Adam Smith Would Have Been Horrified By The Way Banks Operate These Days. But Then What Did He Know?

Martin McCauley writes from London: Do we need an Einstein to tell us how to solve the banking crisis? Anyone who watched Bob Diamond, now former chief executive of Barclays, being questioned by the House of Commons Select Committee will realise that things are rotten in the City of London. Mr Diamond swatted away questions about responsibility for the LIBOR scandal – fixing illegally the rate of interest banks pay to borrow from each other. He maintained that he only became aware of the fraud a month before it became public knowledge.

This is unbelievable. No wonder bankers are now despised universally.

So what has gone wrong? Loss of trust is the simple answer. Barclays was set up by Quakers who had a strict moral code. Your word was your bond. They would have regarded engaging in fiddling the books to make a profit as sin.

An interesting question is if you had been in a comparable position would you have resorted to illegal practices? Most people would immediately say ‘no’. However, at the back of their minds is the thought that doing something illegal is thrilling. Why do most people avoid such behaviour? Because they are afraid of being found out. This could mean the end of their careers. So the price to pay is too high.

The financial world is part of the market economy. It is capitalism in action. Adam Smith, in his classic work, The Wealth of Nations, showed that a market can only function if there is a certain level of trust. If all actors act morally, the outcome will be good. The reason for this is that there is an ‘invisible hand’ which ensures this will happen. In other words, the market is self-regulating.

Smith is the father of classical economics. But his views were disputed by John von Neumann who argued that an economy worked according to different principles. Whether a decision was good or bad depended on how others responded to it. That could not be predicted in advance. In order to illustrate this von Neumann thought up Game Theory. This posits that two rational agents acting in their own self-interest will produce an outcome unfavourable for both, individually and collectively.

The key variable in a market economy is trust. You can either have a trust economy or a risk economy. A trust economy is one in which you rely on agents to act in the common interest. In other words, to act in the best interest of customers.

In a risk economy you rely on regulations, laws, rules, conventions, punishments, fines and so on. The problem is that bankers such as Bob Diamond are clever enough to drive a coach and four through any legislation. So judicial and parliamentary inquiries, select committee hearings, debates, conferences and the like will never arrive at legislation which is capable of eliminating fraud, cheating and malpractice.

Without trust, self-interest is a cancer which defeats legislation and undermines institutions. It almost brought the whole financial world to its knees in 2007-08.

The greater the distance between the decision maker and the customer, the greater the risk that the decision will not favour the customer. In the old days, the bank manager knew his customers and was trusted by them to act in their interests. Nowadays, decisions are taken at head office by someone working a computer model. This is one of the reasons that it would be better to split retail and investment banking. Retail banking can regain trust through direct contact between the manager and the customer. Investment banking, which is so impersonal and based on computer models, is in crisis. The employee takes a decision and has no idea how it affects the final outcome of a deal. The goal is simply profit. The best deal for the customer is one which makes most money for the bank.

How does one restore trust in investment banking? I suspect that even Adam Smith would not have been able to give an answer to that if he were alive. But then what did he know?

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