Five Scandals That Show Why We Need Structural Reform in the Banking Industry

Multibillion-dollar scandals have continued to occur at big banks across the world, throwing the integrity of the banking system into question. The current state of banking ethics, the enormous size of banks and the banks’ inability to detect real-time fraud all contribute to the ongoing failures in preventing serious banking crimes. In addition to this, the big banks have complicated organizational structures with thousands of subsidiaries operating across multiple markets. Bank acquisitions and cross-ownerships across the globe can make it difficult to unwind trades and transactions in the case of a bank’s failure during a crisis.

Since the 2008 financial crisis, violations at the world’s leading banks have resulted in huge costs and tarnished the reputation of the entire financial system, leaving the public skeptical about the industry. According to a CCP Research Foundation analysis, over 200 billion pounds (nearly $300 billion) was paid out by banks in penalties and settlements during the period of 2010 to 2014. In 2015, banking crimes in the industry remain an ongoing and unaddressed issue.

The president of New York Fed, William Dudley, in 2013, acknowledged that “the deep-seated cultural and ethical failures at many large financial institutions” had been a result of the growing size and complexity of banking structures, as well as a result of bad incentives. Democratic presidential candidate Sen. Bernie Sanders (I-Vermont) and Sen. Elizabeth Warren (D-Massachusetts) have called for breaking up the big banks by reinstating the Glass-Steagall Act of 1933, the Depression-era law originally passed in response to the 1929 stock market crash, which was later repealed in 1999 under the Clinton administration.

The 21st-century Glass-Steagall Act, introduced by Senators John McCain (R-Arizona), Warren, Maria Cantwell (D-Washington) and Angus King (I-Maine), would significantly reduce the size of the banks by separating traditional banks (secured by the Federal Deposit Insurance Corporation) from investment banks that are involved in high-risk trading and speculative activities. Such reforms would help enable the efficient supervision of banks and make the foundation of the financial system more secure and stable.

A closer look at the following five banking scandals underscores why a structural reform of the banking system is urgently needed.

1. The Libor Scandal

The London interbank offered rate (Libor) is a benchmark interest rate set in London and reflects the average rate that banks pay to lend to each other. It establishes the base rate used for setting interest rates on consumer and corporate loans.

From 2005 to 2007, Barclays manipulated the Libor, allowing traders to make profits on derivatives. These traders worked with other banks so that the interest rates remained coordinated at low levels, thus misrepresenting the actual rates. In 2012, the bank was fined $435 million by UK and US regulators for its manipulation of Libor and Euribor (the “Euro interbank offered rate” at which European banks borrow funds from one another) interbank rates. Around 20 big banks underpinned trillions of British pounds worth of loans, mortgages and financial contracts in Europe and the United States. Such manipulations affected $350 trillion in securities. As of May 2015, global banks have paid over $9 billion in fines, with many traders and brokers being fired, barred and forced to resign.

2. The Money Laundering Scandal

The London-based bank HSBC was accused in 2012 of allowing “rogue states” and drug cartels to launder billions of pounds through its US division. The bank paid a record fine of $1.9 billion for ignoring warnings and violating safeguards that could have stopped the laundering of money from Mexico, Iran and Syria at an early stage. Between 2006 and 2009, according to the US Department of Justice, HSBC had failed to supervise and check $670 billion in wire transfers and $9.4 billion in cash transactions from its Mexico bank operations.

HSBC joined a list of many financial institutions that previously admitted to unlawful money transfers. Swiss bank Credit Suisse paid $536 million in 2009 for transactions with Iran and other countries, and in June 2012, Dutch bank ING agreed to pay a $619 million penalty for violating economic sanctions. They had moved billions of dollars through the US financial system at the order of Cuban and Iranian clients.

The UK bank Standard Chartered agreed to pay $340 million in 2012 to settle charges for violated transactions to Iran, Burma, Libya and Sudan. Later in 2014, the same bank agreed to again pay $300 million for lapses in tackling the money laundering compliance that it was required to follow.

3. Foreign Exchange Rigging

The foreign exchange market is the largest in the world, averaging a total trade of $5.3 trillion a day. Any manipulation in this market can lead to huge losses (considered profits for manipulators).

Four banks, known as “the cartels,” operated as early as 2007. Through online chat rooms and coded language, they rigged the key currency marker – “the fix” – in an effort to increase their profits. In 2015, regulators in the US, UK and Switzerland fined six of the biggest banks $5.8 billion in penalties. Citigroup, Barclays, JPMorgan and Royal Bank of Scotland were fined by the US after pleading guilty to charges of manipulating the price of US dollars and euros.

4. Mis-sold Payment Protection Insurance

PPI, or payment protection insurance, is supposed to cover debt repayments in the event of inability to work, but has been mis-sold to millions of people in recent years. PPI policies have been sold alongside mortgages, loans and credit cards since the 1990s.

The now-defunct UK Financial Services Authority began imposing fines for PPI mis-selling in 2006. By 2011, the PPI scandal had been unwinding for more than a decade in the UK. Repeated investigations found that there were lapses, but the banks refused to admit their mistakes. UK banks have already paid out 23 billion pounds to victims of the mis-selling of payment protection insurance, in what is to be the most expensive scandal in British financial history.

5. Frauds Related to the 2008 Financial Crisis

In 2012, many big banks paid billions of dollars to settle federal charges concerning offenses that were connected to the banks’ unlawful and abusive behavior involving foreclosures on homeowners.In December 2012, Bank of America paid $335 million in a settlement over discriminatory practices against borrowers (2004-2008) at Countrywide Financial, which it bought in 2008.

In 2012, Wells Fargo, the largest residential home mortgage originator in the United States, agreed to pay at least $175 million to settle US Department of Justice accusations. It was accused of discriminating against qualified borrowers of color, giving them more costly subprime loans or charging them higher fees.

In 2014, Bank of America was required to pay $16.65 billion ($9.65 billion in cash and $7 billion toward consumer relief). According to US Attorney General Eric Holder, “This historic resolution – the largest such settlement on record – goes far beyond ‘the cost of doing business.'”

After a series of investigations, big banks like JPMorgan Chase, Deutsche Bank, Morgan Stanley, UBS and Citigroup were penalized for individual offenses related to the events of 2008 and agreed to settlements.

The Ethical Question

Following these scandals, banks have tried to reduce the financial system’s exposure to systemic risk by restraining shadow banking activities and adopting more sophisticated risk-modeling processes. But the financial system still remains vulnerable to risky activities that can spread to traditional banking activities. In a speech at the Americans for Financial Reform and Economic Policy Institute Conference, the Fed governor Daniel K. Tarullo pointed out that even with much reduction, “the scale of shadow banking activities remains very large.” Additionally, ethical failures and lapses in banking supervisions are becoming common because the people involved rarely face criminal charges. Usually the concerned CEOs and the involved executives either voluntarily step down or are sacked in the event of fraud detection. Former trader Tom Hayes is so far the first and only example to date of an individual who has been charged and sentenced to 14 years by British authorities for Libor rigging.

According to a report by Labaton Sucharow LLP, one-third of bank employees with less than 20 years in the industry say they would engage in “insider trading to make $10 million, if there was no chance of being arrested.” Clearly, the existing structural system of the banking sector needs tougher rules and higher penalties for breaking them.

In addition to reducing their size and finding new ways to enforce anti-fraud rules, banks should consider encouraging their employees to report observed misconducts anonymously. By doing so, banks could detect frauds at an earlier stage, thereby minimizing the costs of banking crimes and retaining the trust of the public.