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A Cheating Culture in Banking

David Callahan

In testimony before a British parliamentary committee, the disgraced CEO of Barclays, Robert E. Diamond Jr., had a familiar excuse for reporting deceptive data on interest rates: The other guys were cheating, too, so we had no choice. “A number of banks were posting rates that were significantly below ours that we didn’t think were correct,” Diamond told the committee.

If that sounds like a disingenous way for Diamond to dodge real blame, think again. In fact, American and British regulators are said to be investigating more than 10 major financial institutions, including JPMorgan Chase, UBS and Citigroup. Barclays' $450 million settlement is likely to be just the first big penalty meted out.

It is perfectly plausible that Barclays was a follower, not a leader, on reporting deceptive data. One of the most insidious consequences of lax regulation in business and the financial sector is how cheating by just a few actors can end up pulling in a lot of other institutions, too.

Regulations and rules are supposed to set a level playing field. But when some people start breaking the rules and defecting from a regulatory regime -- and aren't punished -- they instantly achieve a competitive advantage. That creates powerful incentives for others to cheat, too. Nobody wants to be the chump who follows the formal rules when others are playing by an informal set of rules -- especially if it means losing money. And, once cheating is widespread, it starts to seem so normal that people may not stop to question it.

This cheating culture dynamic helps explains many of the financial scandals of recent years. In the wake of the earnings fraud scandals of a decade ago involving Enron and Worldcom, as well as dozens of other companies, we came to learn how normal it was for many public firms to "manage" their earnings data to produce results more pleasing to investors and thus help their stock price -- and how big accounting outfit like Arthur Andersen helped them.

The more companies that did this, the more it seemed normal -- and disadvantageous to not do it. Earnings fraud spread widely because federal regulators didn't have the resources to ensure that numbers were honest. In 2000, at the height of the epidemic, top SEC official Lynn Turner noted that the agency could only review under 15 percent of all quarterly earnings reports -- meaning that there was no way to catch bogus numbers in the vast majority of companies. The SEC's review rates haven't changed much since then.

The real estate bubble was fueled by cheating culture dynamics on several fronts. Appraisal fraud was widespread and normalized, as I noted in a report back in 2005. More insidious, was the lowering of underwriting standards and widespread false reporting of financial information of homeowners. Banks  that maintained rigorous underwriting standards lost market share to banks that handed out loans to anyone who walked in the door. And unethical mortgage brokers who pushed the envelope made more money than brokers who were honest.

A similar story unfolded on Wall Street: Investment banks that were more aggressive with mortgage-backed securities did better than those that weren't.

All of this is why tough regulation and enforcement is so important. Businesses benefit when regulators create and enforce a level competitive playing field. But if the watchdogs are asleep, things quickly devolve in a moral free-for-all that can cause even good people to do bad things.

I don't have great sympathy for Robert Diamond and don't think that competitive pressures are an excuse for cheating. But, actually, I believe Diamond when he says that the manipulation of interest rates by his bank had made him  “physically sick.”