A cycle of bribery

A cycle of bribery

28 Oct 2008

Vice Chancellor Professor Paul JohnsonVice Chancellor Professor Paul Johnson
Email: paul.johnson@latrobe.edu.au

The financial crisis should force fundamental changes to the way in which financial institutions charge for their services and remunerate their staff.

First published in the Herald Sun on 28 October 2008.

When something goes wrong we all want someone to blame.

If a medical process goes wrong we blame the doctors, if a bridge collapses we blame the engineers, and we then go to court for compensation or revenge.

But when the problem is so huge that no individual or group can be held responsible, we tend to simply blame the government.

It's that way with the drought. So it is with the financial crisis.

First we look for a scapegoat — someone like former US Reserve head Alan Greenspan.

After all, it was his job to prevent the "once–in–a–century credit tsunami" that has left him in "shocked disbelief."

While we thought that he, and other finance chiefs, were actively protecting our interests, he was sitting back and letting "the self–interest of lending institutions protect shareholder equity."

Fine in theory, but it didn't work.

So now we look to government to take revenge on our behalf.

And we are disappointed.

Instead of finding and punishing the culprits, governments in Australia and worldwide seem to be cosying up to them, providing billions of dollars to prop up the very institutions that caused the crisis in the first place.

But before we get too angry about that, hold on. We should remember that we have all played a role.

We watched our super funds produce double–digit growth, and worked out how soon we could retire.

We all believed that the good times would just roll on and on.

Maybe we've all been suckers — the mum and dad savers as much as the Wall Street bankers.

If so, we are in good company.

The history of financial crises (and they come round every decade or so, though this one is the biggest ever) shows they follow the same pattern.

An investment "bubble' drives up prices, and making money seems so easy that everyone tries to join the bandwagon. The market reaches giddy heights, then confidence wavers, and suddenly prices slump.

With the wisdom of hindsight, everyone says that the collapse was inevitable, and that government should stop it happening again.

So the politicians draw up some new regulations, the markets recover (as they will in a few years), the financial institutions develop products that get round the new regulations, investors forget the lessons of the past, and the next investment bubble begins.

Is there any way of stopping this cycle of boom and bust?

Greenspan, previously a high priest of deregulation, is now arguing for a web of technical rules to govern complex financial instruments such as credit default swaps.

But what is really needed is not a minor technical fix but a much broader look at the way people get paid in financial markets.

The driving force behind financial institutions is commission — if the deal isn't closed, the fees aren't paid.

Whether the deal is in the customer's best interest doesn't much matter to the salesperson, who wants it signed off so they can take their cut.

The sub–prime mortgage market in the US was driven by mortgage agents signing up as many borrowers as possible, regardless of their ability to repay the loan.

Similar problems exist with the credit rating agencies such as Moody's.

They earn fees from selling services to the very institutions they are supposed to be assessing.

Their objectivity is put to the test.

The agencies' staff sometimes knew they were rating "a house of cards".

The US Securities and Exchange Commission uncovered a ratings agency email in which one employee lamented an investment "could be structured by cows and we would rate it".

These conflicts of interest are nothing new.

As long ago as 1826, Charles Babbage (who designed the world's first computer) argued that the payment of commissions (he called them "bribes") to financial agents would inevitably lead to the mis–selling of investments.

He's been proved right time and time again.

So when the shock waves have died down, politicians and regulators should draw at least one lesson from history.

They should force fundamental changes to the way in which financial institutions charge for their services and remunerate their staff.

Professor Paul Johnson is an economic historian and the Vice–Chancellor of La Trobe University.

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