Friday, November 28, 2014

Finance’s Crisis of Legitimacy

WASHINGTON, DC – The recent departure of Robert Diamond from Barclays marks a watershed. To be sure, CEOs of major banks have been forced out before. Chuck Prince lost his job at Citigroup over excessive risk-taking in the run-up to the financial crisis of 2008, and, more recently, Oswald Grübel of UBS was pushed out for failing to prevent unauthorized trading to the tune of $2.3 billion.

But Diamond was a banker supposedly at the top of his game. Barclays, it was claimed, had come through the 2008-2009 crisis without benefiting from government support. And, while his bank had been found in violation of various rules recently, including on products sold to consumers and on how it reported interest rates, Diamond had managed to distance himself from the damage.

Press reports indicate that regulators were willing to give Diamond a free pass – right up to the moment when a serious political backlash took hold. Diamond started to fight back, pointing an accusatory finger at the Bank of England. At that point, he had to go.

There are three broader lessons of Diamond’s demise at Barclays.

First, the political backlash was not from backbenchers or uninformed spectators on the margins of the mainstream. Top politicians from all parties in the United Kingdom were united in condemning Barclays’ actions, particularly with regard to its systemic cheating on the reporting of interest rates, exposed in the Libor scandal. (The London Interbank Offered Rate is a key benchmark for borrowing and lending around the world, including for the pricing of derivatives).

Indeed, Chancellor of the Exchequer George Osborne went so far as to say, “Fraud is a crime in ordinary business; why shouldn’t it be so in banking?” His clear implication is that fraud was committed at Barclays – a serious allegation from Britain’s finance minister.

After five years of global financial-sector scandals on a grand scale, patience is wearing thin. As Eduardo Porter of The New York Times put it,

“Bigger markets allow bigger frauds. Bigger companies, with more complex balance sheets, have more places to hide them. And banks, when they get big enough that no government will let them fail, have the biggest incentive of all.”

Second, Diamond apparently thought that he could take on the British establishment. His staff leaked the contents of a conversation he claimed to have had with Paul Tucker, a senior Bank of England official, suggesting that the BoE had told Barclays to report inaccurate interest-rate numbers.

Diamond apparently forgot that the continued existence of any bank with a balance sheet that is large relative to its home economy – and its ability to earn a return for shareholders – depends entirely on maintaining a good relationship with regulators. Barclays has total assets of around $2.5 trillion – roughly the size of the UK’s annual GDP – and is either the fifth- or eighth-largest bank in the world, depending on how one measures balance sheets. Banks at this scale benefit from huge implicit government guarantees; this is what it means to be “too big to fail.”

Diamond apparently believed his own rhetoric – that he and his bank are critical to economic prosperity in the UK. The regulators called his bluff and forced him to resign. Barclays’ stock price rose slightly on the news.

The final lesson is that the big showdowns between democracy and big bankers are still to come – both in the United States and in continental Europe. On the surface, the banks remain powerful, yet their legitimacy continues to crumble.

Jamie Dimon, CEO of JP Morgan Chase, presided this year over reckless risk-taking to the tune of nearly $6 billion (we might call it a “three Grübel” debacle), yet his job apparently remains secure. Dimon even remains on the board of the Federal Reserve Bank of New York, despite the fact that the New York Fed is deeply involved in the investigation not only of JP Morgan Chase’s trading losses, but also of its potential involvement in the broadening Libor scandal.

As Dennis Kelleher, the president of the advocacy group Better Markets, documented in recent congressional testimony, two years after the passage of the Dodd-Frank legislation, the US banking system continues to fight hard – and effectively – to undermine meaningful reform. (Kelleher’s testimony is a must-read assessment, as is his opening statement to the hearing).

But progress is nonetheless being made. Dimon is the public face of megabanks’ resistance to reform; repeated and public egg on this particular face strengthens those who want to rein in these banks’ excessive and irresponsible risk-taking.

Meanwhile, the European situation looks explosive. The European Union’s approach to bank regulation encouraged financial institutions to load up on government debt – supposedly a “risk-free” asset. Now, given the profound sovereign-debt crisis in the eurozone periphery, government defaults threaten to take down the big banks. The European Central Bank has provided a great deal of emergency “liquidity” funding to banks, which they use to buy even more government debt. This holds down interest rates on that debt in the short run, but creates even bigger potential losses in the case of potential default.

Banks and politics are deeply intertwined in all advanced economies. Diamond discovered that, ultimately, politicians trump bankers – at least in the UK.

But what really matters is legitimacy and informed public opinion. Do you really believe the increasingly dubious notion that megabanks, as currently constituted, are good for the rest of the private sector, and thus for economic growth and job creation? Or do you begin to consider more seriously the increasingly mainstream proposition that global megabanks and their leaders have simply become too powerful and dangerous?

Read more from our "The Big Bank Battle" Focal Point.

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    1. CommentedMichael Cohen

      Big banks are taking an increasing percentage of total corporate profits. What benefit have the given to society in return? Essentially none.

      Their increased profits come from a proliferation of complex derivatives that do little to improve real GDP, but do a great deal to cloud values, promote fraud, and increase bank profits.

      "Too big to fail" and "too big to prosecute" must be ended or we will have another meltdown sooner rather than later.

    2. CommentedBen Leet

      Financial corporate profits reached 41% of all corporate profits in 2007 in the U.S. In 1964 they were 2% of all corporate profits. (According to Wm Tabb in Restructuring Capitalism in Our Time, page 14) Tabb analyzes the problem in these sentences:
      "Financial returns exceeding the rate of profit in the real economy can be realized over an extended period only if finance increases efficiency so that discounted future earnings increase. If, as is more often the case, profits are achieved by short-term expedients: squeezing wages, [squeezing] the prices received by suppliers, [squeezing] research and development expenditures, and the sale of company assets, the rate of economic growth outside of finance slows. In a basic sense these sources of financial profits come as an appropriation from the rest of the economy." It's a transfer of wealth that leaves the entire society less well off. Charles St. Pierre has it right. My blog

    3. CommentedCharles St Pierre

      Libor, Laundering drug money, Laundering Iranian money, Liar loans, Securitization (CDO's) based on those liar loans, UBS eg and tax evasion, Robo-signing, Interest rate swaps with municipalities.

      As for government being co-opted: Gutting regulations and regulatory agencies like the SEC and IRS. Slaps on the wrist for major crimes, and even then not against the people involved, but only the institutions. 'Incompetent' prosecutions of individuals. Allowing statutes of limitations to lapse. Allowing TBTF institutions to continue. Elected officials taking big campaign money from bankers.

      Then there is the revolving door between regulators and the institutions they regulate.

    4. CommentedMark Pitts

      Mr. Johnson continues his angry vendetta against American banks. But does he even do his homework?

      He refers to JP Moargan's $6Billion loss as "reckless risk-taking."

      But does he know that figure constitutes only about 1/3 of 1% of JP Morgan assets?

      Does he know the loss cost taxpayers $0 ?

      Does he know such swings in value are common in most large businesses, not just banks?

      Please, Professor Johnson, at least pretend to be objective.

        CommentedHoang-Anh Ho

        Yes, professor Johnson is too hostile against American banks.

        He should restrain his criticism of the institutional flaws in the financial system until the loss is really bigger and taxpayers actually pay the price.

        Let the disease kills, then take the bill, and forget about the vaccine!

    5. CommentedCharles St Pierre

      Finance's crisis of legitimacy can only worsen. To big to fail means to big to legitimately succeed. Bankers must use fraud, duplicity, and theft to maintain the bottom lines of institutions which are simply too big to function in a socially useful way. They must act in ways which are economically and socially destructive. No longer do they perform their proper task of the useful allocation of society’s resources, but instead suck those resources into the maw of their own consumption.


      Their co-opting of governments is a necessity of these institutions' survival. Thus they compromise the legitimacy of any government which helps to sustain them. That government becomes instrumental to the harm the financial sector inflicts on its citizens.

        CommentedCharles St Pierre

        Here's one particular: Just yesterday, Morgan Stanley agreed to pay the govt $4.8 mil, on a deal they made $21 mil. Demonstrates all my points. Total penalties were $16.8 mil, on a deal that price fixed electric rates and cost the public $300 mil. See above comment for things you can Google.

        CommentedMark Pitts

        J'accuse, j'accuse, j'accuse. Please, provide proof for your accusations.

        If you are correct, crimes have been committed that are not being prosecuted, which means the Attorney General's office is part of the criminal conspiracy.

    6. CommentedPaul A. Myers

      Quite possibly during the US presidential campaign, the Obama campaign will re-position Mitt Romney as the face of Big Finance and Big Banks. This is the logical place to go after tax returns and offshore accounts.

      An attack campaign against Big Bank Privilege could be highly effective since almost no voting block in the US likes big banks. Any Obama appeal based on "responsible bank regulation" should have broad appeal.

      Internationally, top-tier political leaders are quite willing to through bankers under the bus because they understand they are one election away from being retired by the voters. And voters don't like bankers. There is a democratic simplicity to this.

      And I suspect top political leaders are more than a little disgusted with having to bail these guys out with trillions in monetary expansion.

        CommentedMark Pitts

        No doubt you know that the gov't actually made money on the bank bailout. The biggest cost to taxpayers, by far, will be Freddie and Fannie. And these were regualted directly by congress. So, it looks like regulation by the politicians is what is really expensive for the taxpayers.

        CommentedBrian Holmes

        In their book on the subject, entitled 13 Bankers, Johnson and Kwak recall Obama's early meeting with the major bank CEOs. "My administration is the only thing between you and the pitchforks," he said. And more revealingly, he added: "Help me help you."

        Obama can excoriate Romney in the campaign, but that doesn't make him FDR. There is no proof he will stand against the banksters.