A bankers’ ethics oath risks being seen as empty posturing

The suggestion put forward yesterday by ResPublica think-tank that we can restore consumer trust and confidence in the financial system, or prevent the next crisis by requiring bankers to swear an oath seems excessively naïve.

Such a pledge trivializes the ethical issues that banks and their employees face in the real world.  It gives a false sense of confidence that implies that an expression of a few lines of moral platitudes will equip bankers to resist the temptations of short-term gain and rent-seeking behavior that are present in the financial services industry.

In fairness to ResPublica’s report on “Virtuous Baking” the bankers’ oath is just one of many otherwise quite reasonable proposals to address the moral decay that seems to be prevalent in some sections of the banking industry.

I don’t for a moment suggest that banking, or any other business for that matter, should not be governed by highest moral and ethical standards.  Indeed, the ResPublica report is written from Aristotelian ‘virtue theory’ perspective that could be applied as a resource for reforming the culture of the banking industry.  ‘Virtue theory’ recognizes that people’s needs are different and virtue in banking would be about meeting the diverse needs of all, not just the needs of the few.

The main contribution of the “Virtuous Banking” report is to bring the concepts of morality and ethical frameworks into public discourse.  Such discourse is laudable but we should be under no illusion that changing the culture of the financial services industry will be a long process. Taking an oath will not change an individual’s moral and ethical worldview or behaviour.  The only way ethical and moral conduct can be reintroduced back into the banking sector is if the people who work in the industry were to hold themselves intrinsically to the highest ethical and moral standards.

Bankers operate within tight regulatory frameworks; the quickest way to drive behavioural change is therefore through regulatory interventions.  However, banking is already the most regulated industry known to man and regulation has not produced any sustainable change in the banks’ conduct.  One of the key problems with prevailing regulatory paradigms is that regulation limits managerial choice to reduce risk in the banking system, rather than focuses on regulating the drivers for managerial decision-making.

Market-based regulations that do not punish excellence but incentivize bankers to seriously think through the risk-return implications of their business decisions, will be good for the financial services industry and the economy as a whole.  A regulatory approach that makes banks and bankers liable for their decisions and actions through mechanisms such as bonus claw-back clauses will be more effective in reducing moral hazard at the systemic level and improving individual accountability at the micro level than taking a “Hippocratic” bankers’ oath.

What joy, another entrant in the not-think tank stakes

We’re just so terribly fortunate to have another entrant in the non-think tank stakes here in London. Welcome to Philip Blond and ResPublica!

The last time we looked at these two and their proposals they were suggesting that this Social Credit idea from Major Douglas might be a good idea and then hinting that perhaps Belloc and Chesterton were pretty good economists too. At least one reviewer of this combination pointed out that this was in fact the Fascists economic program: and the real Fascist economic program, not just the usual insult to be bandied about for anyone you don’t like.

Recovering from this they’ve made a new suggestion:

An oath for bankers should be introduced to raise accountability and standards in banking, said the think tank ResPublica.

It said the lack of public trust in banking after numerous scandals was an “ongoing concern” for the industry and the government.

In a new report, ResPublica called for an oath for bankers to “fulfil their proper moral and economic purpose”.

Well, yes. We know very well that nearly all people in modern society live in mortal fear of being an oath breaker, don’t we? Most unlike olden days when no one believed in an afterlife of the threat of the devil waiting to boil those who broke their word. Most unlike. And of course Harold Shipman would have been stopped in the tracks of his rampage if only doctors did take that Hippocratic Oath.

But maybe Blond has actually got something here. Think how many choirboys would be unsullied if only the Catholic Church insisted that priests took an oath of chastity?

Should central banks do emergency lending?

A barnstorming new paper from the Richmond Fed, written by its President Jeffrey Lacker and staff economist Renee Halter, argues that the Federal Reserve has drifted into doing too much credit policy to the detriment of its traditional goal of overall macroeconomic stabilisation.

In its 100-year history, many of the Federal Reserve’s actions in the nameof financial stability have come through emergency lending once financial crises are underway. It is not obvious that the Fed should be involved in emergency lending, however, since expectations of such lending can increase the likelihood of crises. Arguments in favor of this role often misread history. Instead, history and experience suggest that the Fed’s balance sheet activities should be restricted to the conduct of monetary policy.

The first step in their case is attacking the idea that the Fed was created to be a lender to specific troubled institutions or sectors:

Congress created the Fed to “furnish an elastic currency.”…In other words, the Fed was created to achieve what can be best described as monetary stability. The Fed was designed to smoothly accommodate swings in currency demand, thereby dampening seasonal interest rate movements. The Fed’s design also was intended to eliminate bank panics by assuring the public that solvent banks would be able to satisfy mass requests to convert one monetary instrument (deposits) into another (currency). Preventing bank panics would solve a monetary instability problem.The Fed’s original monetary function is distinct from credit allocation, which is when policymakers choose certain firms or markets to receive credit over others.

They go on to explain further the difference between monetary policy (providing overall nominal stability; making sure that shocks to money demand do not lead to macroeconomic instability & recessions) and credit policy (choosing specific firms to receive support and funds—effectively a form of microeconomic central planning):

Monetary policy consists of the central bank’s actions that expand or contract its monetary liabilities. By contrast, a central bank’s actions constitute credit policy if they alter the composition of its portfolio—by lending, for example—without affecting the outstanding amount of monetary liabilities. To be sure, lending directly to a firm can accomplish both. But in the Fed’s modern monetary policy procedures, the banking system reserves that result from Fed lending are automatically drained through off setting open market operations to avoid driving the federal funds rate below target.

The lending is, thus, effec-tively “sterilized,” and the Fed can be thought of as selling Treasury securities and lending the proceeds to the borrower, an action that is functionally equivalent to fiscal policy.

They go on to explain why Walter Bagehot provides “scant support” for the creditist approach to crisis management, while the facts of the Great Depression do not fit with the creditist story.

Finally, they note that even if there are inherent instabilities in the financial system—something far from proven—many of these are made substantially worse by central bank intervention in credit markets.

Financial institutions don’t have to fund themselves with short-term, demand-able debt. If they choose to, they can include provisions to make contracts more resilient, reducing the incentive for runs. Many of these safeguards already exist: contracts often include limits on risk-taking, liquidity requirements, overcollateralization, and other mechanisms.

Moreover, contractual provisions can explicitly limit investors’ abilities to flee suddenly, for example, by requiring advance notice of withdrawals or allowing borrowers to restrict investor liquidations. Indeed, many financial entities outside the banking sector, such as hedge funds, avoided financial stress by adopting such measures prior to the crisis.Yet, leading up to the crisis, many financial institutions chose funding structures that left them vulnerable to sudden mass withdrawals. Why?

Arguably, precedents established by the government convinced market participants of an implicit government commitment to provide backstop liquidity. Since the 1970s, the government has rescued increasingly large fi nancial institutions and markets in distress. This encourages large, interconnected fi nancial fi rms to take greater risks, including the choice of more fragile and often more profi table funding structures. For example, larger financial firms relied to a greater extent on the short-term credit markets that ended up receiving government support during the crisis. This is the well-known “too big to fail” problem.

I apologise for the length of the quotation, but the paper really is excellent. Do read the whole thing.

Voxplainer on Scott Sumner & market monetarism

I have to admit that I usually dislike Vox. The twitter parody account Vaux News gets it kinda right in my opinion—they manage to turn anything into a centre-left talking point—and from the very beginning traded on their supposedly neutral image to write unbelievably loaded “explainer” articles in many areas. They have also written complete nonsense.

But they have some really smart and talented authors, and one of those is Timothy B. Lee, who has just written an explainer of all things market monetarism, Prof. Scott Sumner, and nominal GDP targeting. Blog readers may remember that only a few weeks ago Scott gave a barnstorming Adam Smith Lecture (see it on youtube here). Readers may also know that I am rather obsessed with this particular issue myself.*

So I’m extremely happy to say that the article is great. Some excerpts:

Market monetarism builds on monetarism, a school of thought that emerged in the 20th century. Its most famous advocate was Nobel prize winner Milton Friedman. Market monetarists and classic monetarists agree that monetary policy is extremely powerful. Friedman famously argued that excessively tight monetary policy caused the Great Depression. Sumner makes the same argument about the Great Recession. Market monetarists have borrowed many monetarist ideas and see themselves as heirs to the monetarist tradition.

But Sumner placed a much greater emphasis than Friedman on the importance of market expectations — the “market” part of market monetarism. Friedman thought central banks should expand the money supply at a pre-determined rate and do little else. In contrast, Sumner and other market monetarists argue that the Fed should set a target for long-term growth of national output and commit to do whatever it takes to keep the economy on that trajectory. In Sumner’s view, what a central bank says about its future actions is just as important as what it does.


In 2011, the concept of nominal GDP targeting attracted a wave of influential endorsements:

Michael Woodford, a widely respected monetary economist who wrote a leading monetary economics textbook, endorsed NGDP targeting at a monetary policy conference in September.

The next month, Christina Romer wrote a New York Times op-ed calling for the Fed to “begin targeting the path of nominal gross domestic product.” Romer is widely respected in the economics profession and chaired President Obama’s Council of Economic Advisors during the first two years of his administration.

Also in October, Jan Hatzius, the chief economist of Goldman Sachs, endorsed NGDP targeting. He wrote that the effectiveness of the policy “depends critically on the credibility of the Fed’s commitment” — a key part of Sumner’s argument.

But read the whole thing, as they say.

*[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16]

An unpublished letter to the LRB on high frequency trading

Lanchester, John. “Scalpers Inc.” Review of Flash Boys: Cracking the Money Code, by Michael Lewis. London Review of Books 36 no. 11 (2014): 7-9, http://www.lrb.co.uk/v36/n11/john-lanchester/scalpers-inc

Dear Sir,

It is striking for John Lanchester to claim that those who believe high-frequency trading is a net benefit to finance (and by extension, society) “offer no data to support” their views. Aside from the fact that he presents such views in the line of climate-change deniers, rather than a perfectly respectable mainstream view in financial economics, it doesn’t really seem like he has gone out looking for any data himself!

In fact there is a wide literature on the costs and benefits of HFT, much of it very recent. While Lanchester (apparently following Lewis) dismisses the claim that HFT provides liquidity as essentially apologia, a 2014 paper in The Financial Review finds that “HFT continuously provides liquidity in most situations” and “resolves temporal imbalances in order flow by providing liquidity where the public supply is insufficient, and provide a valuable service during periods of market uncertainty”. [1]

And looking more broadly, a widely-cited 2013 review paper, which looks at studies that isolate and analyse the impacts of adding more HFT to markets, found that “virtually every time a market structure change results in more HFT, liquidity and market quality have improved because liquidity suppliers are better able to adjust their quotes in response to new information.” [2]

There is nary a mention of price discovery in Lanchester’s piece—yet economists consider this basically the whole point of markets. And many high quality studies, including a 2013 European Central Bank paper [3], find that “HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors, both on average and on the highest volatility days”.

Of course, we should all know that HFT narrows spreads. For example, a 2013 paper found that the introduction of an algorithmic-trade-limiting regulation in Canada in April 2012 drove the bid-ask spread up by 9%. [4] This, the authors say, mainly harms retail investors.

The evidence is out there, and easy to find—but not always easy to fit into the narrative of a financial thriller.

Ben Southwood

[1] http://student.bus.olemiss.edu/files/VanNessR/Financial%20Review/Issues/May%202014%20special%20issue/Jarnecic/HFT-LSE-liquidity-provision-2014-01-09-final.docx
[2] http://pages.stern.nyu.edu/~jhasbrou/Teaching/2014%20Winter%20Markets/Readings/HFT0324.pdf
[3] http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1602.pdf
[4] http://qed.econ.queensu.ca/pub/faculty/milne/322/IIROC_FeeChange_submission_KM_AP3.pdf