Forex scandal exposes difficulty of financial regulation

Forex scandal exposes difficulty of financial regulation

The latest foreign exchange fixing (forex) scandal, which led to a $4.3 billion bank settlement with American, British, and Swiss regulators reinforces the difficulties of effectively regulating the financial markets.

Hooray nice teamwork” read one chat room message between foreign exchange traders who allegedly colluded to manipulate the foreign exchange market. It was “teamwork” like this that led to last week’s settlements between six major banks and American, British, and Swiss regulators, totaling $4.3 billion.

This scandal – and the Libor fixing scandal and London Whale before it – is a jolting reminder that behind all the charts and algorithms in finance, the market is run by bands of individuals carrying the banners of their banks. These markets are far more complicated than a few algebraic equations and statistical relationships – and that is exactly what makes effective regulation of them so difficult.

The idea behind many of the changes in financial regulation since 2008 has taken one of three forms: to raise capital requirements to prevent safeguard banks in crisis situations, to decrease conflicts of interest, or to improve risk management.

Improving risk management is arguably the most difficult idea to effectively move from concept to reality, and the forex rigging scandal is a prime example of why. In this case, the scheme was not a product of managerial direction to the involved traders, but rather a collective of individual traders at several institutions, who allegedly took initiative on their own.

That is at the heart of why risk regulation is difficult: banks are large and complex organisms, with hundreds of thousands of employees across six continents, each with different motives and incentives.

When the U.K.’s Financial Conduct Authority (FCA) or the US’s Securities and Exchange Commission (SEC) implements a new rule or reprimands bad behavior, the goal is to counteract the ‘tragedy of the commons‘ – behavior that in the short run is good for an individual bank but is detrimental to the financial system.

Two questions determine how well the regulators’ actions perform: do the bank’s top decision-makers take to heart the regulation or penalty, and does the impact flow down deeper into the organization?

Perhaps the most illustrative example is JPMorgan’s CEO and Chairman Jamie Dimon. Throughout the financial crisis, he was known as the Wall Street executive with the best grasp of risk management. If any bank were to internalize the threat of regulator rebuke, it would be Dimon’s JPMorgan. But the bank paid $25 billion in fines and settlements with regulators in 2012 and 2013, and now another $1 billion for the forex rigging scandal.

Given Dimon’s reputation, the long list of scandals indicates that either regulators’ rules and punishments are ineffective, the organizations are not feeling the same threat as the executives, or both. Assuming it is anything other than both of these suggests  a lack of understanding of the complexity of today’s global financial markets by regulators.

But addressing these shortcomings is easier said than done. This is where politicians and commentators invoke their ultimate blanket for what needs to be changed: “culture.” In many ways this is a vague, utopian panacea – if banks change their culture, everything will be fine – but in others may be precisely what is needed. Perhaps a better approach would be to take a lesson from economists and focus on two of their favorite concepts: incentives and dynamic equilibria.

For regulators designing regulation and banks creating more robust risk management practices, a pragmatic shift of attention from changing culture to structuring better incentives may spark more populist outrage, but yield a closer alignment of individual and regulatory goals.

The other concept, dynamic equilibria, would be an attempt to overcome two clichés of financial regulation. Regulators are seen to be either still fighting the last battle or fixing a broken dam with just their fingers, at least in several conversations this author has had with industry professionals.

The main criticism is that regulation is compartmentalized and stationary. It moves forward without regard for run-on consequences in a complex system. It would be akin to changing the supply of apples and expecting the price of apples and demand for oranges to remain unchanged.  That is too narrow a view to regulate the entire system.

A steady stream of banking scandals, and subsequent settlements without admission of guilt, almost seems normal after the London Whale, Libor scandal, forex rigging, and however many others. But as much as a no-scandal world is an unreasonable expectation, recognition of incentive structuring and the dynamic nature of markets would help regulators and risk management teams become more effective in preventing future scandals.

Categories: Finance, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.