Time to drug test the financial sector. So to speak
Updated
In late 2008, Floyd Landis was finally stripped of his 2006 Tour De France yellow jersey.
The US cyclist had tested positive for unacceptable levels of testosterone during the Tour and, after further damning analyses, charges of doping were upheld, despite Landis appealing to sporting bodies around the world. Worldwide anti-doping cooperation had at last borne fruit. There is a decided advantage in collecting and preserving information today so that it can be analysed later – witness the number of decades-old 'cold cases' that are being solved as a result of new DNA analysis techniques.
Do we need the concept of 'cold case' analysis in the financial sector, particularly to identify culprits for crises (unfortunately plural rather than singular)?
Over the past few months, it appears that the gods of the financial markets just cannot be appeased. Governments attempt to tackle a problem, only to find that, a few weeks later, 'financial markets' find that enough is not enough and another cycle of rising interest rates followed by ratings downgrade happens again - and then again.
Now it is without doubt there are huge economic and financial problems in the USA, Europe and even in Australia. But the current volatility in financial markets is at least in part due to speculation, in particular, hot money betting on the probabilities of default of sovereign nations. For example, over the last month the cost of insuring against a default by Italy, in the Credit Default Swaps (CDS) market, rose by over 75 per cent, default by Spain by over 40 per cent. This is despite these governments taking painful steps to get their houses in order. CDS are bets that countries (and companies) will fail. Such markets have been labelled casinos often enough not to repeat here, but it appears that the 'financial markets' have become a huge RSL, with governments as the meat tray.
Like the Australian love of punting, there is little wrong with market speculation, provided that one does it with one's own money and that it does not become destructively addictive. But the players in the CDS market are not always punting with their own money; they are, in the case of large banks, being underwritten by taxpayers. That is, taxpayers are taking bets against their own prosperity.
So what to do?
First, regulators, as they are permitted to do, should be ordered by the G7 to request that all regulated banks report all of the trades (CDS and other derivatives) that have made in the past six months and continue over the next few months. Think of this, as a blood sample or fingerprint collected at the scene of a possible crime.
The boards of regulated banks should also be sternly reminded of their duty to ensure a robust 'risk culture' in their institutions and to ensure that no trading takes place that is outside of the Board's own risk limits. They should be reminded that their risk taking activities should also be backed by sufficient capital to cover losses from all forms of risk, including 'systemic risk'. Note that the very real difficulties in measuring systemic risk does not abrogate the need to acquire capital against it. This would mean that boards must ensure that if they are involved in market speculation, they have covered the resulting systemic risk by sufficient capital.
This will not help resolve the current crisis but will allow forensic analysis of its possible causes at some time down the road – a crisis cold case if you like.
If, after such an analysis, it is found that regulated banks have indulged in speculative trading that has not been covered by the capital maintained by them, then the outcome is obvious – board members should be severely sanctioned. In addition, new remuneration rules should ensure that bonuses, resulting from any such breaches, are retrieved by the taxpayer.
Of course, it is possible that banks will not be implicated in any crisis and all that would be lost is that banks would have undertaken a quick check to ensure everything was in order, in itself not bad.
It may have, however, have a beneficial effect, in that it might cause boards of banks to exit the sovereign CDS market, unless they can be assured that they thoroughly understand the capital impact of such speculative trading. Speculation by non-regulated firms, such as hedge funds would still take place but without the support of the biggest players, the banks, the market will become a sideshow rather than the main game.
Maybe what is needed is the financial equivalent of the WADA (World Anti Doping Agency). Forensic accounting might even become sexy?
Dr Patrick McConnell is a Visiting Fellow at Macquarie University Applied Finance Centre, Sydney