Thursday, 5 July 2012

Watchdog Capital: Setting a hedge fund bloodhound on the trail of financial crime

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
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.