ETHICS AND INCENTIVESIn the Financial Industry

UdoPhilipp– December2017 www.udo-philipp.de

Loss of confidence

Sudden Stop

392 BN EUROSJust in Germany

Therealissue:persistingoutputgap

source:FederalReserveNov2014PotentialOutputandRecessions:arewefoolingourselvesCf alsoReinhard andRogoff,Thistimeisdifferent

34.019 PAGESof regulation since 2010

Will they fall?

PRIVATE EQUITY?

GREED IS GOOD

Banks have changed fundamentally

0%

10%

20%

30%

40%

50%

60%

70%

80%

Loans as percentage of totalbalance sheet atDeutschenBank

Quelle:DeutscheBank,Geschäftsberichte1989-2013.EigeneDarstellung.

CAGR1987-2007:loans 3,6%=x2Balancesheet 14,4%=x15

assets- trading book- derivates

liabilities- wholesale financing- Repos

AlsoGoldmanSachsgot only 10%of income from IPOs

Banks: extremely levered hedgefonds

Quelle:DeutscheBank,Geschäftsberichte2012.EigeneDarstellung.

HypoRealEstate in2007had capitalof only

0,08%Quelle:UdoPhilipp,Untersuchungsaussschuss HypoRealEstate,Juli2015,S.4http://udo-philipp.de/wp-content/uploads/2016/08/HypoRealEstate.pdf

Cfalso:Anat Admati undMartinHellwig,Bankersnew clothes

Regulatory capital requirement

Explodingfinance

Cf.recentbooks:JohnKay,OtherPeople’sMoney– Mastersoftheuniverseorservantsofthepeople?AdairTurner,BetweenDebtandtheDevil– Money,creditandfixingGlobalFinanceMartinWolf,TheShiftsandtheShocks– Whatwe’velearnedandhavestilltolearnfromthefinancialcrisis

Explodingcompensation

source:Philippon&Reshef (2009),WagesandHumanCapitalintheU.S.FinancialIndustry,1909-2006

Scandals• Libor• Ratefixing• Liborisbenchmarkrateforalmostallcreditcontracts• Majorbankshadtopaybillionsoffines

• Foreignexchangefixing• Tradersriggedfx markettomakeprofit• Bankspaidbillionsinfines

• LondonWhale• 6.2bn USDtradinglossforJPMorgan

Scandals2• Mis-sellingofpaymentprotectioninsurance

• Mis-sellinginterestrateswaps

• Mis-sellingcreditcardtheftinsurance

• Mis-sellingofmortgage-backedsecurities

• Mis-sellingofmunicipalbondinvestmentstrategies

• Mis-sellingofstructureddepositinvestments

• Mis-sellingofforeignexchangeproducts

• Fraudrelatedtothepackagingandsellingofmortgage-backedsecuritiesthatinstitutionsknewtobe“toxicwaste”

• Misleadingstatementstoinvestorsinvolvingcapital-raisingrightsissue

• Misleadinginvestorsinthesaleofcollateralised debtobligations

• Abusivesmallbusinesslendingpractices

• Predatorymortgagepractices

• Abusiveorininappropriateforeclosurepractices(WellsFargoamongothers:

• Abusiveimpositionofunwarrantedfeesandcharges

• Conductingfalseappraisalsandchargingcustomersforthem

• Aidingandabettingtaxevasion

• Aidingandabettingmoneylaunderingforviolentdrugcartels

• Violationsofrogue-regimesanctions

• ManipulationofLibor

• ManipulationofEuribor

• ManipulationofFXmarkets

• Manipulationofgoldfixing(London)

• Manipulationofcommoditymarketsviametalswarehousingpractices

• Manipulationofelectricitymarkets(California)

• Manipulationoftheswapsmarketbenchmarkindex(Isdafix)

• CollusionrelatingtocreditdefaultswapmarketdealinginviolationofUSanti-trustlaws(“settlement”reachedwithauthoritiestoresolveallegations)

• FilingfalsestatementswiththeSEC(LondonWhale)

• Keepingfalsebooksandrecords(LondonWhale)

•

Source:BETTERMARKETS:https://www.bettermarkets.com/sites/default/files/Speech%20Berlin%20Financial%20Stability%20Conf%20Nov%202016.pdf

Scandals3• ReportingfailuresrelatingtoMadoff

• WithholdingofcriticalinformationfromItalianregulators

• BribingcivilserviceemployeesinJapan

• Mis-reportingrelatedtoBarclaysemergencycapitalraising

• Stealingconfidentialregulatoryinformationbyabanker

• CollusionwithGreekauthoritiestomisleadEUpolicymakersonmeetingEurocriteria

• FinancialengineeringwiththeaimofmovingItaliandebtoff-balancesheet

• ManipulationofriskmodelswiththeaimofminimizingreportedRiskWeightedAssets/capitalrequirements

• ElectronicFXtradingrelatedmarketmanipulation

• Processandcontrolfailureswithrespecttodealingswiththeultra-wealthy/“politicallyexposedpersons”.(ElephantDeal- Barclays11/’15)

• FailuretopreventbriberyofAfricanofficials(StandardChartered)

• Peddlingcomplextaxavoidancestrategiestocorporateclients(Deutsche)

• ImproperlyprovidinginformationaboutaJapanesecompanytoitsclients(Deutsche)

• Abusesrelatingtodarkpooltradingplatforms(Barclays)

• Failuretodiscloseconflictofintereststowealthmanagementclients(JPM)

• Misleadinginvestorswithwrong/incompleteinformation(JPMLondonWhalelosses)

• Conspiracytocommitmulti-milliondollarsecuritiesfraud(RBS:

• OverchargingcustomersforFXtransactions(Barclays:Times/Oct30,2015)

• Failuretomeetthetermsofthe2013Mortgageforeclosureabusessettlement(JPM)

• Repeatedviolationoffederallawsconnectedwithsourcingsecuritiesforclientshorting(GS

• ManipulationofKoreanstockmarket

• Unfairlyjumpingthecreditorqueuetosecure(confiscate?)collateralrelatingtoLehman

• Publishingresearchandtradinginthesharesofacompanyitwasadvising(GoldmanSachs)

• Othermortgagerelatedabusesincluding:failingtoaccuratelytrackpaymentsbyborrowers;chargingunauthorised fees;andprovidingfalseandmisleadinginformationinresponsetocomplaintsbycustomers.(HSBC)

• Useofminorityownednonconsolidatedsubsidiariestoarbitragecapitalrequirements

• Investmentbankanalystsalteringstockresearchrecommendationstocurryfavour withcompaniestheywereresearching.(DeutscheBank/Feb17)

• Useofillegaloffshoreschemestoavoidpayingincometaxonbonuses(Deutsche/UBS)

• ExFederalReserveemployeeworkingatGoldmanconspiredwithformerCentralBankcolleaguetoleakconfidentialinformation

Scandals4• Overchargingcustodyclientsthroughtheuseofundisclosedorsecretmark-upsonforeignexchangetransactionsincontradictionofitspromisetoclientsof“bestexecutionrates.”[StateStreetsettlesallegationsfor$530mio.– July28]

• Mis-sellingofloanstosmallbusinesscustomersundertheUK’sEnterpriseFinancescheme[RBS]

• Offerstoprocureprostitutestocurryfavour withSWFclients[GS/LibyanSWF]

• “Manufacturedeuros7.2billioneurosofdepositsbyshamtransactionstoinflatereporteddepositbaseduringthecrisis[Ireland]

• Predatorypracticesconnectedwiththeissuanceofbankingdebitcards

• SupervisoryfailuresconnectedwithChicagoMercantilerelatedexchangeandclearingfeeprocessingwhichinturninvolvedoverchargingofcustomers[MerrillLynchandBarclaysCapitalUS/CFTCfines]

• Falsifyingaccounts(manipulatingmark-to-marketpricingofderivativespositions)toreducereportedunrealised losses[Deutsche]

• Dismissalofwhistle-blowerwhocomplainedabouttheabove[Deutsche]

• Creationoffakeclientaccountsandmakingunauthorised transferstoachievebonusdrivensalestargets- involvingsome2millionclientsandnolessthan5000employeeoffendersoversome5years(WellsFargo)

• MisleadinginvestorsviamisclassificationofprivateclientassetaccountswithaviewtoinflatereportedNetNewAssetsforthebank.Andcurrentlyunderinvestigation...

• Manipulationofpreciousmetalsmarkets(gold/silver/platinum/palladium- Switzerland)

• Manipulation/collusionoftheUSTreasuryMarketauction/clientsales

• Manipulationofenergymarkets

• Shortchangingclientsasecondtimeinnotpayingsettlementsinfull

• Violationsconnectedwithemergencyfundraisings

• Falsifyingcustomerdataandrecords

• MisleadingshareholdersaheadofRBSrightsissue

• MisleadingshareholderinformationwithrespecttoLloydstakeoverofHBOs

• Conspiracytoforcesmallbusinessesintobankruptcytothebenefitofthelender

• InsertionofillegalratefloorsinSpanishmortgagelending

• Fakingcustomerfilestojustifypredatoryforeclosurepractices

• Misleadingprofitandcapitalstatementsbasedonquestionableaccountingpractices

• Bribing(“Improperpayments”)officialsinconnectionwithlicenseapplicationsinSaudiArabia

• Hiringsonsanddaughtersofseniorofficialsinreturnforfavours

• Fabricatingcomplaintlettersafterthefacttojustifydismissalofawhistle-blowerwhoraisedalarmsoverpossiblemis-sellingofmutualfunds.

• “Mis-informing”(lying)to4500peopleoverexistenceofdormantaccounts

• Useof“mirrortrades”($10billionsworth)tocircumventRussianrelatedsanctions(Deutsche)

• Overchargingcustomerswhoarepastdueontheircreditcards(HSBC:14Dec/Times)

Scandals5• MarketriggingofGilttrading(Lloyds/CS)

• HidingfailedLoansinitscommercialrealestateportfolioin2009.2010atatimeofissuingnewstocktorepaygovernmentbail-outmoney.WilmingtonTrust,Delaware.

• NontransparentandexcesschargesforFXtransfersbymajorUKbankstosmallbusinessesintheUK:

• Manipulatingshareholdingsarounddividendpaymentdatestotriggerdishonestlyacquiredtaxreimbursements.(DB/Barclays/BNP/GS/UBS)

• ManipulationoftheAustralian“bankbillswaprates”

• Manipulationofthegovernmentsponsoredbondmarket(supranational,sub-sovereignandgovernmentagencydebtor“SSAmarket.”)

• Useofsecret/undisclosedpaymentsofcirca$500mioconnectedwithemergencycapitalfunding.(Barclays)

• Knowinglyacquiring“dirtydebt”(aloanusedaspartofamulti-millionpoundembezzlementscheme)andusingittodemandcompensationfromanAfricangovernment(StandardChartered)

• Conspiracywithborrowertofalsifyworkestimatestotally$400millionoffraudulentaccountsreceivable:(Citibank)

• Facilitatingfraudulentactivitybycustomersviauseofimportadvancepayments(Barclays)

• “Spoofing”intradingofUSgovernmentbonds(Barclays)

• LaunderingtheproceedsofPetrobrasrelatedcorruption(HSBC)

• Mis-sellingof“lobo”loanstoUKLocalCouncils

• FraudandCriminalmismanagementinconnectionwithaccountmanagementfortheformerprimeministerofGeorgia(CreditSuisseGeneva)

• Forcingcustomerstoswitchfromvariable(“tracker”)mortgagesintofixedratemortgages– inafalling/lowrateenvironment.[UlsterBank-RBS]

• Mis-sellingexpensivelifeinsuranceproductstolittleoldladiesinFrance(BarclaysFrance)

• FacilitatingAfricanmoneylaunderingonagrandscale(BarclaysFrance)

• MisleadingLiborsubmissionswiththeaimofboostingconfidenceinthebank’sperceivedcreditworthiness(Citi)

• ConspiringtofacilitateVATevasionthroughmanipulativecarbontradingtransactions(RBS6/2016)

• MisleadinginexperiencedofficialsinnascentLibyanSWFintocomplexandultimatelylossmakingderivativetrades(GoldmanSachs)

• Mishandlingoftheproceedsofsecuritiesofferingsforastateinvestmentfund(GoldmanSachs/1MDB)

• Offeringforuse,falseandmisleadingvaluationopinionsonM&Atransactionstocurryfavour withwealthmanagementclients(GoldmanSachs)

• Abusivepracticesinhandlingmortgagearrears(Lloyds/29July)

• ErrorsandabusesconnectedwithreversemortgagesandrelatedforeclosuresinNYState[NYDFSinvestigationofReversedMortgageSolutionsandChampionMortgage]

• ManipulationofAustralianBankBillSwapRate– BBSW.[Lloyds/RBS/HSBC/JPM/MS/UBS/DB/others]

• Forgingclientsignaturestocreateunwantedcreditcardaccountandthenharassingtheindividualfornonpaymentofchargesrelatingtoacardneverappliedfor(WellsFargo)

• Dismissingemployeeswhofailedtomaketheirsalestargetsthroughfraudulentbehaviour [WellsFargo]

• Forcingdistressedbankingclientstohireaturn-aroundconsultantwhorecommendedexpensivenewlendingfacilitiesandfromwhomthebankerreceivedpersonalkickbacks

• CollusiontofalsifyaccountsofItaly’sthirdlargestbank.

Abacusscandal– agreedfacts

• HedgefundPaulsonaskedGoldmanSachstoassemblesyntheticCDOs(Abacus)withsubprimemortgagesinexchangeforafeeof$15m

• AbacuswasboughtbyGermanIKB

• PaulsonshortedAbacusbybuyingCDS

• Abacuslost$900m,IKBlost$150m

• Paulsonmadeagainof$1bn

Abacus– ethicalissues• Conflictsofinterest• Agencytheory:Servingtheinterestofthebankandoftheclient

• Reputation• Repeattransactions• Incentivestructures:onlymakemoneyifclientmakesmoney

• Servingtwoclientssimultaneously• PaulsonandIKB• TypicalforI-Bankstohave“chinese walls”• Workforsellerandbuyer(arrangefinancing)atsametime• Maybenotatsametimebuthaveoneregularandlargeclientandaone-offsmallclient

• Truthtellingandtransparency• Doesitworkwithunsophisticatedcustomers?

Hugebonuses

• TomHayes(UBS):sofaronlypersonconvictedforLiborrigging• 14yearsprison• <30yearsoldin2008/09• Banksrivalledtohirehim.

• Goldmanoffered3msignonbonus• UBSpaidstaybonusinstead

• ChristianBittar (DeutscheBank)• bonus:84mEurosin2008and63mEurosin2009

Equitybasedcompensationdoesnothelp

• EvidencethatbankswithCEOswhoseincentiveswerebetteralignedperformedworse• Cf.Fahlenbrach andStulz,BankCEOincentivesandthecreditcrisis,JournalofFinancialEconomics,2011

• Topmanagerscouldcashoutevenwithsharebasedpay• Cf.Bebchuk,Cohen,Spamann,Thewagesoffailure:executivecompensationatBearStearnsandLehman2000-2008,YaleJournalonRegulation,2010• Shareholdershadnegativecumulativereturn• Top5executiveslost$800mand$600m• Butcashedout$1.4bnand$1bn,sonetprofitof$600mand$400m

The magic of debtand limited liability

Themagicofleverageandlimitedliability- 1

• Invest100– return150– profit50• Takedebt100– 40interest– profit10• E.g.1equityfinancedand49debtfinanced:expectedvalue1x150+49x10=640

• Risk:50%chanceof150and50%chanceof120• expectedvalue:0.5x150+0.5x120=135

• 135<140soreturnislowerthanwhatyouneedtopaybacktothebank• Innegativescenario:20profitonequitybutlossof20witheachdebtfinancedbet

• 1x120+49x(-20)=- 860• Expectedvalue0.5x640+0.5x(-860)=- 110

• Limitedliability:youcanonlylooseyourequity,somaxloss=100• Ifyouinvest100youhave50%chanceofgettingbackyourmoneyplusprofitand50%chanceoflosingall• .5x640+.5x0=320

• Itisrationaltotake49debtforsuchriskygamble

Themagicofleverageandlimitedliability- 2• Evenextremelyriskybetsmakesensewithleverage

• E.g.invest100,20%chanceofgetting150and80%riskoflosingall:• .2x150+.8x0=30• Theexpectedvalueof30ismuchlowerthanthe100youneedtoinvest.Youwouldneverinvesttomakesuchabigloss

• Butwithdebtyoucanonlyloseyourequity• EV.2x640+.8x0=128• Expectedvalueof128islargerthanthe100investment.Soitmakessensetoinvest

• Typicalbetinfinancialindustry:veryhighlikelihoodoflowreturnandverylowprobabilityofveryhighloss• .999x10+.001x(-100,000)=- 90.01

• Negativeexpectedvalue,nobodywouldinvest• Abankneeds3%ofequity,sothemaxlosswouldnotbe100,000butonly3,000.Theoutcomeispositive,it

makessensetoplaythisgamble• .999x3,010+.001x0 =3,006.99

• Stockoptionsputleverageonleverage• Nopersonalinvestment,onlyupside

Cf.Bebchuk andSpamann,RegulatingBankers’Pay,TheGeorgetownLawJournal,2010

Problemhighlyleveredbanks

• Debtholders donotpreventhighleverage• Depositsinsured• Wholesalefinancing

• Veryshorttermdebt• Repo(fullysecuredfinancing)• TBTFguarantee

• TBTFsubsidies200bnEurosp.a.inEuropeSource: IMF,GlobalFinancialStability Report,April2014

Doesbankingcultureleadtodishonesty?

StudyinJournalNature• 200bankemployeesassignedtotwogroups

• Bankgroup:participantshadtotalkabouttheirbankingjobs

• Controlgroup:talkaboutprivatelife

• Test:participantscouldmakelotofmoneybycheating

• Controlgroup:honestonaverage

• Bankinggroup:significantlylesshonest

• Controlstudywithotherprofessions:nosignificantresults

Source:Cohn,FehrandMarechal,businesscultureanddishonestyinthebankingindustry,Nature,November2014

Recentmeasures

• Bonuscap• 2xbasesalaryhasbeendecided• Betterwouldbe:highcompensationdeferredover10years

• Moreequity• 3%leverageratiobetterthan2%,butstillhomeopathicdose

• Structuralreform(implementedonlyhalfheartedly)• Donotsubsidizetradingwithinsureddeposits• Easiertoresolve• ShrinkeconomicrentsinI-Banking

Re-introduce liability

Reintroduceliability

• Investmentbanksusedtobepartnerships• Fullpersonalliabilityofpartners

• i.e.privatewealthonthehook• GoldmanSachswaspartnershipuntil1999

• Criminalliability• UKParliamentaryCommissiononBankingStandards

• SeniorManagerregime• Executiveresponsibilityofsystemicfailure

• JohnKay“denofthieves”• Criminaloffencetobeinchargeofadenofthievesnotbeathieveyourself

EntrepreneurialriskinPrivateEquityvsshorttermbonusinbanks• CarriedInterestinPE• Substantialprivateinvestment

• Leadstohighpersonaldebts• Highthreshold– minimumreturn

• 8%netafterallcost• Fundcarry:after10-12years

• Investorshavereceivedalltheirmoneybackincludinghighminimumreturn

• Lowbasesalary

• Bonus/Stockoption• Nopersonalrisk

• Nominimumreturn

• Yearlypayout• Investorskeeprisk

• Highbasesalary

Triodos – ethicalbank

• Nobonuses• Overalllimitonpay• Genderbalancing• Clearethicalstandards