The Politics of Financial Risk, Audit and Regulation

A Case Study of HBOS

Atul Shah

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351857079
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The biggest corporate failure ever in British history occurred in 2008 with very little forewarning. The management of HBOS, a major national bank with a long history of prudence prior to the merger in 2001, were allowed to act incompetently. Auditors and regulators failed to act, ignoring a key senior whistleblower, and the 'competitive' stock market failed to spot management failure in time.

This book is the first academic study of this collapse, uncovering some surprising evidence on the power and politics of large financial institutions. It details the processes and degrees to which financial challenge and regulation are undermined by this power. The research exposes a pro-active process of regulatory risk management by these institutions; the ease with which auditors and regulators can be captured; and how politicians and investors can be all too happy to hop on the stock market and management spin ride – with other people's money. The study questions the ideology and politics which supported and encouraged the management hubris, raising profound questions about the 'politics' of the academic disciplines of banking, finance and accounting today, and the theories they underpin.

This account of management gone wrong is essential reading for students, researchers and professionals involved in banking, finance, credit infrastructure, economics and management studies.

1 Introduction

This book is primarily about the link between finance and politics, by focusing on the UK’s largest bank failure in history – HBOS. Its direct and indirect damage to the UK economy, in terms of pension and investment losses, housing bubbles and crashes, government bailouts, consumer exploitation, unemployment and economic collapse cannot be easily quantified but is in the hundreds of billions. As a reality-check, we must remember that HBOS was not a Chernobyl but a man-made institution with a long history and tradition, which exploded in the space of a few hubristic years. Even though lots of people were watching it closely, or required to monitor it, the failure was indeed sudden and dramatic. It is critical we learn lessons from such failures, including what they mean for our received wisdoms and expertise in finance and accounting. For students and researchers in finance, this detailed interpretive case study should open their eyes and minds to the critical role of theory and academic knowledge in the creation of such bubbles. It exposes the ‘expert’ detachment from social conscience and cultural devastation, and aims to awaken students to the urgency of reconnecting finance to its basic roots and meaning. This book exposes how the academic finance world is living in a ‘scientific’ bubble, whilst the real world is suffering from the ravages of financialisation. Given that both business and finance are practical endeavours, this book exposes the perils of ivory tower theorisation and the ‘rigorous’ testing of the theories whilst the practice is experiencing huge scandals and crises. It opens up the significant possibilities and opportunities of inter-disciplinary research in finance and its potential to reform both theory and practice.

In most business schools across the world, finance is taught in an apolitical and technical way with a focus on models and methods to help shape value and efficiency in business and markets. In fact, even the science of political economy is rarely taught, despite the undisputed fact that big business is hugely powerful and many multi-nationals run bigger economies than whole countries. Furthermore, the politics that shapes the financial institutions and markets is ignored, in the process subconsciously denying its very nature and importance. There are dreams and ideologies of perfect markets where everyone behaves rationally and satisfies the desires of the scientist to create neat models and valuations. However, the reality is very far from this, and both history and recent experience has shown that the industry of finance is highly political and compromised by greed, selfishness and hubris.

Political economists have long understood the link between finance and politics and written many research papers and books on the subject (see e.g. Strange 1986; Coggan 2012; Moran 1991; Hertz 2001; Palan et al. 2010; Hancher and Moran 1989; Hutton 2010; Germain 2010). However, there is rarely an interaction between the highly technical and clinical teaching of finance and the real-world politics of finance. In actual fact, there is a denial of politics in mainstream finance teaching and research, which seems bizarre. In line with some academics (see e.g. Gendron and Smith-LaCroix 2015; McSweeney 2009; Daly and Cobb 1994; Frankfurter and McGoun 2002), I conclude from this observation that finance theory and research have a deliberate tendency to obfuscate the truth and hide behind a disciplinary boundary shaped for its own convenience and status – something which Daly and Cobb call ‘disciplonatory’. There is also research emerging (see e.g. Whyte and Wiegratz 2016) which argues that the very idea of neo-liberalism is helping to shape a moral economy of fraud, where fraud becomes a norm in modern society. Thus finance research and teaching, which has a strong neo-liberal bias, is potentially complicit in this. Perhaps the denial of politics is deliberate and profoundly ideological rather than scientific (see e.g. Froud et al. 2006).

The focus on politics in this book enables us to look closely at key people, their culture and values, the networks and influence they commanded and the thinking which drove their actions. The themes of risk, accounting, auditing and regulation all have significant political undertones as they are administered and managed by people, and interpretations are often very subjective. Politics helps us focus on the decision-makers and opinion formers, be it individuals, professional firms or networks and leadership cultures. The research here is not a technical analysis of a bank failure. Fundamentally, financial risk, accounting and regulation are social phenomena, and it is often misleading to study them in pure technical terminologies.

This chapter sets the tone of this study by examining the history and politics of the finance discipline, the processes of financialisation, teaching in finance, the origins and nature of money, connecting finance to ethics and issues of power and politics and then setting the backdrop for HBOS and the research methodology of this study. The chapter explains why a personal approach has been adapted in the writing of this investigation, expressing the underlying values and motives of this study. It encourages readers to take a personal interest in finance and its academic future to help shape its reform and transformation.

Ethics, Values and Financial Power

As an academic discipline, finance is relatively young (Mackenzie 2006) – only fifty years old, yet its size and reach has grown exponentially. The curriculum of finance taught in different parts of the world is virtually imported wholesale from North America. Economics, its mother discipline, is also presently in crisis, and huge questions are being raised about its scientific credentials (PCES 2014; Chang and Aldred 2014; Kay 2011). There is no allowance for the cultural and contextual diversity of finance in different countries – it is theorised and taught in an acultural manner. Given the huge crises we have been experiencing resulting from finance, this arrogance and mischief has to come to an end. Humanity has already paid a huge price for failures in banking and financial markets, and continues to do so. As I write, the Wells Fargo frauds are in the news. There is an endemic culture of greed and disdain for honesty and fairness, in the very industry which requires and depends on trust and integrity.

It is an undisputed fact that banking and finance occupy a hugely powerful and influential role in the modern world (Froud et al. 2006; Lewis 2012; Das 2011). As evidence of this, we only need to look at the size and reach of firms which operate in this arena – Goldman Sachs, Citibank, Barclays, HSBC, RBS, Deutsche Bank, UBS, Credit Suisse – a few global conglomerates with billions of dollars in assets and capital. Theories like efficient markets, perfect competition and rational choice are demolished by the size and growth of these institutions. The evidence of monopoly, inefficiency and hubris is all around us, but somehow ignored in the discipline.

In reality, the big banks dominate and control products and markets and are growing ever bigger through acquisitions and consolidations. Many of these firms have also faced allegations of corruption, fraud, market and investor manipulation, customer exploitation, conflicts of interest and even financial meltdown, but, somehow, they have still survived and prospered. Some have even argued that their size and reach have made them very difficult to manage and police centrally (see e.g. Admati and Hellwig 2013), yet they seem to soldier on, with no decline in management rewards and bonuses. Many argue that contemporary finance is like a gravy train – you are lucky if you can hop on for the ride, but no need to fear the consequences of failure as they will be someone else’s problem, with no recourse to the perpetrators (Das 2011; Kay 2015). Contradiction is rife in the science and industry of finance, although the experts would not like to admit it. It is possible that, as Beck (1992) has predicted, for the experts, it is very convenient to keep the field highly technical and sophisticated so that it is very difficult for others to probe into what is really going on, or to regulate and control it. Whilst this behaviour may not be concerted or deliberate, it has the effect of removing any powerful challenge from the academy, and instead fuelling the significant cultural and ethical problems. Also, the technical nature can be a convenient method of hiding and disguising the underlying values, ideologies and subjectivities (Tett 2010).

The sources of banking power come from certain very basic facts – the money multiplier, where the private banking system effectively have a licence to create money; their size and reach; the ease with which banks can raise loans and capital for themselves; and the state protection given to them in the event of failure. Their regulation is a chimera, continuing to fail in bigger and more devastating ways, but somehow after every crisis the response is the same – revision of regulation. What is avoided by both the science and industry is the actual culture of finance – the behaviour of the people who run and manage the teaching, research and the financial institutions that continue to breed exploitation and inequality. When anthropologist Luyendijk (2015) investigated the global finance industry in London through anonymous interviews, the findings were truly shocking. Not only is the power of the industry ruining the wider economy and society, but it is also eating into its own people and ruining their personal lives, relationships, health and happiness. There is something deeply disturbing about the modern world of extreme finance, but society seems paralysed about substantive reform of its power and accountability. A recent review of banking culture, demanded by the UK parliament, was actually quietly abandoned by the Financial Conduct Authority (Dunkley 2015). In its effort to distance theory from observed fact, it seems finance has also distanced the human being from acknowledging his or her own pain and suffering. It is therefore no surprise that there is also a mental health crisis in finance (Lewis 2016; Luyendijk 2015).

Finance Literature and Teaching

There are tomes written on the practice and science of finance, financial risk management, auditing and even banking regulation and supervision (Eales 1994; Roggi and Altman 2013; Saunders and Cornett 2014). Whole professions and bodies thrive on these ‘expert sciences’, giving credibility and generating income for the practitioners. Sadly here again, the politics or culture are rarely mentioned, even though the primary role in these exercises is played by people, networks and institutions. Whilst a risk management text may admit that culture is important to creating a measured risk environment, it will feign from looking at the links between culture and the ways in which risk is measured and hedged. One has to become suspicious about why this is so, and how it is that such denial has been sustained for so long. In fact, not only politics but human values and norms are also rarely discussed, and if so, in a very technocratic or legalistic manner. Given the state of modern-day financialisation, we cannot avoid conducting a microscopic analysis of big financial institutions and their behaviour and politics. Effectively, they are both the market and the financial system (see e.g. Goldman Sachs – Cohan 2011; Lehman Brothers – McDonald and Robinson 2009; RBS – Fraser 2015). These books show very clearly that politics and power are at the heart of the management of such institutions.

As an example, let us look closely at a series of international textbooks in the fields of corporate finance, accounting and risk management published by McGraw-Hill, pioneered by the original Brealey and Myers which is now in its eleventh edition (Brealey et al. 2014). All of them are into several editions, and very popular among business schools all over the world. That is correct – business education, like business, has become formulaic, like a factory and a production line. In none of these books is there any serious mention of politics or even culture and ethics. For example, Hillier et al. (2016) makes this very short and sweeping statement about ethics (p. 53):

Given that this book concerns financial decisions and how to use these decisions to maximise firm value, it is implicitly understood that the decisions will be ethical.

It shows that the authors know little about ethics and its significance to finance. Similarly, Saunders and Cornett (2014), an international text on financial institutions management and risk management, does not have a single chapter on politics, culture or ethics. Deegan and Ward (2013) is a highly technical text on international financial accounting and reporting, where politics, culture or ethics have no place.

Such a technical approach to the teaching of finance, risk, accounting and auditing helps sustain the illusion that people, culture, networks and power do not matter. For a student sitting in these classes, it can be a very disempowering experience, as the knowledge is in denial of human norms and subjectivity. In fact, it is often the case that research and consultancy in finance is a much bigger priority than teaching, so there is an academic distaste in engaging with the ethical culture of learning and education. It forces students to detach their emotions and personal experiences of meeting bankers, risk managers or accountants and auditors. Students are also customers of banks and consumers of financial products like bank accounts, credit cards, student loans and cash and currency exchange services. Somehow none of this experience matters or is related to in the teaching of finance.

Subtly but deliberately, finance (and economics) research is putting numbers, measurements and profits above people and society (Frankfurter and McGoun 2002; Bakan 2004; Ekins et al. 1992). Instead of describing selfishness, it is shaping it. This is in stark contrast to what is reported in the business news and financial news on a daily basis. Students are drowned in technical detail, detaching them from connecting with the wider world and the real stories and methods of big business. Business schools are scared of exposing these truths, as they are businesses themselves, trying to show how firms are great and good, and how their expert science is complex and worthy of dedicated study. The technical complexity can paradoxically attract students to mastering the expertise – especially those who want to get rich quick and discover hidden formulae of doing so. A core part of public economy, taxation, is hardly taught at all, except as a cost to business. The vast benefits taxes provide to ensure smooth finance and markets is completely ignored (Murphy 2015; Tax Justice Network 2015). The impression given is that anything that is private is good, and anything that is public is bad. Above all, business schools believe that firms are right to be greedy profiteers and selfish. If such selfishness leads to the acquisition of influence and power, so be it, but here in the business school, we will repeat the mantra that the success has been achieved purely through merit and ability. Individualism and utilitarianism have become the ethic of business education, sadly.

Much more disturbing is the growing awareness that the very ideas of neo-liberalism are fraudulent (Whyte and Wiegratz 2016). There are immense and rising contradictions denied by contemporary finance research. The phrase ‘efficient markets’ disguises market failure. Free markets need public bailouts. Perfect competition is replaced by the reality of giant multi-nationals and monopolies or oligopolies. Individualism leads to egoism and hubris, and instead of creating happiness, often leads to cultural and social breakdown, insecurity and mental health crises. Materialism has led to emotional and cultural bankruptcy. Instead of markets being a source of fair distribution of wealth, we are cultivating an increasingly unequal world. We will see in this book that HBOS had a long history and played an active part in the communities in which it operated. All this was destroyed very quickly by a neo-liberal ethic and mind-set, with no punishment for the leaders or compensation for the sufferers. We cannot analyse this case without examining the ideology that underpinned the hubris and lack of moral, professional and regulatory restraint.

Nature of Money and Finance

At root, money is a social construct – it is created by society to facilitate exchange, saving and investment (Simmel 1978; Graeber 2013). Economists have forgotten this abstraction and virtually denied its impact on society and the environment for decades. Instead, finance scholars treat money as an objective fact. There is a ‘fallacy of misplaced concreteness’ which has come to prevail, with devastating consequences for society (Daly and Cobb 1994). The symbol has come to dominate the reality – what is a symbol of value has become value in itself. As the subject and practice of finance is the management of money and wealth, the discipline is a further abstraction from the reality (Kay 2011), as its focus is on the accumulation of the symbol that is money. Furthermore, instead of selfishness being a theory, it becomes reality through the teaching of finance in business schools. The silos and complexity of finance teaching are used to disguise the abstractions of money. Paradoxically, the more finance is critiqued, the more academics have dived into their theories and boundaries, digging an even deeper hole for wider society (Kay 2015; Das 2011). The power and politics of the finance academy itself are not subject to independent research scrutiny. Mackenzie (2006) has proven that the academy is an engine, not a camera – it has a direct influence on products and markets. Fundamentally, the value of money is derived from public confidence, trust and responsible economic management. By making money, prices and values the ultimate reality, and at the same time ignoring ethics like honesty, trust and contentment, finance connives in the disruption of society. When we look at and examine HBOS in detail, we will see the hubris executives had about their power over society, and the total ignorance of the fundamental nature of money and wealth. As in the collapse of RBS (Fraser 2015), they were able to destroy thousands of jobs and billions of pounds in the space of a few years, and get away totally unpunished.

What is most surprising is that people and networks are at the heart of finance – yet there is a virtual silence about this in the mainstream literature both in finance and in accounting. People are not perfect: they can be selfish and conflicted, and they may miscalculate risk or be driven to ignore certain aspects of risk while the going is good. Their actions can be very subjective and influential. Power and status can get into people’s heads, and the kick of doing a deal, or becoming the biggest, or winning a war with a competitor can drive financial decisions emotionally rather than rationally – tendencies of psychopaths (Hare 1996; Kets de Vries 2012). Where challenge is weak, finance leaders can start believing in their own Midas touch and consider themselves infallible (see the story of Lehman Brothers in McDonald and Robinson 2009). Hubris often leads to irrational decision-making, influencing whole institutions and markets. Collusions or networks of people can undermine a whole market, as happened in the case of LIBOR and FX, but no finance text discusses the dangers of these. Instead the ideology of efficient markets drives the science and the theories.

Fiction and Financialisation

Some strongly argue that the modern industry of finance is a powerful fiction – where even the objective treatment of money and measurement is fictitious. For example, ‘The Keiser Report’ is a popular RT (Russia Today) media-sponsored YouTube series fronted by Max Keiser and Stacy Herbert which regularly exposes the fictions using a mixture of analysis and humour. Modern money is a fiat currency, no longer backed by gold but instead by state power and manipulation, and the price and value of assets is relative with little understanding of absolutes. Markets are regularly exploited and undermined by powerful interests. Instead of spreading equality of access to finance, fairness in pricing and practices, democratic values and open competition (Hawken 1994; Kay 2015; Das 2011), the focus is on what they can get away with, and how quickly – society and the environment are far from the horizons. Instead of truth, trust and honesty, its lies, mistrust and fraud have become the norms. Even after the huge public outcry over the 2008 Global Financial Crash, bankers continued to deceive and manipulate in the foreign currency, rate fixing and stock and commodities markets. This proves that it was the culture which needed changing. The values of assets seem to be determined more by the perceptions that can be created about future potential than the risks and uncertainties behind their pricing. It is a sad fact that most of the books and studies critical of finance still come from outside the academy (examples include Lewis 2011, 2012, 2014; Das 2011; Kay 2015; C. Ferguson 2012). Even the Academy Award-winning film on the crash, Inside Job, was researched and directed by a non-academic (Ferguson 2010).

One of the biggest developments of the last fifty years is the financialisation of everyday life (Froud et al. 2006; van der Zwan 2014). For a long time in human history, the basic needs were food, shelter and clothing, and these were met outside the monetary economy, through shared vill...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Foreword
• Acknowledgements
• 1. Introduction
• 2. About HBOS
• 3. The Politics of Risk Management
• 4. The Chemistry of Audit Failure
• 5. Regulatory Failure
• 6. Findings and Implications for Finance Teaching and Research
• Bibliography
• Index