers are fake. Nearly all of the fraudulent accounting policies adopted by Enron could have been deduced from its public filings if you knew where to look.

More common is the situation that prevailed in the period immediately preceding the global financial crisis.Analysts occasionally noticed that some things didn’t add up, and said so, and one or two of them wrote reports that, if taken seriously, could have been seen as prescient warnings. The problem is that spotting frauds is difficult and, for the majority of investors, not worth expending the effort on. That means it is not worth it for most analysts, either. Frauds are rare. Frauds that can be spotted by careful analysis are even rarer. And frauds that are also large enough to offer serious rewards for betting against them come along roughly once every business cycle, in waves.

Analysts are also subject to very similar pressures to those that cause auditors to compromise their principles. Anyone accusing a company publicly of being a fraud is taking a big risk, and can expect significant retaliation. It is well to remember that frauds generally look like very successful companies, and there are sound accounting reasons for this. It is not just that once you have decided to fiddle the accounts you might as well make them look great rather than mediocre.

If you are extracting cash fraudulently, you usually need to be growing the fake earnings at a higher rate. So people who are correctly identifying frauds can often look like they are jealously attacking success. Frauds also tend to carry out lots of financial transactions and pay large commissions to investment banks, all the while making investors believe they are rich. The psychological barriers against questioning a successful CEO are not quite as powerful as those against questioning the honesty of a doctor or lawyer, but they are substantial.

And finally, most analysts’ opinions are not read. A fraudster does not have to fool everyone; he just needs to fool enough people to get his money.

If you are looking to the financial system to protect investors, you are going to end up being disappointed. But this is inevitable. Investors don’t want to be protected from fraud; they want to invest. Since the invention of stock markets, there has been surprisingly little correlation between the amount of fraud in a market and the return to investors. It’s been credibly estimated that in the Victorian era, one in six companies floated on the London Stock Exchange was a fraud. But people got rich. It’s the Canadian paradox. Although in the short term, you save your money by checking everything out, in the long term, success goes to those who trust.