The ease with which the
Libor scandal has brought down the towering figure of Bob Diamond, master of the universe and investment banker extraordinaire, is truly momentous. It reveals how small cracks in corporate structures can turn into gaping chasms that engulf whole management teams. For those that haven’t been following the scandal, the gist of it is that traders have been caught submitting inaccurate figures to manipulate the
Libor rate – an index which tries to reflect the average rate that banks can borrow on the 'interbank market' (aka. from each other) – for various dubious schemes.
Libor relies on banks submitting honest figures to the
British Bankers Association (BBA), the organisation that calculates the index. Interestingly enough, I was at a
debate a few weeks ago on the topic of financial sector corruption, which pitted investigative journalists
Ian Fraser
and
Nick Kochan against a representative of the British Bankers
Association. Kochan and Fraser argued that London was a hotbed for corruption
and dirty money. The BBA representative didn't agree, arguing that greed and corruption
ends in the City, rather than starting in it. Needless to say, the conversation
probably would have been somewhat awkward for him if it had been scheduled for
this week instead.
Ian Fraser’s analysis at the
debate was hard-hitting. He argued that the concept of genuine stewardship in
finance had completely broken down, with people entering it as a glorified
get-rich-quick scheme. He argued that big intermediaries (banks) are riddled with
conflicts of interest, that they often act at the expense of their clients, and
that the
‘Big Four’
accountants are complicit in this process. The regulators are under
pressure to prioritise City competitiveness over public interest, and prefer to
make scapegoats out of juniors than target senior executives. Even financial
journalists are ambivalent about exposing scandals, in fear of losing favour in
the courts of precious financial information. Fraser labeled it a ‘dictatorship
of finance’, and suggested an independent enquiry was needed in order to regain
trust.
Time for a true activist hedge fund
In the wake of the Libor scandal
it appears the government might indeed hold
some type of enquiry, but I’m
skeptical of how deep it will go. If regulators, auditors and even journalists
have limited will to uncover fraud, perhaps we need some new approaches. I
noticed the other day that Barclay’s share price plummeted over 15% on the news
of the Libor scandal. That’s a pretty big drop. If someone had
shorted (bet
against) Barclays shares, they would have done well. It’s naturally occurred to me
then, that perhaps one solution is to set up a
hedge fund, trained to sniff out
financial fraud, expose it, profit from the resultant scandal, and then steer the money back into
further financial activism.
The Investment thesis Part 1: The public scandals are
just the tip of the iceberg
The Libor scandal offers fresh
insights into financial skulduggery, but it’s always hard to tell whether
these instances of financial crime, market manipulation and corruption are
once-off anomalies or endemic, widespread problems. For one thing, financial
crime is often incredibly difficult to detect, and very hard to prove. The occasional
scandals tend to be the most sensational cases, but most corruption probably
isn’t overt and outrageous. It could be subtle and even subconscious. Earlier
this week The Telegraph published the
statement of an insider who claims to
have known about the Libor rigging. It echoes some of the points I made in a
previous post about the
problems whistleblowers face: In an environment where
dubious behaviour gets normalised by an overall culture of acquiescence, it’s
easy to go along with it. Collective inaction can be as strong a form of
corruption as the individual actions they quietly ignore.
I personally tend to think that
the cases of corruption we see are just the tip of the iceberg. My basic theory
comes partly from an academic paper I wrote back in 2007, entitled
Free market crimogenesis, corporate
governance and international development. In it, I suggested that free
market systems tend to encourage short-termism, and that encouraged structures
and value sets which are ‘
criminogenic’, a fancy way of saying ‘crime-promoting’
or ‘crime-facilitating’.
The first part of my argument is that there are criminogenic
structures within financial organisations. I’m not in the camp that says that
rampant greed is the only underlying value in finance, and I strongly believe that
people within the sector are motivated by a wide range of factors (as will be
discussed in a later post). I would argue though, that financial professionals are
often working within structures which can amplify those parts of human
behaviour we call ‘greed’. Bonuses are often cited for the damaging incentive
effects they can have, promoting ‘get-rich-quick’ expectations, but there are
many structures within finance that have criminogenic potential. For example,
take job promotion systems in which
upward mobility is based on the ability to hit short-term targets. This, over
time at least, could (statistically) favour those who are prepared to be
'morally flexible', those who are most prepared (and skilled enough) to bend
the rules to meet targets, and those who are prepared to cover up misdemeanors
of juniors under them. If middle and higher management gets populated by individuals
who view such ‘flexible’ and ‘creative’ behaviour as comparatively normal, the
implications for corporate culture lower down the ranks are severe.
The second part of the argument though, is that there is a lack of
policing mechanisms to counteract or de-emphasise the short-term greed-enhancing
factors in the system. Many systems in the world have crimogenic potential, but
that is often dampened and contained through
formal policing (e.g. official regulation and legal systems), and
informal policing via systems of social
disapproval and
shunning
for bad behaviour. Both of these appear to be somewhat deficient in the financial
sector though. Regulators appear muzzled by a serious lack of political will to
prosecute financial crime, which means fear of prosecution is limited. As for
informal policing, many argue that the culture of finance actively encourages
dubious ‘
Gordon Gekko’
style behavior. Even if you (like myself) disagree with that stereotype, it’s
hard to argue that the internal culture of banks would excel at preventing bad
behaviour.
Investment thesis 2: The rest of the iceberg can be successfully uncovered,
and exploited
I strongly suspect there is a treasure trove of financial frauds waiting to be discovered. Sniffing out
when and where they will be exposed, quickening that process, and then betting
on the downfall of exposed companies could be a great investment philosophy,
not to mention societally useful. The term ‘activist hedge fund’ is used to
describe any fund that challenges company management, but this would be a truly
activist hedge fund, steering the profits made in exposing negative behaviour
back into financial campaigns.
It wouldn’t be easy though. We’d need a unique combination of skills, a motley crack team of radical crime-fighters. For example, we’d have to hire:
- Ex-FSA & SEC employees, skilled at the ins and outs of regulation and the loopholes
- Ex-traders (and especially rogue traders), skilled at understanding the operations of various financial professionals
- Criminologists, with deep understanding of criminal structures and how they work
- Ex-bank IT staff and back office staff, who know the nuances of bank IT systems
- Activists/Campaigners, passionate about mobilising networks of people and raising awareness
- Hackers, for occasional… um… unorthodox information retrieval.
- Ex-FBI agents and Mi6 operatives with advanced analysis and infiltration skills
- Forensic audit experts, and big data experts, to spot anomalies among numbers
- DJs: To provide atmospheric background tracks in the office
Days will be spent doing elaborate research of bank structures and strategies. Nights will be spent
trawling City bars in search of leads. We’ll have offices on the edge of the financial district (London & New York initially) with big screens mounted to the walls and satellite surveillance
equipment. Of course, there will be beanbags in the office, and hammocks.
Now that I come to think of it,
such a fund would have obvious crossover with my
Financial Wikileaks concept – perhaps the professionals at the fund
could be the ones processing leaks that get steered to the site…
Watchdog Capital: Bloodhound Fund No.1
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| FEED ME BABY |
All the details can get
straightened out later. Most importantly though, the hedge fund would need a punchy name. Any ideas? There are certain
conventions to naming hedge funds and even a
hedge-fund name generator. I’m thinking of
Watchdog Capital, hunting down financial scandals since 2012. Our first fund could
be called The Bloodhound Fund 1, and it will raise money from a variety of
angel investors and charitable foundations. If you’re interested in joining the
team, send your CVs.
