The Criminality of the Financial Sector

Many supporters of the Occupy movement identify the need for more effective regulation of financial institutions as one of their central demands. At the same time, the response of governments to the myriad abuses and ethical failures of the financial sector has been to call for new regulation or legislation, which in the UK resulted in the Independent Commission on Banking under Sir John Vickers.

However, such re-regulation of the sector would fail to address the accumulating pressures on global markets that lie behind the rising tide of abuse since the 1970s. Also, it ignores a still more fundamental flaw in the existing régime: the weakness of law enforcement. The enactment of new laws or regulations designed to prevent wrongdoing can only help restore the confidence of the public if the public can believe that the authorities will uphold the law with integrity. Sadly the record of the recent past gives little grounds for any such belief.

In the UK, perhaps the most spectacular case of failure to enforce existing laws surrounds the “sub-prime” mortgage boom during much of the last decade, which is the single most important factor behind the catastrophic global insolvency of the banking industry. The massive accumulation of bad debts could hardly have occurred without the systematic resort to mortgage fraud perpetrated by the financial sector.

As in the US, the principal mechanism involved was the provision of mortgages to individuals lacking the capacity to service the debt. To achieve this, mortgage providers routinely incited borrowers to overstate their incomes (often by 100 per cent or more) on application forms – despite knowing this was a criminal offence. The prevalence of this practice was exposed by the BBC Money Programme in 2003, and again in 2004, yet no action was taken by the authorities. It can be argued that not only the prosecuting authorities but the regulators – including both the Financial Services Authority and the Bank of England (led then as now by Governor Mervyn King) – were knowing accessories to criminality.

Official complicity in the violation of existing laws happens all the time, particularly in the US. For example, there was the failure of the Securities and Exchange Commission (the public regulator) to take any action against mega-fraudster Bernard Madoff until after his giant Ponzi scheme went bust in 2008 – even though a whistle-blower repeatedly drew attention to the obvious fraudulence of his business model for years before its collapse. And there was the pressure put on Ken Lewis (CEO of Bank of America) in 2008 by Treasury Secretary Hank Paulson (former CEO of Goldman Sachs) to recommend to BoA shareholders a takeover of Merrill Lynch without disclosing the huge scale of Merrill’s losses – in breach of his fiduciary obligations.

It’s become common practice in the US, when corporations are indicted for malpractice, for courts to allow them to pay a fine without admitting wrongdoing. The result is effectively to give management personal immunity from prosecution. And given that fine payments come out of shareholders’ funds, the only deterrent against taking risks in violation of the law is the possible loss of their jobs.

Such signs of the growing breakdown of the rule of law – supposedly a cornerstone of modern civilisation – are not confined to the financial sector. One of the most extreme examples was the conviction this year of a Pennsylvania federal judge for accepting payments from operators of private correctional facilities (but paid for by the public authorities) in return for sentencing juveniles to periods of judicial detention – and for the most trivial offences, such as insolence to their school teachers.

I believe systemic change must include removing the incentives to greed presently incorporated in company law: pre-eminent among these is the effective obligation on company management to give priority to maximisation of returns to shareholders – who are in turn protected by a blanket right to limited liability. If such a change were to be implemented it would be seen to undermine the whole basis of the capitalist model as it has existed since around 1860.

If the rights of shareholders as owners were to be compromised by a requirement to give equal weight to those of the rest of the community (including employees, consumers and taxpayers) it might well lead many investors to decide against continuing to risk their funds. If this led society to turn away from the dehumanising worship of the golden calf of profit and the compulsive pursuit of perpetual unattainable growth (needed to facilitate the continuous expansion of profits) how many people would now regret such a transformation?

By dissident economist Harry Shutt, author of The Decline of Capitalism, and member of the Economics Working Group. More from Harry at harryshutt.com