Controlling Capital

Public and Private Regulation of Financial Markets

Nicholas Dorn

• Publisher: Routledge
• Year: 2016
• eBook ISBN: 9781317374015
• Edition: 1
• Topic: Economics
• Subtopic: Finance
• Index: Economics

Controlling Capital examines three pressing issues in financial market regulation: the contested status of public regulation, the emergence of 'culture' as a proposed modality of market governance, and the renewed ascendancy of private regulation.

In the years immediately following the outbreak of crisis in financial markets, public regulation seemed almost to be attaining a position of command – the robustness and durability of which is explored here in respect of market conduct, European Union capital markets union, and US and EU competition policies. Subsequently there has been a softening of command and a return to public-private co-regulation, positioned within a narrative on culture. The potential and limits of culture as a regulatory resource are unpacked here in respect of occupational and organisational aspects, stakeholder connivance and wider political embeddedness. Lastly the book looks from both appreciative and critical perspectives at private regulation, through financial market associations, arbitration of disputes and, most controversially, market 'policing' by hedge funds.

Bringing together a distinguished group of international experts, this book will be a key text for all those concerned with issues arising at the intersection of financial markets, law, culture and governance.

Part I Command regulation: revitalised or mythological?

1 On culture, ethics and the extending perimeter of financial regulation

Justin O'Brien

DOI: 10.4324/9781315672724-2

Introduction

Every June the financial denizens of the City of London gather at the Mansion House to receive a statement of intention from the Chancellor of the Exchequer. For the sixth consecutive time, the Chancellor George Osborne returned in 2015. Electorally triumphant, the governing Conservative Party nonetheless faces a multiplicity of tactical and strategic questions on the future of capital market governance. These focus less on technicalities but the more complex, contested and perennial issue of the role and function of finance in society (O'Brien 2014). No longer dependent on the Liberal Democrats, who had done much to anchor finance more securely to a renewed social contract, the chancellor, together with his party, wants to use the power of the City of London to drive an innovation agenda. Both he and it remain cognisant, however, that any lessening of regulatory oversight without evidence of meaningful change, risks breaking already fragile bonds of trust.

The increasingly shrill debate on the role of the City in British society is made manifest, for example, by the machinations over the future domicile of HSBC (Donnellan 2015a). The bank remains mired in scandal. It is reviewing not only its federated structure, which it accepts is no longer fit for purpose, but also whether to abandon the United Kingdom (UK), in part because of increased regulatory costs and in part because of the uncertainty associated with a promised referendum on European Union membership. It is a fear shared by many in the City. A British exit would have profound implications for the dominance of the City in European finance (Donnellan 2015b). George Osborne (2015) thus sought to untie the Gordian knot with the release of the ‘Fair and Effective Markets Review’ (FEMR) (HM Treasures and Others 2014).

As a reformulation of a ‘social contract’, it is designed to reposition the City as a global marketplace informed by the institutionalisation and internalisation of restraint. It is both a laudable and long-standing goal (Kennedy 1934). The unresolved question is whether it will work or whether it is simply an exercise in political symbolism, designed to mask rather than comprehensively deal with deeply embedded structural problems.

Announced the previous year at the Mansion House (Osborne 2014), the final findings of the FEMR offer, if implemented in full and, crucially, if its underpinning normative purpose is accepted by industry, an opportunity to shift a deeply corrosive narrative. There are, to be sure, reasons for scepticism. For a country that has had more intensive examination than most of the causes and consequences of malfeasance and misfeasance in the capital markets, the decision to constitute the FEMR was in itself, on one level, perplexing.

The UK had already diagnosed incompetence and hubris in the management of major financial services institutions (Financial Services Authority 2011); the limitations associated with short-termism (Kay 2012); the problems of regulatory capture (Treasury Select Committee 2012); and the institutionalisation of malign cultures (Parliamentary Committee on Banking Standards (PCBS) 2013). Why was it necessary to convene yet another inquiry? What would its purpose be? The answer lies in the wave of benchmark scandals that have engulfed the City of London, in the process fracturing belief in the efficacy of market ordering without credible oversight.

These scandals include the corruption of the London Interbank Offered Rate (Libor), a daily calculation of what a panel of banks determines to be the hypothetical cost of borrowing in a range of currencies and timeframes. It is the most important number in finance (Talley and Strimling 2013). To date billions of dollars of fines have been collected, the majority of which have been levied by the United States (US) with an increasing component booked by UK regulators (Financial Services Authority 2013; Financial Conduct Authority 2013, 2014a and 2014b).

The malfeasance uncovered also includes systemic manipulation of the multi-trillion dollar foreign exchange (forex) markets. The most important benchmark in this domain is the WM 4PM Fix, a calculation of paired currency rates administered by a subsidiary of State Street in conjunction with Thomson Reuters. Ever more stringent settlements related to Libor and forex manipulation have induced institutions that operate offshore subsidiary operations to plead guilty to corporate criminal misconduct (Department of Justice 2014; 2013). Individuals also have begun to enter guilty pleas (Binham 2014), as have holding companies (Baer 2015).

In many cases, reductions in financial penalties are brokered in exchange for ongoing cooperation with regulatory and law enforcement agencies. Increasingly, sophisticated investigatory methods are being deployed. Very deliberately, the Department of Justice in the US, for example, has signalled the ongoing deployment of undercover operatives inside financial institutions (Holder 2014). The policy problem is that fine escalation and, as yet, haphazard application of criminal and civil sanctions, have proven insufficient to change conduct in demonstrable, warranted ways.

From the implicated banks’ perspective, the financial penalties have been written off as part of the (albeit increasingly expensive) cost of doing business (the arrival of anti-trust regulators into financial markets, may, however, cause a re-evaluation of that particular cost-benefit analysis: see Baer 2015). Notwithstanding the apparent insouciance of market sentiment, the result of institutionalised collusion has had profound practical and theoretical implications. It undermines, if not decisively then certainly damagingly, vaunted theoretical and practical reliance on the restraining power of market forces. This supposed more effective remedy than direct regulatory intervention has been largely missing-in-action. Understandably, the public remains angry and deeply sceptical.

For a trade-off that withdraws overt and invasive external regulation in favour of agonistic dialogue with the industry over the future trajectory of reform to be acceptable, there needs to be demonstrable change on the part of industry and the incentive to achieve this was precisely what George Osborne offered at the Mansion House in June 2015. Government, he argued, was ready and willing to exit ownership of the woefully-run Royal Bank of Scotland (RBS). Moreover, bank baiting was to end in favour of a dialogue designed to make London the destination of choice for global banking. The ‘ratcheting up ever-larger fines’ was neither sustainable nor, in policy terms, a ‘long-term answer’ (Osborne 2015), the chancellor told a receptive audience. In return, he asked for, indeed demanded, change. In order to effect that change, the Governor of the Bank of England set out the key performance indicators at the same dinner (Carney 2015).

The forced departure of the combative head of the Financial Conduct Authority (FCA), Martin Wheatley, announced later in the northern summer, does little to change this existential battle, notwithstanding orchestrated media claims to the contrary (see Binham and Guthrie 2015). Seeking an accommodation with the City does not necessarily pre-ordain capitulation. Indeed, the political risk of failing to address identified problems in the wholesale market has been magnified by Martin Wheatley's early departure, occasioned, it must be said, as much by pique as by design. From a design perspective the work is completed. The challenge now is implementation.

For banking, it is an exquisite but dangerous moment. As the banking editor of the Financial Times put it: ‘a new era of finance feels within reach’ (Jenkins 2015). The devil, however, will be in the detail. This chapter explores how the combination of regulatory and criminal investigation and a genuine offer of partnership offer a time-limited but potentially transformative opportunity. It assesses the conceptual coherence of attempts, driven by the UK Government, but with significant support from both the Financial Stability Board (FSB) and the International Monetary Fund (IMF), to create ‘fair and effective’ markets informed by the commitment of the sector to the changed demands of ‘inclusive capitalism’ (Carney 2014). The policy innovation leaves it to the market to negotiate the practical parameters and deliver tangible progress in improving market conduct. Crucially, this reframing of regulatory policy transcends narrow economic efficiency. It suggests that violation of the letter or spirit of the new proposed compact could have profound implications (although there is a worrying lack of detail on what sanctions are considered).

The chapter thus evaluates the theoretical justifications and how practical nudging could further advance policy objectives through, for example, enhanced contractual terms in the use of deferred prosecutions. First, it sets out the rationale for importing into finance the logic of responsibility. This derives primarily from the stated but as yet untested commitment of the finance sector to a professionalisation agenda, which is predicated on an obligation by it to uphold an underpinning social contract. Secondly, it evaluates specifically how the fair and effective markets rubric addresses the corruption of market integrity. Thirdly, and relatedly, it highlights the systemic nature of the problem, as evidenced by the admission of wholesale banks that, by default, they allowed cartels to operate with impunity. Fourthly, it excavates the philosophical foundations of the proposed solution. Fifthly, and finally, it notes a deep suspicion of associational governance and suggests that the expansion of the regulatory agenda shows no sign of abating. It concludes that what is on offer is not a return to the freedom to set standards once offered but squandered by the associational governance model but an invitation to verify stated commitment.

The rationale for professionalising finance

The moral failings of the market have been a defining feature of myriad official inquiries into the Global Financial Crisis. The British Parliamentary Commission on Banking Standards (PCBS) has carried out the most detailed evaluation of ethical deficits and whether these could be addressed by systematically importing norms and mores into the finance profession. From the beginning, the Commission identified a major problem. The professionalisation project presupposed that there existed within the capital markets a distinct kind of activity that could be characterised as having the attributes of professional life (e.g. specific tertiary educational requirements that act as a barrier to entry, ongoing continuous professional development, meaningful codes of conduct that are effectively monitored and enforced, effective and demonstrable commitment to the development and enhancement of professional standards and, crucially, mechanisms to suspend or withdraw a professional licence to operate in the event of misconduct). Notwithstanding the stated commitment of the British Banking Association of the need for a professional body with requisite regulatory power, the final report of the Parliamentary Commission demonstrates an acute wariness. Banking, it concludes, ‘is a long way from being an industry where professional duties to customers, and to the integrity of the profession as a whole, trump an individual's own behavourial incentives’ (PCBS vol 2: para 597). This was based on five inter-linked failings. First, the Commission noted a sharp decline in the membership of existing banking associations. Secondly, it questioned these associations’ actual commitment to upholding their stated values, noting that the industry to date had proved unwilling or unable to use existing sanctions (PCBS vol 2: para 586). Thirdly, the lack of ‘a large common core of skills and values inculcated in the course of pre-qualification education or training [means that] banking is not a profession in the same way [as law, medicine and accountancy] and cannot become so by the stroke of a pen’ (PCBS vol 2: para 606). Fourthly, it discounted the credibility of proposed remedial strategies, noting that a ‘set of expected qualifications which forces bank clerks to night school for years to come, but gives a free pass to those working in wholesale banking or at more senior levels – the groups which most conspicuously failed in recent years – would ignore the lessons of the crisis’ (PCBS, vol 2: para 607). Fifthly, and most damningly, it detected in the push for the fast-tracked establishment of a professional standards board an inappropriate attempt to garner regulatory power: ‘On the basis of our assessment of the nature of the banking industry, we believe that the creation of a professional body is a long way off and may take at least a generation’ (PCBS vol 2: para 601).

Notwithstanding these concerns, the Commission did leave open the possibility for the industry to demonstrate commitment to upholding professional values by setting out a series of milestones that could provide evidence of change. These milestones are further developed in the FEMR. They include the need for comprehensive coverage, the integration of wholesale and retail components, and the development of credible sanctions, with applicability across industry. Crucially, progress towards these objectives does not necessarily mean commitment on the part of regulatory or political authorities to a scaling back of the regulatory perimeter. In fact the opposite is the case. In the search for accountable governance, policy remains regulative rather than constitutive and is likely to remain so. There is an invitation to industry to buy in and thereby avail of a seat at the regulatory table. What is most definitely not on offer is a blank cheque or return to unverifiable principles-based regulation. The need for such a sceptical approach has been magnified by the extent to which market integrity has been compromised by the corruption of core financial benchmarks.

Benchmarks and the corruption of integrity

The manipulation of financial benchmarks can be unpacked at three distinct levels. Each provides deleterious feedback loops to the others. First, at the level of the firm, the capacity to monitor conduct was and remains low. The extraordinary testimony provided by senior bankers at RBS to the PCBS (2013) is talismanic in this regard. It demonstrated the ...

Table of contents

• Cover Page
• Half-title Page
• Title Page
• Copyright Page
• Table Of Contents
• Notes on contributors
• Introduction: questions asked
• PART I Command regulation: revitalised or mythological?
• PART II Culture: organisations, stakeholders and politics
• PART III Concession: private regulation in the ascendancy
• Index