If it seems that high finance and scandal go hand in hand, this is not by accident. If you follow the money that passes through the financial sector, you might reasonably come to see it as a game of hot potato. Everyone who wants to make a killing in finance will try to go into the high-risk transactions because that is where the high rates of return are. The trick, though, is to hold on to the risky transaction just long enough to skim off your share of the proceeds, before passing the risk off on to someone else. This is fundamentally the reason that derivatives exist, but it goes way beyond derivatives. It is the reason so many companies end up getting involved in even very simple financial transactions.
A simple credit card purchase can’t take place without about ten companies getting involved. For a home mortgage, the number might be closer to twenty. It is all about passing the risk along to someone else.
In many cases, the actual risk is not shifted at all, but this does not necessarily matter. If the accounting measures of risk can be manipulated, that may be good enough, especially for a bank, for which risk is one of the critical financial measures. This explains how AIG, an insurance company, came to be the most important company in Wall Street banking five years ago. AIG issued derivatives that allowed it to take colossal amounts of risk, quadrillions of dollars worth, off the hands of the banks. The fact that AIG’s own solvency became something a fiction along the way did not matter for accounting purposes, as long as AIG could manage to stay out of bankruptcy, as so far it has. AIG eventually became a company with no net worth to speak of, but it nevertheless (with government help) was able to deliver the accounting magic that would keep transactions from being listed on a bank’s balance sheet.
When so much is riding on arcane accounting designations, controversy and scandal are all but unavoidable. These stories came up on a daily basis this week. Deutsche Bank hid $12 billion in losses, former employees told the Financial Times. The bank, though, insists its accounting designations of assets were done by the book. UBS was said to be preparing to pay $450 million in fines to settle charges that it falsified its Libor reports. That would be similar to the amount that Barclays paid previously. In a story that sounded like an echo, Standard Chartered was said to be close to settling charges related to its money-laundering past for $330 million, in addition to the $340 million it has already agreed to pay for keeping false records in connection with the same transactions. Standard Chartered apparently created fictional owners for bank accounts to get around money laundering rules in much the same way that a bank might create fictional owners to get around loan underwriting rules.
Banks’ hot-potato treatment of risk could not exist without insurance companies, and there was a similar story this week in insurance, in which Aetna agreed to pay $120 million to settle claims that it systematically underpaid insurance claims.
The size of the fines might seem enormous until you look at the scale of the transactions at issue. Aetna and Standard Chartered both have said that the payments won’t make a dent in their profitability for the quarter, and UBS has already set aside more than enough money to cover its reported settlement.
When even record-large fines are something a bank can take in stride, it tells you something about the relationship between the business and law enforcement. That is, questions of legality may not rise to the level of strategic importance that would make them a concern for the executives, but are often instead a detail to be worked out by the lawyers.