Banks as Bad Guys: How the Banking Industry Went from Respected to Reviled
- Mar 28, 2013
Bankers used to be respected members of the community, and banks were important civic institutions. Those were the good old days, at least for the banks. Nowadays, bankers are considered little more than common criminals. Never in the history of capitalism has there been a decline in reputation as dramatic and precipitous as that of U.S. financial institutions like Goldman Sachs and JP Morgan, and related businesses like the big credit rating agencies like Standard & Poor's and financial regulators like the SEC. In this article, I examine the reasons behind the reputational decline of the banking industry.
The full magnitude of the reputational demise of America's premier financial institutions is evident in a U.S. District Court judge's reaction to a lawsuit filed against Goldman Sachs claiming that Goldman committed fraud against its own shareholders in connection with its failure to disclose that it was allowing Henry Paulson to pick the securities that he planned to short. Goldman's fraud, according to the plaintiff, was that it made false and misleading disclosures to shareholders, claiming to behave ethically when it did not. Specifically, Goldman was charged in the complaint with fraudulently claiming that, among other things "Integrity and honesty are at the heart of our business" and "Our clients' interests always come first."
It should come as no surprise that the Judge's endorsement of this lawsuit did not go unnoticed. The New York Times called this the "lawsuit that haunts Goldman Sachs." This seems right. After all, it is pretty unusual—and disturbing—for a major company to be sued for fraud because it lied when it claimed that it tried not to lie and worked to avoid cheating its customers.
Not so long ago, reputation was essential to the success of financial institutions like Goldman Sachs. Only firms with stellar reputations for integrity could hope to attract customers willing to invest their savings in the financial products offered by banks. The world is starkly different now. The high trust environment that was thought to be critical to the successful operation of capital markets and corporate financing transactions generally no longer exists. Let's explore why.many of the biggest names in the financial industry appear to have lost any interest in cultivating and maintaining their reputations for integrity.
Historically, corporate finance and capital markets relied heavily on the ability of companies and other firms to develop what is known as reputational capital. For companies involved in finance, like credit rating agencies, big corporate law firms, investment banks, stock exchanges and accounting firms, reputation was their most important asset. These firms invested heavily in nurturing their reputations by proving to customers and counter-parties that they could be trusted to put the customer first in markets and in contracting relationships because nurturing and maintaining their organizations' reputation was absolutely critical to their growth and continued success. Today, on Wall Street, company reputation matters far less than it used to matter for three reasons.
- Improvements in information technology have lowered the costs of discovering information about people. This, in turn, has made it worthwhile for individuals involved in the financial markets—lawyers, investment bankers, accountants, analysts, regulators—to focus far more on the development of their own individual reputation rather than on the reputation of the companies for which they work.
- Law and regulation serve as a substitute for reputational capital, at least in the minds of regulators and market participants. In modern times, particularly since the promulgation of modern securities laws, market participants have come to rely far more on the protections of the law, and far less on the comfort provided by reputation, when making investment decisions and in deciding whether or not to deal with a particular counter-party. The current financial crisis, in my view, demonstrates that, in reality, regulation is no substitute for reputation in assuring contractual performance and respect for property rights.
- Finally, the world in general and the world of finance in particular have become so complex that people who design complex financial instruments have simply replaced high-reputation practitioners of "Old School Finance."
One empirical implication is that we should expect firms in the financial services industry to have weak reputations relative to firms in other, less regulated industries. A second empirical implication is that financial firms in countries like the United States, which have systematic and pervasive laws and regulations for the locally domiciled financial services industry, will have weak incentives to invest in developing and maintaining their reputations.
In each of these contexts, my story involves important variations on a single theme. The single theme is the rise and subsequent fall of a simple economic model in which companies and firms in time period 0 find it rational (profitable) to make investments in reputational capital, and then, in time period 1 it turns out that it is no longer rational to do this, so they stop. The investments in human capital that occurred early on required companies and firms to make costly commitments to being honest and trustworthy in order to compete successfully in their businesses. Concomitantly, the later decline in investment in reputational capital by such companies and firms necessarily resulted in a dramatic decline in the amount of honesty and trust in the business sectors in which these companies operate. Corporate downfalls from Enron to Madoff can, in my view, best be explained by the theory of reputational decline that is the core of my book.
The traditional economic model of reputational model can be used as an historical baseline and is very straightforward. Companies and firms find it profitable, and therefore rational, to invest money immediately in developing a reputation for honesty, integrity and probity, because doing so allows the company or firm to charge higher prices, and thus earn superior returns in later periods. The theory is that resources expended to develop a strong reputation enable the firms that have developed such reputations to make credible commitments to clients and counter-parties that they are honest and reliable, and therefore are desirable contracting partners.
The reputational model posits that companies and firms start their corporate lives without any reputations. This lack of reputation is of far more importance and relevance in some businesses than in others. Where the quality of the product or service being offered by a business can be evaluated accurately in a short period of time at zero cost, then reputation matters little. People are willing to buy name-brand wrapped candy or newspapers at any newsstand or kiosk because the proprietor's reputation (or lack thereof) is largely irrelevant to a rational purchaser. A Baby Ruth candy bar or the Wall Street Journal is the same price and the same quality at every newsstand.
In contrast, the industries in which I am interested (investment banking, capital markets, accounting, law, etc.) require enormous amounts of human capital to deliver their products or services. Indeed, in these sectors of the economy, human capital is the only significant asset that participating businesses actually have. The physical capital necessary to conduct such businesses is trivial. In these sorts of businesses, reputation plays a very important role. In such businesses, it takes a substantial amount of time for a customer to observe the quality of the businesses' human capital. In my view, however, analysis of this sort, while historically accurate, is completely out-of-date because it no longer describes today's world. Specifically, while it used to be the case that loss of reputation generally was fatal to accounting firms like Arthur Andersen, law firms like Vinson and Elkins, and credit rating agencies like Moody's (all of which appear to have failed flamboyantly in protecting their reputations in the Enron scandal), I argue here that this is no longer true. While these sorts of firms once depended on their reputations to attract and retain business, such firms no longer depend on maintaining their reputations as a key to survival. Instead, clients generally are required to use the services of particular firms, so reputation is no longer particularly important in customer and client decisions about which firm to deal with. As such, reputation is no longer an asset in which it is rational to invest.
Thus, ironically, it is good news is that investors trust the reputation of the SEC and other financial regulators even less than they trust the reputations of the firms in the industry. The folks at the SEC are too cozy with the businesses they are supposed to regulate, too slow, and too interested in getting themselves on the revolving door to Wall Street riches. A few firms like Morgan Stanley are changing their compensation scheme and bringing in highly trusted individuals in order to reestablish trust with their current and future customers. This sort of strategy is likely to be very successful because everybody in the market is looking hard to find somebody that they can trust.