New York Fed Worried About Gambling in Casablanca, Um, Ethics Problem at Big Banks

This story would be funny if it weren’t so pathetic. Yesterday, the Financial Times reported that the New York Fed woke up out of its usual slumber and realized that the crisis has changed nothing and that banks still are in the business of looting have unaddressed ethics issues.

From the Financial Times:

The Federal Reserve Bank of New York is stepping up pressure on the biggest banks to improve their ethics and culture, after investigations into the alleged rigging of benchmark rates led officials to conclude bankers had not learnt lessons from the financial crisis…

Fed officials were surprised that some of that reported behaviour occurred after the 2008 crisis, leading them to believe bankers had not curbed their poor conduct.

To make sure the biggest banks are paying enough attention to ethics and culture, NY Fed bank evaluations have begun incorporating new questions emphasising such issues. Topics include whether the right performance structure is in place to punish bad behaviour, especially when it comes to compensation.

The NY Fed does not have the authority to write regulations, but it plays a crucial role in the regulatory landscape, overseeing banks in its jurisdiction that include Goldman Sachs, JPMorgan, Citigroup, Barclays and Deutsche Bank. It assesses banks through evaluations, which often do not contain specific criteria but which provide guidance for standards.

NY Fed general counsel Thomas Baxter has also been meeting bank executives to emphasise that when it comes to ethics and culture the tone needs to be set at the top, people familiar with the efforts said. The agency will also hold a workshop on bank ethics and culture in the autumn…

“Banks are taking the Fed’s message very seriously,” a banking industry source said. “We just want to make sure we know what the rules are.”

The steps taken by the NY Fed come after its president, William Dudley, gave a surprisingly scathing speech in November saying tougher capital requirements may not solve the problem of banks’ “apparent lack of respect for law and regulation”.

This is simply ludicrous. How do you get bankers to behave in an ethical manner? You have serious consequences if they don’t, particularly for those in supervisory and executive positions.

The cute notion that the tone is set at the top (or more vividly, the fish rots from the head) is true but meaningless, since everyone knows that no one senior suffered any meaningful punishment for the colossal damage done in the crisis. It was the New York Fed, for instance, that was unwilling to renegotiate pay deals in the AIG Financial Products Group, the unit that booked the credit default swaps that led to the certain failure of the giant insurer had the Fed not rescued it.

As we pointed out, the authorities had the perfect mechanism for punishing bank executives, which was Sarbanes Oxley, passed in the wake of the Enron bankruptcy. It was meant to put an end to the “I’m the CEO and I know nothing” excuse. It requires that the CEO and the CFO personally certify the accuracy of the financial statements and the adequacy of internal controls. For financial firms, that includes risk controls. The fact that major banks and what were then investment banks would have all keeled over save for the munificence of the authorities and ultimately the American taxpayer is prima facie evidence that risk controls were seriously deficient.

It was obvious the banks had an ethics problem as of the end of 2009. The fact that they paid executives and staff record bonuses, greater even than in the previous record level of 2007, rather than tone it down and use more of their gpvernment-gifted profits to boost their capital levels, screamed that there had been no behavior change. The fact that the Fed can profess to be shocked at this juncture reveals either extreme cluelessness or a disingenuous effort to play cop on the beat when this cop regularly plays cards with the crooks.

Since the Fed brought up the “tone at the top,” let’s look at the example set by the highest profile, most lauded banker over recent years, Jamie Dimon. In the London Whale fiasco, JP Morgan disclosed a material weakness in internal controls. That’s the worst level of internal control failure a going conern can report. In JP Morgan’s case it’s more damning since Dimon, as recently as May 10, 2012, Dimon certified that all was well with internal controls as of the end of the first quarter of 2012. JP Morgan has effectively admitted the gross inadequacy of its financial and operational oversight via its plans to spend over $4 billion and add 5,000 people for better compliance and risk control. So what exactly was Dimon doing to earn his keep, besides lobbying in DC?

And the London Whale was simply one in a long string of serious risk control failures at the Morgan bank. As Dave Dayen wrote:

I urge you to read an astonishing new report, which I’ve embedded below, from analyst Josh Rosner of Graham-Fisher and Co. The best way to describe the report, “JPM – Out of Control,” is that it reads like a rap sheet. Notably, Rosner takes mortgage abuses almost entirely out of the equation, and yet still manages to fill a 45-page report with documented case after documented case of serious fraud and abuse, most of which JPM has already admitted to (at least in the sense of reaching a settlement; given out captured regulatory structure the end result is invariably a settlement with the “neither admit nor deny wrongdoing” boilerplate appended). Rosner writes, “we could not find another ‘systemically important’ domestic bank that has recently been subject to as many public, non-mortgage related, regulatory actions or consent orders.”…

It’s hard to summarize all of the documented instances in this report of JPM has been breaking the law, but here’s my best shot. I try to keep up on these matters, and yet some of these I’m learning about for the first time:

Bank Secrecy Act violations;
Money laundering for drug cartels;
Violations of sanction orders against Cuba, Iran, Sudan, and former Liberian strongman Charles Taylor;
Violations related to the Vatican Bank scandal (get on this, Pope Francis!);
Violations of the Commodities Exchange Act;
Failure to segregate customer funds (including one CFTC case where the bank failed to segregate $725 million of its own money from a $9.6 billion account) in the US and UK;
Knowingly executing fictitious trades where the customer, with full knowledge of the bank, was on both sides of the deal;
Various SEC enforcement actions for misrepresentations of CDOs and mortgage-backed securities;
The AG settlement on foreclosure fraud;
The OCC settlement on foreclosure fraud;
Violations of the Servicemembers Civil Relief Act;
Illegal flood insurance commissions;
Fraudulent sale of unregistered securities;
Auto-finance ripoffs;
Illegal increases of overdraft penalties;
Violations of federal ERISA laws as well as those of the state of New York;
Municipal bond market manipulations and acts of bid-rigging, including violations of the Sherman Anti-Trust Act;
Filing of unverified affidavits for credit card debt collections (“as a result of internal control failures that sound eerily similar to the industry’s mortgage servicing failures and foreclosure abuses”);
Energy market manipulation that triggered FERC lawsuits;
“Artificial market making” at Japanese affiliates;
Shifting trading losses on a currency trade to a customer account;
Fraudulent sales of derivatives to the city of Milan, Italy;
Obstruction of justice (including refusing the release of documents in the Bernie Madoff case as well as the case of Peregrine Financial).

And, exhale.

The sheer litany of illegal activities just overwhelms you. And these are only the ones where the company has entered into settlements or been sanctioned; it doesn’t even include ongoing investigations into things like Libor, illegally concealing inclusions of mortgage-backed securities in employer funds (another ERISA violation), the Fail Whale trades, and especially putback suits for mortgages, where a recent ruling by Judge Jed Rakoff has seriously increased exposure. While the risks are still very much alive and will continue to weigh on the firm, ultimately shareholders will pay, certainly not executives as long as the no-prosecutions standard holds.

We’ve argued at length that Dimon may be guilty of criminal violations of Sarbanes Oxley. Yet when called to testify before Congress on the London Whale, Dimon clearly had not bothered to prepare for the session and was often arrogant.

With Dimon the most visible face of the banking industry, and not a peep of a public or apparently much of a private critical word from regulators about his conduct, employees at banks have a very clear message as to what the real game is: deliver profits, no matter how many rules you disregard in the process, and take an aggressive posture with regulators if they happen to catch any transgressions. Tea and cookies talks with banks about fixing their compensation structures is pathetic. The Fed and regulators need to take the lead by being vastly tougher with the CEOs themselves. The Fed had no compunction about compelling the resignation of the three top officers of Salomon Brothers, then the biggest bond trading firm, in 1992, over regulatory abuses. The Bank of England similarly forced the ouster of the chairman, CEO and president of Barclays for mounting a frontal attack on its authority. Could you imagine anything like that out of a US regulator today? Nothing meaningful will change unless the Fed demonstrates that it is willing to remove top executives if the needed changes aren’t forthcoming, and to push for prosecutions when warranted.

Instead, the Fed is acting as if it expects a largely extractive industry to shape up just because it has made them look like a chump. Or perhaps this is all kabuki for Congress and the rubes, so the next time a major scandal breaks out, the Fed can piously claim it did what it could. While that excuse was and remains nonsense, there are enough media amplifiers that the central bankers and other regulators can continue to get away with professional negligence.