New Scandals Show the Financial System Needs Repair

The City of London. Credit: Wikipedia

During the Great Depression, angry Americans responded to news about bankers’ shenanigans by demanding that Washington rein in risky behavior. Politicians in Washington responded to those protests by passing tough regulations that fostered stability in America’s financial industry for nearly half a century. The situation is quite different today. Recent investigations show that bankers and traders at major firms violated the public’s trust. Yet this news has not excited much discussion in the media, and legislators in Washington are slow in adopting measures aimed at preventing future abuses.

There is much more talk these days about reducing regulations affecting bankers’ activities rather than expanding them. Critics of regulation often focus on the Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress established after the 2008 financial meltdown. Dodd-Frank aimed to protect investors and the public from another crash and from unfair business practices. Critics complain that Dodd-Frank’s rules (which are still in development) slow business progress because they create too much red tape.

During the 1930s, it was easier for reformers in Congress to arouse public indignation and achieve regulatory reform. The Great Depression packed a mightier economic blow than the recent Great Recession. It seemed obvious to the public in the early 1930s that banking practices had to change. Reformers were in a good position to get their way. Franklin D. Roosevelt and Democratic candidates for the House and Senate swept the 1932 elections. Today’s Democrats have considerably less influence in Washington. Their grip on the Senate slipped after Ted Kennedy died and Republican Scott Brown took his seat in early 2010. The Democrats’ clout weakened further after the GOP recorded huge gains in the 2010 congressional elections.

A report on causes of the recent financial crash appeared in 2011, but it has not had nearly the impact on public opinion of as an investigation conducted by the Pecora Commission during the Great Depression. In 1933, President Franklin D. Roosevelt urged Ferdinand Pecora, a feisty lawyer, to expand a probe of wrongdoing on Wall Street. Pecora’s investigation showed that the great banks were involved in shady enterprises. It revealed that Albert Wiggin of Chase National Bank had been short-selling his own firm and worked out sweetheart business deals with corporations where he served as a board member or director. The Commission’s study discovered, too, that Charles Mitchell’s prestigious company, National City Bank (the nation’s largest bank), had deceptively marketed risky bonds from Latin American countries to gullible customers.

In the 1930s the public demanded action against such abuses. Congress responded by separating commercial banking from investment banking, imposing rules for reporting by financial institutions, and regulating the sale of stocks and bonds. Spokesmen for the financial industries resisted these changes and managed to soften some of the legislation, but, overall the reforms brought financial practices under much tighter control.

A 2011 report of the Financial Crisis Inquiry Commission, led by a Democrat, former California state treasurer Phil Angelides, documented a long train of abuses that contributed to the 2008 meltdown, but that report received little public attention. In 545 pages the Commission showed how dangerous risk-taking by Wall Street firms, improprieties in the mortgage business, and serious ethical lapses by traders left markets vulnerable to a collapse. The report identified lax regulation as the primary cause of troubles. “What else could one expect on a highway where there were neither speed limits nor neatly painted lines?” the Commission asked.

In recent weeks and months new evidence suggests that the Commission’s question is pertinent. Abuses continue in a financial system that practices regulation-lite. Conservatives complain that governmental rules often obstruct business development. Yet it is difficult to imagine a more powerful hit on businesses and the Americans’ personal finances than the disaster we call the Great Recession. Deregulation came at a huge price.

Consider just a few of the most egregious problems that have come to light -- examples of corporate wrongdoing that show problems related to the crash of 2008 have not been corrected.

One of the most astounding news stories related to the manipulation of Libor rates. Several large banks in the U.S. and abroad create these rates by submitting information about the cost of loans they make to each other. Libor numbers are used to determine interest rates on student loans, credit cards, mortgages, and many other financial instruments. The Libor numbers affect $700 trillion in derivatives markets, and they provide evidence of the strength or weakness of banks. Municipalities and pension funds may have lost millions or billions because of rate manipulation.

Leaders at the huge British bank, Barclays, have agreed to pay $450 million to settle a claim that their traders adjusted the benchmark rates to benefit Barclay’s bottom line.

This is a huge scandal, and details about it are just beginning to emerge. Barclay’s officials are cooperating with U.S. and foreign officials. Reports by the Financial Times indicate that traders at several other major banks could be implicated in the schemes. Monkey business associated with Libor rates may have affected interest rates on money paid and received in recent years by most Americans as well as millions of people abroad.

News reports have also raised questions about practices at JP Morgan Chase, the venerable bank led by an impressive “banker’s banker.” JP Morgan’s chief executive, Jamie Dimon, pressed long and hard to win exemptions from the Dodd-Frank rules, including freedom from regulations on derivative trades arranged through foreign branches, subsidiaries or affiliates. Then news appeared showing that risky trades in derivatives handled by JPMorgan’s London office led to gigantic losses. Initial reports listed a $2 billion hit; a few weeks later estimates of the loss had climbed to $5 billion. A contrite Jamie Dimon acknowledged that his company made “egregious mistakes” and had “egg on the face.”

Critics of JPMorgan Chase’s practices were eager to point out that this problem resembled much larger troubles at the American International Group (AIG) in 2008. Casino-like gambling with derivatives by traders at AIG’s London office pushed that firm close to bankruptcy. AIG’s crisis threatened to pull down the international financial system.

Disturbing, too, is a revelation that traders working with MF Global, an old firm involved in the derivatives business, made dangerously risky bets on sovereign debt. When the company approached bankruptcy in 2011, its traders evidently used customers’ money to meet capital requirements. Authorities are presently looking for $1.2 billion in missing customer funds. In recent weeks a related problem emerged at a smaller firm, PFGBest. That company brokered foreign exchange and commodities futures. Its clients learned that $220 million had disappeared from brokerage accounts.

Many other abuses have been reported recently. We have learned that traders at major banks sold clients bundles of mortgages without telling clients that the banks allowed some investors to configure those mortgage instruments would likely lose value (the investors gained by betting against their’ value). A suit is currently under way against two of the major credit rating agencies. It is based on claims that the agencies gave top ratings to collateralized mortgage securities that were obviously risky investments. And just a few weeks ago evidence turned up about efforts by financial advisers at a major bank to steer clients toward the company’s own family of mutual funds (despite the funds’ poor record of returns) rather than recommend investment opportunities offered by other financial institutions that had superior performance records. This news raised questions about practices around the country by financial advisers who are supposed to represent their clients’ interests.

How much dirty laundry needs to appear before the American public demands a major cleaning operation?

In the current political environment, there does not seem to be much interest in Washington to reform these practices. Republicans stand firm as radical tribunes of laissez-faire. They frequently praise unfettered markets and welcome discussions with lobbyists from high finance. Democrats are more supportive of regulation, but they are not full-throated champions. Lots of them receive campaign contributions from banking interests. They do not wish to alienate deep-pocketed interests. Also, some Democrats depend on the generosity of Wall Street titans for their favorite philanthropic causes.

The Pecora Commission’s hearings in 1933 and 1934 made a substantial impact on Washington because the nation was still deep in a depression at the time the Commission uncovered major banking scandals. The situation is quite different today. America’s largest banks are on stronger footing than in 2008. Even though Americans are hurting from the housing slump and substantial unemployment, their economic situation is not as difficult as the one millions of Americans faced in the Great Depression.

Absent a larger financial crash, today’s bankers and traders will likely get a pass. They will need to deal with some restrictions under the Dodd-Frank legislation, but they will still find many opportunities to engage in questionable business practices and avoid public scrutiny. Bankers and traders had to operate in a quite different environment in the 1930s. They were corralled by angry Americans and their action-oriented representatives in Congress. That reaction established a strong foundation for the Great Prosperity of the post-World War II decades.