THE behaviour of the banking sector in the run up to the crash is still very much in the public eye. But this is nothing new. Readers of a certain age may recall Bernie Cornfeld, and his company Investors Overseas Services (IOS). It failed dramatically in the 1970s after allegations of fraud. IOS encouraged the flight of capital from developing countries and tax avoidance in the West. Meanwhile, Cornfeld enjoyed an exceptionally flamboyant lifestyle, had mansions all over the world, threw extravagant parties and lived with a dozen girls at a time – movie stars, supermodels and princesses. The only penalty he suffered was eleven months in a Swiss jail, after which he was acquitted.
It is not only bankers who might find the trade-off between risk and reward attractive. So how do we manage to get them to behave responsibly? Cornfeld was very astute. He remarked “if you want to make money, work directly with money. Don’t horse around making light bulbs.” Clearly, people work in banks because they want to make money. John Maynard Keynes wrote in the 1930s that, if people in the financial sector were not driven by money, the work would be intolerably boring. He went on to say that the markets performed a useful social function. Many people in them exhibit serious pathological tendencies, and the pursuit of money diverts them from violence and crime.
The standard way of discouraging irresponsible activity is by changing the incentive structure. This is what lies behind the recent Parliamentary report recommending jail sentences for reckless bankers. Deterrence is important. But there are two parts to any deterrent: the severity of the penalty itself, and the probability of receiving it.
Andrew Tyrie’s report says that top bankers should not be able to use the defence that they did not know what was going on. But even if the law already permitted jail terms, how would the Co-op Bank debacle be dealt with? It reportedly fell into trouble due to the risky loans of the Britannia Building Society. When the Co-op took Britannia over in 2009, these loans were certified as acceptable by two sets of auditors and the Financial Services Authority. Who would do the porridge?
The motives of Tyrie’s report are perfectly understandable. But the risk is that regulators with job security and gold-plated pensions will simply use the wisdom of hindsight to assign guilt. It is easy for a bureaucrat to say that, if a loan ever goes bad, even years after it has been granted, someone must be to blame. Uncertainty about the future is an inherent part of the human condition.
Incentives do matter. But their real impact comes when they stimulate permanent changes in attitudes and values in the relevant social network. A statement that, for the next five years at least, no one from the City will be given a peerage, knighthood, or even invited to Buckingham Palace garden parties would work wonders. It would send the clearest possible message that the financial services sector needs to clean up its act.
Paul Ormerod is an economist at Volterra Partners, a director of the think-tank Synthesis and author of Positive Linking: How Networks Can Revolutionise the World.