by Mike Soden
The two major banks in Ireland, AIB and Bank of Ireland, have, over time, drawn up frameworks as to the policies and procedures for the operation of their respective institutions. A great deal of thought has been put into this area, and over the years these policies became better articulated and more suitable and applicable to their customers, employees, shareholders and the community at large. However, such documents are only as useful as they are put into daily practice. Somewhere along the line, smaller banks that were under the control of the Financial Regulator and that were independently audited failed to follow or comply with accepted good practice in relation to conflicts of interest and the moral hazard that exists in a community where a large majority of professional people were not only doing their day jobs, sometimes carelessly, but were actively moonlighting and had outside interests. For example, many members of the legal and accounting professions, in their own right or on behalf of their own firms, borrowed large sums for investment purposes. Over the past decade these investments were likely to have been in property. Whether such investments were part of a partnership’s capital expenditure programme or part of a pension portfolio, they put the investor in an unenviable position when the downturn occurred. When the Government prepared a list of solicitors who would be deemed eligible for NAMA advisory work, many on the list presented conflict of interest issues as they owed banks substantial amounts on property loans on the one hand and, on the other hand, were being asked to represent NAMA to prosecute people who were in a similar position to themselves.
Banks are traditionally cautious in the context of the borrowings of directors and executives. Normally, to avoid potential conflicts of interest, if members of one bank have a need to borrow they will do so from a competitor bank, and often reciprocal arrangements may exist to accommodate the directors and executives of the other bank. These borrowings would be used for mortgages, personal loans, car loans and shares. Frequently, an accommodation would be put in place to allow the executives to execute share options and subsequently share purchases. The purpose of these loans was always made clear and the size of outstanding personal borrowings was monitored closely. Directors and executives were encouraged to have a shareholding in their bank but the quantity of shares was limited to a multiple of remuneration (salary) or some amount that most would consider conservative. If there was, for whatever the reason, a failure to perform under these loan agreements, the discussions were of a private nature between the director and the facilitating bank. Thus, any potential conflicts of interest were avoided by the director’s or executive’s bank.
Auditors would send around a form to be signed annually as to what amount was borrowed during the year (personal loans and mortgages), what amount was outstanding at year end and, importantly, if there were any outstandings during the year. Of the four major banks that I have worked for (Citicorp/Citibank, Security Pacific, National Australia Bank and Bank of Ireland), all had one thing in common with regard to personal borrowings – they were thoroughly evaluated and closely monitored. The philosophy in all four banks was that employees were committed full time to the bank and outside interests, investments or other directorships had to be approved by a designated director or a subcommittee of the board. The problem with lax governance is that it turns the potential problem of conflict of interest into an actual problem. The failure to disclose conflicts of interest to boards should be treated as a criminal offence.
The Large Hadron Collider (LHC) is a gigantic scientific instrument near Geneva, where it spans the border between Switzerland and France about 100 metres underground. It is a particle accelerator used by physicists to study the smallest known particles – the fundamental building blocks of all things. Physicists use the LHC to recreate the conditions they believe were present just after the Big Bang, by colliding two beams head-on at a high energy level. This massive project began in 1998. The first planned particle collisions took place on 30 March 2010. A brave new world of physics is in the process of emerging, as new knowledge of particle physics from the new accelerator will contribute to our understanding of the workings of the universe.
In 1986 the London financial markets had their own ‘Big Bang’, the phrase used for the deregulation of the London financial markets and the market activity expected to ensue. Deregulation included the abolition of fixed commission charges and a change from open outcry to electronic screen-based trading. The measures were taken by Thatcher’s Government in order to make London financial institutions competitive with those in New York and around the world.
As a result of deregulation, for the first time in the history of the UK financial markets, brokers and market makers emerged and most were absorbed by major US commercial banks that wished to extend their financial footprint internationally in the securities business. The first acquisition was by Security Pacific, a California-based bank later taken over by Bank of America. In April 1986, as a director of Security Pacific Ltd, I had signed an agreement to take an 83 per cent share in Hoare Govett Ltd, the third largest stockbroker in the UK. Over six months later we bought a small market maker (jobber) in London.
A new company was formed called Security Pacific Hoare Govett (Holdings) Ltd. This institution was the first of a new breed of international capital market operation in London, which was created a mere twelve months previously. By the time the integration had occurred between the debt activities of Security Pacific Ltd in the euro-markets with the gilts and equity businesses of the established blue blood firm of Hoare Govett Ltd, the new entity had a total staff count in excess of 3,700. These were exciting times in the markets and it was not long before new premises were occupied in the European headquarters of the group in Broadgate, London.
The aspiration of the group was to achieve a prominent position in the global international capital markets. The skill base and experience of those in charge were extensive. However, nothing was to prepare us for the meltdown that took place on Black Friday, 16 October 1987. As the equity markets headed south and the values of shares were dropping like rocks into a pond, it was difficult to get a fix on the real losses being incurred. Big Bang was now rocking the UK financial markets and it would take another week to account for the depth of the cost of the meltdown. Marking to market the various positions in both debt and equity securities, which should have been done automatically, was being challenged by all as few could believe the size of the growing losses. A manual check had to be initiated to confirm the losses being incurred. For those who were from a commercial banking background, the shock of the magnitude of the securities losses was staggering. The substantial capital of the operating subsidiaries was wiped out by the accumulated losses that were going to have to be recognised immediately. The parent banks were well capitalised but the recapitalisation of the subsidiaries, which was soon to take place, forced a review of the strategic plans for a global capital markets capability.
The regulators who found the risk profiles of Security Pacific Hoare Govett (Holdings) Ltd unacceptable could not discern the difference between the domestic and international operations in the context of governance. The steps that could be taken to ensure that no further incidents of this nature occurred were examined immediately. The macro-economic picture was akin to the hundred-year wave. Few, if any, recognised the possibility of another collapse, which did actually occur in January 1989. Risk management, balance sheet management and less ambitious strategic thinking became the order of the day.
The effects of these two crises on the UK market weren’t more than a fraction of what the current crisis has wrought over the past three years in Ireland. The need for improved and strong governance is often the cry from the regulators after the fact. Unfortunately, it would appear that the speed and complexity of the markets is such that regulators are followers and not leaders. There is no substitute for common sense and good judgment, and in the face of greed it takes very strong, balanced management to make the right decisions.
The moral to all this is that the gr
owing of a financial services business requires experience, strong skill sets and a large capital base, with a culture of managed growth suitably governed. The consequences can be catastrophic for shareholders, employees and directors if the internal and external governance is lax. Cronyism and insider trading had prevailed extensively in the London market before Big Bang. Deregulation did dilute this, since it brought the Americans in. Taking advantage of privileged information before the market was made aware was not tolerated in this new environment. The response from those who could no longer engage in insider trading was a forlorn ‘How are you expected to make money?’
CHAPTER 4
Who Pays the Piper?
The Concept of Fairness in Our Society
The crisis in our economy and banking system has exposed the failures of regulators, bankers, developers, politicians, auditors and solicitors, and has led to finger-pointing in the media. It is easy to understand why those who now find themselves in negative equity, without a pension or facing bankruptcy are calling for retribution. Judgment is what the senior people in banks are paid for. When this judgment is compromised or impaired for reasons of competitive pressure, insecurity or greed, it is difficult for these decision makers to demonstrate balance in their business dealings, the consequences of which are conflicts of interest and a loss of authenticity.
Impact statements are good vehicles by which victims can express the losses they have incurred, be they physical, emotional or financial, or related to dignity or privacy. But what happens when the victim is society itself? Whatever the final outcome though the judicial system, there is no punishment severe enough to cover a loss of over €24.4 billion. The damage to the country’s economic and banking reputation due to the various questionable actions undertaken by some of our banks is not quantifiable. We have an international reputation for our social, cultural, economic and sporting contributions, not only in our own country but in the many countries that have welcomed our immigrants over the years and where a strong Diaspora has been established. We have influence internationally, disproportionate to our size, in the fields of education, medicine, law and social services. This reputation has been earned and not given lightly. It has now been tarnished badly by a few, who either through greed, ignorance or simply bad practice have left themselves open to a charge of misprision of treason, which is having knowledge of the principal crime (reputational damage) and concealment thereof. The intention may never have existed to damage Ireland’s reputation but surely ignorance is no defence, though one has to wonder whether a plea of ignorance or stupidity would put the wrongdoers in a better light.
Our society requires standards of behaviour for all those in positions of authority, which are consistent from one profession to another. We see people every day being criticised for what most in our community would deem to be unethical or amoral practices. Common sense lies behind such judgments. But common sense seems to be often in short supply in the context of our legal infrastructure, which is supposed to promote justice and morality in society. As someone once said, ‘If morals, ethics and law coincided, it would be a coincidence.’ Creating a media court that would hear the complaints of a community with the jury being the viewers might be a worthy production for RTÉ. It would be a form of reality TV show where a case for the prosecution would be made and the defendants would be given equal time for their rebuttals. The Court of Public Opinion, as the show might be called, would provide a forum for people to express their concerns about the weaknesses of a legal system that appears to take an excessive amount of time to adjust to our changing society. This show would not replace any judicial system but it would provide a forum for naming and shaming people or companies who are the culprits in this crisis, punishing wrongdoers and fully recognising the plight of victims.
Concerns about the effectiveness of the law in bringing wrongdoers to account can be too easily dismissed by intellectual arguments that condone white-collar crime or acts of amoral conduct by leaders. Expressions such as ‘mental reservation’, ‘error of judgment’ and ‘economical with the truth’ have crept into our vocabulary of recent times. These expressions can be seen to represent an intellectual tolerance for untruth and weakness.
It appears that, in Ireland, not only do wrongdoers go unpunished but they continue to receive excessive remuneration for perceived failure.
Whether in a small, closed society or in a large, open one, people have a genuine interest in the private wealth and earnings of others. The intriguing question behind this curiosity is what others have done to succeed in a given pursuit that results in what one might describe as obscene gains. Every year in many countries, the ‘rich lists’ of the top 100 or 500 richest people in an area or occupation are published. With the excitement of motoring through these lists, the reader’s fingers start perspiring and at some point in the process pages stick to the index finger and the page is torn. This sudden sharp interruption does little to prevent the reader reaching a name he or she recognises or coming to an abrupt halt at the poorest rich person on the list. How embarrassing. How do you manage to be the last person on this privileged list?
Who makes up these lists and where does the information come from? Is it reliable? Although the entrants are aware of the weaknesses of the process, they too are prurient. It may be easy for researchers to identify some, if not all, of the assets of the published entrants, but it is highly unlikely that they can get a comprehensive understanding of the true wealth of the entrants since who is going to disclose their liabilities?
In certain sectors of society where duties are performed on an hourly basis and the payment is made at the end of the task or the end of the week, such payment for one’s labour is usually described as ‘wages’. The average industrial wage in Ireland in 2009 was about €700 per week (see Figure 2 in the Appendix). This figure for the average wage generally does not excite much interest, except in relation to the average size of a mortgage.
‘Salary’ was a term introduced in the twentieth century and was coined to differentiate between the compensation paid to white-collar employees and blue-collar workers. The implication of this categorisation was that if you received a salary you were likely to be much better off than your colleague on a wage.
Whether you receive a wage or a salary, it is highly likely that you have had the pleasure in your life of making the acquaintance of those who charge fees. As the saying goes, ‘Dentists don’t charge their patients; they just sidle up to them.’ So we now come into this glorious group of professions who have qualifications and make their living out of charging fees: doctors, dentists, solicitors, accountants, and many other professions including brokers and investment bankers. In terms of the hierarchy of compensation, we are now discussing the top level.
What differentiates the price for a unit of labour between parties in our society? Namely, time, effort, skill, education and experience, combined with the economic equation of supply and demand. Any job that can be done by many is valued less in society than the job done by the individual who has a scarce skill set. In medicine, finance, law, photography or entertainment we see examples of uncommon skills. Often we pay fees for a service the value of which is priceless. We probably wouldn’t begrudge the fees charged by an eye specialist who removes a cataract to restore or improve our sight. This applies to the whole medical profession, whether you are talking about oncologists, pediatricians, cardiologists or radiologists.
Let’s look at the medical profession at one extreme and the entertainment sector at the other in terms of our attitudes to compensation for groups in our society. Those in the medical profession are well educated and continuously trained, while the time and effort put into their pursuits entail major personal and family sacrifices. We are not an egalitarian society yet but there is a school of thought that would suggest that these skilled, learned people must or should give their services to our society on what might be described as a subsidised rate. Our society is entitled to the best medical system av
ailable and it should be available to all. The financial rewards to the practitioners may not be proportionate to the high value of the service provided. However, it is believed that there is a psychological element to medical professionals’ compensation. Surely, for doctors, there is emotional and psychological satisfaction involved in caring and curing. If you are fortunate to be born with the attributes that make you join that special club in our society, which is so often referred to as a ‘vocation’, remember that the cost of membership can be very high. The medical profession should ensure that they are not taken for granted in society.
The nature of a financial discussion is that things can be debated in terms of numbers with all other associated facets removed. However, bearing in mind that quality of life is probably high on our list of priorities, maybe we should ask ourselves what would be the outcome if certain services disappeared. If there were no doctors, or fewer, many in our society would live for a shorter time and have a much lower quality of life. The economist might surmise that this would result in smaller contributions being required for pension funds because of the reduction in life expectancy. In one fell swoop one of the single largest financial challenges facing society in the twenty-first century – the pension deficit – would be largely dealt with. On this cynical note we now turn to the entertainment sector.
The entertainment sector encompasses a wide range of skills and talents in the areas of music, arts and sports. If we say that leverage is the opium of the entrepreneur or developer, it is perhaps fair to conclude that entertainment is that of the masses. Whether we get our fix through great sporting events, music that ranges from classical to rock or the visual sensation of a Hollywood spectacular, there seems to be no end to what fans and supporters are prepared to pay. Take football stars whose genius comes at birth with the facilities of speed, strength, touch and agility or movie stars who choose a life in the public eye – both groups receive substantial, and perhaps obscene, rewards for success. Have we ever considered the speed at which we book a concert seat, buy a season ticket or make a dinner reservation compared to our casual deferral of a doctor’s appointment? Or how willingly we pay the cost of a concert or a dinner in comparison to our reluctance to pay a fee to the medical profession?