Non-Governmental Reform

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While our attention can be temporarily redirected to more pleasant matters, it does not take long to remember that the banking and financial systems are in need of serious reform.

The most recent episode of irresponsible trading in the US was by Knight Capital Group. The Group instituted a new software system with a glitch that led to a loss of over $400 million in less than an hour of trading. The glitch was the result of the software being put into practice before it could be fully tested. The thought was, if this new software could be implemented ahead of the competition, Knight Capital would gain an edge on its competitors. The rush to beat the competition led to a premature, and thus irresponsible, implementation of its new software. There is no evidence of intentional deception or corruption as was the case with Barclay's, Enron, or MF Global; but it was irresponsible.

Nevertheless, reform does not mean government-led or government-mandated action. Government oversight and intervention are not the answer; a restructuring of how companies operate and reward their employees is. Government reform is always fighting the previous battle. Reforming the way companies operate is the only real response.

The recommendations I make are necessary but not sufficient. I make them not only in consideration of my work as a political theorist and ethicist but also as a result of my experiences as a small business owner who struggles with how to balance profit, ethics, and the law while keeping his employees focused on doing the right thing as they make money.

As long as monetary gain is the motive there will always be corruption and irresponsible behavior, simply because the acquisition of money is not the simple effect of responsible or ethical behavior. We cannot eliminate money or profit. It would be equally foolhardy to think government regulations will do the trick. Whatever restrictions are passed, someone will be waiting to figure out a way around them. But there are three organizational modifications that businesses can make that will help curb abuse and irresponsible behavior. Of course nothing will prevent this sort of behavior entirely, and modifications will always need to be made to keep up with changing times, but what I outline will avoid the false assumptions of government regulation.

First, those in charge of carrying out a company's day-to-day operations should be different from those in charge of managing profit margins. For instance, if a salesperson at a car dealership earns a commission on the cars she sells, she will have no immediate incentive to be honest or fair with the customer. Her goal will be to sell cars at the highest possible price. The same holds true for financial planners. If a planner has to choose between two investments for a client, one that will earn him a higher commission even though it's not the best option for the client, he will be inclined to do so. To say or expect otherwise is naive. Similarly, if those in charge of developing investment software for Knight Capital (not those whose salaries were tied to successful trades) were also in charge of deciding when it was fit to implement, the outcome could have been different. A software engineer making a fixed sum, whose future income will depend on the quality of the software, will have more of an incentive to get it right.

Second, there needs to be transparency. When a firm makes fundamental alterations to business practices or operating procedures, the changes must be submitted to the company's board for approval and made known to all customers and investors whom the changes may affect. Not only will this provide an opportunity for internal checks to keep bad business practices from being put into action but it will make poorly conceived or unethical plans less likely to be presented in the first place. If I know that the changes I make will be open to scrutiny I will be much less likely to act badly.

The third recommendation is delay. When delay procedures are institutionalized, time is available to evaluate any changes in policy or procedure. For instance, if Knight Capital had had a mandatory 90-day evaluation period for any software changes there is a good chance that the most recent fiasco could have been avoided, which would have saved the firm and its investors a lot of money. The SEC already recognizes the benefit of delay, which is why it stops trading whenever a stock drops too drastically in too short of a time. When people are given pause, cooler heads usually prevail.

The recommendations I outline are not a cure-all, but they tap into fundamental issues that must be addressed if any worthwhile reform is to be implemented. Current reform efforts require outside regulation that is generally too slow to adapt and is too easily circumvented. If, however, we change the way companies do business by taking into account how people make decisions, we will be off to a better start.




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Comments

Fred Mora

Mr Scott,

You offer three "solutions" that, unfortunately, have more drawbacks than the problems they want to solve.

Your idea of a mandatory delay before any change is based on an incorrect assumption. Knight Capital's errant software was actually running in test mode because of a human error. Ironically, its bad behavior was attributable to too much test code, not lack of test. A delay wouldn't have changed anything.

Besides, I'd like you to imagine life if financial software had to be frozen for 3 months before any change. A 0-day vulnerability in your bank's web site? No problem, we'll release the fix in 3 months. Meanwhile, gangsters will have a field day emptying all accounts.

As for transparency, this is very hard in many sectors. A successful product launch is basically a conspiracy against competition. Announce your plans and you'll get shot, pre-empted, or fall victim of copycats.

Finally, you want to isolate operation from financial returns. This model already exists, it's called a non-profit. Now, there are very nice non-profits, but the worst abuses you will ever see in accounting ledgers will also be found at non-profits. An orphanage that spends more on executive salaries than on orphan? Check. A charity that distributes only 5% of its donations to intended recipients? Check. What about an institution to help the poor that leases high-end sport cars for its executives? Check. Check the news archives, you'll see these scandals and more. Looking at some non-profits can make you lose faith in mankind. This is possible because nobody in charge of the books is watching the execs. And you want to unleash that model onto corporate America? Good grief!

Kyle Scott

I believe that if you read the entire piece you will see my claim at the beginning and the end that I do not think I have solved anything but offer only recommendations to be considered. I do not have the conceit of certainty. But let me address your points in order.

1.) Delay. The scenario you portray is a possibility, but the delay I am addressing is not in terms of security concerns but voluntary modifications. So I don't see how raising a problem I don't intend to address is a problem with the proposal. If I had written something on security then perhaps your objection would be well placed.

2.) Transparency. To quote, "this is very hard in many sectors." Just because it's hard doesn't mean it can't be done and it certainly doesn't mean it shouldn't be done.

3.) Non-profit. You again have changed the subject and create a scenario which I never proposed. But, I'll try to explain my point again with the hope of generating some clarity. Imagine a car dealership. At most dealerships the salesman gets paid a percentage of the down payment as his/her commission. They are motivated to sell a car for as much as possible to as many people as possible. But some customers may not qualify for a specific car due to lack of income, poor credit, etc. To let a salesman decide the quality of the customer would be a terrible idea, this is why there are F&I managers. If salesmen were allowed to roll anyone with a down payment the dealership would go broke. This has nothing to do with non-profit and everything to do with a good management structure and business plan.

Visitor

I think the primary problem with financial institution's failures have a great deal to do with the consumers of the products.

It's not even to the "buyer beware" level. It's just basic "If it's too good to be true..." and "do your homework".

Investors have come to expect large returns, with little risks. This is an impossiblity. Of course, in reality, the consumer has every reason to expect little risk. Because they should have every expectation that the taxpayer will be forced to step in and make them whole in case of their poor decisions.

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