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Reasons why

 

Six reasons why … good bankers will always turn bad


Themes: Finance

They want to be good, they promise to be good, but will they be good? Cambridge Judge Business School faculty Professor Raghavendra Rau, Dr Bang Dang Nguyen and Dr Pedro Saffi explore six reasons why, whether it’s retail or investment, PPI or LIBOR, there’s something about banking that is asking for trouble.

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1. Explicit contracts – governing conditions of employment – always trump implicit contracts – the unwritten rules that define virtuous behaviour.

“You can tell a banker that they need to be honest and should put the best interests of the client first, but there’s no way to verify they have done so,” says Professor Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at CJBS. “If a banker mis-sells something to a client he can say ‘I thought that this was a good contract for them, it’s not my fault.’ Any bonus based on quantitative measures will overwhelm all the qualitative things a banker has discretion over.”

2. The stakes for the banker outweigh the stakes for those people who may be affected by their actions.

The LIBOR scandal actually affected thousands of people in the UK – it may have meant some people paid £1,000 more on their mortgage over the year – but for a banker the chance to manipulate those rates could have been worth £1m. As Professor Rau says: “Money talks.”

3. Bankers do not encounter sufficient downside risk if they break the rules, or even the law.

Regulations cannot always adapt to swift innovation in products or strategy driven by fierce competition in financial services. So there are always grey areas that unscrupulous bankers could exploit, and the financial rewards for doing so may be very tempting. As Dr Pedro Saffi, University Lecturer in Finance at CJBS, says:

Given the way compensation packages for bankers work, you get huge bonuses if you win and you don’t lose much when you lose.

Even if someone is caught breaking the rules, it seems that only the most spectacular illegal activities attract severe punishment. Since 2008, there have been a number of high profile examples of bankers who acted in an unscrupulous way and lost their jobs as a result – but they still walked away with a handsome payoff.

4. Corporate culture encourages cheating.

If a banker who has tried to be good sees a less virtuous colleague being rewarded more handsomely, good intentions may be undermined. “The banker will say ‘I was careful, but this other guy wasn’t and look at the bonus he got!'” says Professor Rau. Many bankers have also been working for years in an environment where they feel entitled to receive a bonus at least as large as the bonuses received by their colleagues. They may even feel obliged to demand a big bonus, to avoid looking weak in front of their employers. As Dr Bang Dang Nguyen, University Lecturer in Finance at CJBS, points out: “Because you are benchmarked against your peers and you don’t want to tell the world that you are worse than anyone else, if you’re asking for a small bonus people might think you were weak or stupid – so you demand a big bonus. It’s a peer pressure effect.”

5. Once you start cheating, it is easy to convince yourself you should cheat a little more.

Bad behaviour, even on a very small scale, sets a new moral baseline for your actions in the future. As Professor Rau says:

Nobody sets out to be dishonest, but once you’ve done this slightly bad thing, you’ll do things a little worse next time and you end up on a slippery slope.

6. The way bankers are compensated incentivises ruthless, unscrupulous behaviour.

“Pay is related to performance, so there is an incentive to look for a way to gain extra profit out of any grey area in the regulations,” says Dr Bang Dang Nguyen. Basing a compensation package on future performance of an individual and the share price is only really appropriate for some roles in investment banking, where the individual in question is taking risks with money provided by investors who have a very good understanding of those risks. But at present, investment banks feel obliged to pay extraordinary salaries and bonuses to attract the best talent for a much broader variety of roles. Where the stakes are so high the temptation to cheat will always be there.