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The lesson of Libor: look out for the sting in morality’s tail

The Libor scandal has taught the banking industry that mainstream perceptions of behavioural risk are utterly flawed. A new approach to supervision is needed, and fast.

Mention morality in the context of banking reform and the alarm bells begin to ring. Obviously societies tend to function better — and certainly more pleasantly — when individuals behave decently. But introducing the language of morality is usually unhelpful when discussing business.

One ought to be able to assume that the law of the land mandates behaviour approved of by society — so it should be sufficient to require businesses to stick to the law. Those laws may need periodic tweaking, but for many people, it is on that level that the debate should be conducted.

So the moment when the Archbishop of Canterbury, Justin Welby, raised the issue of morality in Monday’s parliamentary committee hearings into the Libor scandal at Royal Bank of Scotland would have caused a collective rolling of eyes among many bankers — and the commentators who follow their industry.

Many must have felt a religious figure had little useful comment to offer on the manipulation of banks’ submissions to the setters of global benchmark interest rates. They may also have scoffed at his naivety in suggesting that banks should somehow “test for the moral culture of a trading floor”.

As it turns out, however, Welby’s intervention was penetrating. He took the discussion briefly to the heart of the weaknesses in supervision that occurred at all banks implicated in the Libor scandal — as well as weaknesses elsewhere in financial industry regulation.

The current and former RBS executives being questioned on Monday insisted that the bank had indeed benefited from risk controls, protecting it from the evil that men do. But they defended their failure to respond quickly enough to the Libor problems. No one had dreamt, they said, that individuals at one bank might be able to tamper with Libor and other rates, because of the way they were calculated, with outlying values excluded.

Some academic studies have questioned that assertion, but the consensus among finance professionals is that it would have taken a co-ordinated effort across several firms for Libor to be affected by dodgy submissions.

Of course, we now know that this is pretty much what happened.

The fact that the risk controls at RBS and the other firms implicated failed even to imagine that such a course of events was possible is yet another indication — if the subprime crisis were not already enough — that banks and regulators need a new approach to what Welby called “immorality risk”.

At the very least, another layer of bottom-up scrutiny is required. It is plainly insufficient to identify a set of feasible risks and then simply look out for those.

A broader observation of behaviour is needed, with more imaginative work then applied to assessing where those behaviours, if corrupted or applied to nefarious ends, might lead.

One lesson of the myriad scandals in banking and financial markets is that pretty well nothing bad should be considered unfeasible. Risks that at first glance appear impossible must be subjected to extra scrutiny, not less.

Tail risks are still risks — and in recent times they have had a nasty habit of being the ones that matter.

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