Banking StandardsWritten evidence from Dr Timothy Johnson

Summary

Certain aspects of banking (and asset management) should be made “regulated professions” by creating a statutory requirement that its participants become members of a recognised professional body, in addition to being regulated by statutory bodies.

This is the situation with, for example, The Law Society/Legal Services Board; Royal Colleges in medicine/General Medical Council; Institute and Faculty of Actuaries and chartered and the recognised institutes in accountancy/the various bodies making up the Financial Reporting Council.

Derivative markets are unnecessarily opaque, preventing oversight by civil society. This can be mitigated by changing public perceptions so that banking is regarded as having foundations in science and engaged with on the same basis as, for example, the technically complex energy or pharmaceutical, industries.

Before 1850 there was a history of very close interaction between science and finance, this re-emerged in the 1950s, but outwith the context of a strong profession.

It would be remarkable if standards in conventional STEM (Science, Technology, Engineering, Mathematics) based professions, such as chemical engineering, were seen as being susceptible to issues of globalisation, innovation, technology or regulatory arbitrage.

Since 2010 we have experienced the Deepwater Horizon and Fukushima Daiichi disasters. In July 2012 GlaxoSmithKline was fined $3 billion in relation to drug promotional practices between 1997 and 2010. There seems to have been closure by the general public on these significant events, something that has not occurred in banking.

Brief Responses to Specific Questions

1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets?

Professional standards, both in the sense of ethics and skills, are lacking in UK banking because it is not a recognisable profession, in the same way that law, medicine, accountancy, actuarial science and engineering are.

See B.7—B.10 and B.25—B.27.

The historic experience is covered in Section A.

4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider (a) the following general themes:

the culture of banking, including the incentivisation of risk-taking;

There was a change in banking culture as virtue ethics were superseded by consequentialist/utilitarian ethics after the 1830s. In this respect banking has followed an exogenous change in culture, and I highlight Buttle v Saunders in 1950 as indicative of this.

See A.21—A.26.

the impact of globalisation on standards and culture;

I do not regard globalisation as being a significant driver in degradation of standards. Finance has always been a global phenomenon and the global derivatives markets in 1910 were not too different to the contemporary markets. The difference between 1910 and 2010 is that the tradition of “my word is my bond” seems to have been replaced by “greed is good” and I identify this with a replacement of virtue ethics by utilitarianism.

The character of Antonio in Shakespeare’s The Merchant of Venice, who was engaged in international trade, can be seen as a personification of the virtue caritas/agape. Shylock was not greedy, he would not take money, but hateful.

The global economy was tightly controlled by a few powerful governments between 1914 and the collapse of Bretton-Woods in 1972. Following the “Nixon shock” of 1972 the world has become more stochastic (random), not simply more interconnected, and in response to these changes the derivative markets re-emerged.

See A.21—A.35.

global regulatory arbitrage;

I make no comment on global regulatory arbitrage, however I do note that the plethora of qualifications acceptable to the FSA leads to the possibility of regulatory arbitrage, by selecting the “easiest” qualification to enable a person to engage in an activity. This situation would be mitigated by the existence of a regulated professional body.

See B.12.

the impact of financial innovation on standards and culture;

I do not regard financial innovation, in and of itself, as having an impact on standards or culture. Twice in the history of Europe there have been periods of significant financial innovation, in the “long twelfth century” and in the second part of the seventeenth century. During both periods science and mathematics developed in the context of developing an ethical assessment of these innovations. These are often overlooked episodes in the history of science and I bring them to the Commission’s attention.

See A.1—A.20 and A.27—A.34.

the impact of technological developments on standards and culture;

The relationship between technology and culture is a question of general interest, but complex and not widely discussed. I argue that if finance is regarded as a “STEM” based discipline, in the same way that industries such as energy or bio-technology are, it would transform finance from a hidden, “magical”, discipline into one that is subject of public debate and discussion, just as the energy and bio-technology are.

See B.13—B.22.

and (b) weaknesses in the following somewhat more specific areas:

recruitment and retention;

other areas not included above.

There are concerns amongst academics that there are the technical skills in depth within banking to support the pricing and risk management of the products being traded, they are not present in breadth. Expertise is concentrated in small, often isolated, groups within the industry.

This has a direct impact on remuneration, grossly inflating the pay of a few with specialist skills. Furthermore this problem is compounded in society in general, to the extent that there is no effective oversight of the markets by civil society.

See A.36—A.54 and B.14—B.25.

5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?

Many of the weaknesses of concern to the Parliamentary Commission on Banking Standards are a consequence of the lack of a strong profession underpinning the industry. The creation of a strong profession cannot be accomplished by fiat but it can be facilitated by legislation and Parliamentary action.

No comment on current international regulatory issues is made, apart from noting the influence the UK has by having strong professional bodies across a range of disciplines.

See B.8—B.22.

6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government’s proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.

The Financial Services Bill and Banking Reform Bill (on the assumption it focuses on structures) do not address the issue of establishing a strong banking profession.

However, the experience from other fields clearly indicates that it is useful to distinguish the regulator and the professional body.

See B.26—B.29.

The Historic Experience

A.1. Many of the financial products that emerged in the late twentieth century would have been recognisable to merchants operating before the seventeenth century.

A.2. To avoid accusations of usury all financial products during the middle ages had to be asset backed and/or involve risk. Usury derives from the Latin usus meaning “use”, and referred to the charging of a fee for the use of money. Interest comes from the Latin interesse, and originated in the Roman legal codes as the compensation someone was paid if they suffered a loss as a result of a contract being broken [Homer & Sylla p 73].

A.3. In light of these restrictions, the basic financial instrument in the medieval period was the census which today would be described as an asset-backed structured product. Censii originated when Carolingian monasteries guaranteed donors a fixed regular income in exchange for a bequest. These contracts developed such that a borrower would receive a lump sum secured against the future cashflow from an asset, rente à prix d’argent. Since the payment stream from the assets underlying a census was uncertain but the loan repayments were usually fixed, there would be an implicit swap involved in the contract.

A.4. Censii were written on the back of assets as diverse as an estate or a craftsman’s labour. Censii evolved into prestati, which were forced municipal bonds that funded the growth of medieval Italian cities.

A.5. The triple, or German, contract (contractus trinus) was developed to fund long distance trade. It involved a loan to fund the venture (the first contract), a swap to transform the variable return of the venture into fixed cashflow (the second contract), and an insurance contract to guarantee the fixed payment (the third contract). The third contract is equivalent to a modern Credit Default Swap. This contract was declared illicit on the basis that the lender received a riskless return [Detestabilia avarita, Pope Sixtus V, 1586].

A.6. Collateralisation, amalgamating loans into a different “tranches” with different risk profiles and then selling off shares in the tranches was practiced in the sixteenth century [Poitras p 269].

A.7. In conjunction with innovations in finance, Fibonacci introduced Islamic mathematical techniques into Europe in the Liber Abaci of 1202. The impact of the Liber was profound and long lasting. The techniques described in the Liber enabled merchants to record, disseminate and improve techniques for managing their affairs. It laid the basis of the “mathematisation of science” in the seventeenth century [Hadden, Kaye, Crosby], mathematicians trained by the text include Copernicus, who wrote on money before he wrote on planets, and Stevin, the tax official who anticipated many of Galileo’s observations and laid the foundations for Descartes’ Discourse on the Method.

A.8. Financial practice became a subject of scholastic enquiry was another stimulus in the “mathematisation of science” and the development of probability theory. The motivation was the assessment of contemporary mercantile practice in the context of Aristotle’s Nicomachean Ethics. Notable early contributions come from the Dominicans Albert the Great, Thomas Aquinas and the leader of the Spiritual Franciscans, Pierre Jean Olivi, followed by the proto-physicists Thomas Bradwardine, Jean Buridan and Nicole Oresme. [Hadden, Kaye, Franklin]

A.9. Medieval morality was built on what are now called virtue ethics, the blending of the four cardinal virtues, described in Nicomachean Ethics, fortitude, justice, prudence (from Latin prūdentia foresight, practical understanding) and temperance (from the Latin temperāre to divide or proportion duly, to mingle in due proportion, to combine properly), and the three Christian virtues of faith (from Latin fīdĕre to trust), hope (in Latin spes) and charity (in Latin carità , related to the Greek ἀγάπη “to treat with affectionate regard”). The blending of the virtues (temperance) acted as a focus for discussion of motives and moral character, moral education, moral judgement, friendship and family relationships, the concept of happiness, the role of the emotions in morality and the fundamentally important questions of what sort of person one should be and how we should live. Chinese morality was traditionally based on a similar system of virtue ethics.

A.10. In the mid sixteenth century Cardano undertook the first mathematical analysis of probability while investigating the ethics of gambling [Bellhouse]. He observed, in relation to his analysis, that “These facts contribute a great deal to understanding but hardly anything to practical play” but that “a just gamble is one between willing and knowledgeable players”, and mathematics provided the scientific basis of a just gamble. A century later Pascal and Fermat, Huygens and J. Bernoulli laid the canonical foundations of mathematical probability in the context of commercial ethics [Sylla, Sylla].

A.11. Contemporary with Cardano, Thomas Gresham, the Factor to the English Crown in Antwerp, manipulated the market in Bills of Exchange to ensure Elizabeth I could borrow at low rates. Gresham created the Royal Exchange in 1565 and bequeathed money to establish Gresham’s College and the first chair in mathematics in the UK, laying the foundations for the Royal Society.

A.12. Shakespeare’s The Merchant of Venice, probably written between 1596 and 1598, can be seen as a commentary on the four forms of love (storge, philia, eros, agape) that highlights the agape (caritas) of Antonio, The Merchant of Venice. When C. Huygens was translating the first mathematical text on probability, On Reckoning in Games of Chance (1657), into Latin, Huygens considers using the terms expectatio (from Latin expectāre to look out for, await) or spes, usually associated with the virtue hope, for what is now known in English as mathematical expectation. The French chose spes and use esperance rather than expectation in mathematics.

A.13. The modern English financial markets emerged during the Nine Years War (1688–1697) along with the establishment of the Bank of England. The historian Anne Murphy [Murphy] estimates that 40% of trade at this time was in options on underlying stocks.

A.14. In response to rampant counterfeiting, in 1696 Parliament instigated the Great Recoinage, precipitating economic collapse. In the same year Isaac Newton was appointed to the Royal Mint, abandoning the Lucasian Chair in Mathematics at Cambridge in 1701 (the salary of the Warden of the Mint was sixteen times that of the Lucasian chair). Newton would oversee the fixing of the gold-silver exchange rate 1717, an exchange rate that would shift Britain from the silver standard to the gold standard. In acknowledging Newton’s achievements at the Mint, John Maynard Keynes would describe Newton as “one of the greatest and most efficient of our civil servants”.

A.15. In 1709 Daniel Defoe wrote about Lady Credit, the coy mistress,

for as once to want her, is entirely to lose her; so once to be free from Need of her, is absolutely to posses her. [de Goede p29 quoting Defoe, 1709]

However speculators had raped her

The first Violence they committed was downright Rape … these new-fashion’d thieves seiz’d upon her, took her Prisoner, toss’d her in a Blanket, ravish’d her, and in short us’d her barbarously, and had almost murther’d her [de Goede p34 quoting Defoe, 1709]]

Ten years later Defoe wrote The Anatomy of Exchange Alley in which he described stockjobbing as

a trade founded in fraud, born of deceit, and nourished by trick, cheat, wheedle, forgeries, falsehoods, and all sorts of delusions; coining false news, this way good, this way bad; whispering imaginary terrors, frights hopes, expectations, and then preying upon the weakness of those whose imaginations they have wrought upon [quoted in p Poitras p 290]

Elsewhere, Defoe wrote that “mathematicians might cure the reckless of their passion for cards and dice with a strong dose of calculation” [Gigerenzer p 19].

A.16. In 1720 the future Poet Laureate, Colley Cibber, wrote the play The Refusal, “Refusal” being a common term for an option contract at the time, describing the action in Exchange Alley

There you’ll see a duke dangling after a director; here a peer and `prentice haggling for an eighth; there a Jew and a parson making up the differences; there a young woman of quality buying bears off a Quaker; and there an old one selling refusals to a lieutenant of grenadiers [Ackroyd p 308]

The inference is that in 1720 the public were familiar with the trading of derivatives, pretty much everyone was involved, and social, religious and political differences were forgotten in the markets.

A.17. 1720 saw the bubbles around the Mississippi Scheme in France and the British South Sea Company burst. There were differences in how the French and British states responded to the crisis. In France, the main protagonists went unpunished; John Law, the Scottish banker was allowed to leave the country by the Regent, who died shortly after, while D’Argenson, the Chancellor, was allowed to retire to the country. While convenient, this response was unpopular; there were riots at D’Argenson’s funeral in Paris while John Law was given the epitaph (translated from the French)

Here is that famous Scot
This calculator without equal
Who, by the rules of algebra
Put France in the hospital.

In Britain, there was more action than in France. The Directors of the South Sea Company were punished by Parliament, typically with fines, with the observation about one Director being “His well-known abilities could not plead the excuse of ignorance or error”. A more profound change came in the re-structuring of the Government and the establishment of Walpole as Prime Minister. Over the next century the British Government was much better able to fund the wars it fought with France, and British entrepreneurs were much better able to fund innovation than their French counterparts.

A.18. Between 1740–1746 a pair of Church of Scotland Ministers aided by Britain’s most prominent mathematician of the time, Colin Mclaurin, created the first ever mathematically managed pension fund, the Scottish Ministers’ Widows’ Fund. In one sense this was a synthesis of statistics, probability and finance. However, the Presbyterian ministers may have seen it as a demonstration of faith in statistics, hope in probability and charity, in the care for ministers’ widows.

A.19. In the second half of the eighteenth century Quakers became dominant in English banking (laying the foundations of Barclays and Lloyds). Their success is often put down to their absolute honesty (a blending of the virtues of fortitude, justice and faith), respect for others (caritas) and an advocacy of education and innovation (prudence, faith, fortitude and hope).

A.20. In the hundred years after the emergence of the financial markets in the 1690s, Parliament would enact various laws to hobble the excesses of the markets, in 1697, 1720 (the Bubble Act), 1733 (Barnard’s Act, which restricted options trading) 1746, 1756, 1762 and 1773. All the Acts, as the 1697 Act stated, were broadly designed to “Restrain the number and ill Practice of Brokers and stock-jobbers”. The fact that a new Act appeared every decade is a testament to their ineffectiveness.

A.21. Ethics is today divided into three main classes, virtue ethics, consequentialism or utilitarianism and deontology. Consequentialism maintains that an act is morally right if and only if that act causes “the greatest happiness for the greatest number”, while deontology is ethics based on obligations or rules. For example, the different ethical systems would address the question of helping someone in need in different ways: The consequence of helping someone will maximise overall well-being, helping someone is following a rules such as “Do unto others as you would be done by” or helping someone is a demonstration of charity.

A.22. In the second half of the eighteenth and first half of the nineteenth century virtue ethics went into a decline. It was overshadowed by both consequentialism and deontology, based on the view that these two systems were superior because they enabled morality to be codified into a set of clear rules and principles. This view is associated with Analytic Philosophy, which places emphasis on formal logic and clarity, as opposed to “Continental Philosophy”, which places more emphasis on the contingency of experience, and relativism in morality. Analytic Philosophy has dominated the English speaking world over the last century, particularly in the form of Logical Positivism in science in general and advocated by Milton Friedman and Paul Samuelson in economics.

A.23. As virtue ethics became overshadowed, the virtues became re-defined. Fortitude was replaced by courage, or bravery, temperance, becomes abstinence, charity becomes giving, while the sin sloth, what we would now describe as depression and was counterbalanced by hope, becomes laziness and characterised the undeserving poor. Virtue ethics re-emerged in the late 1950s with G. E. M. Anscombe’s paper Modern Moral Philosophy and is becoming an important topic in business, with The Journal of Business Ethics preparing a special edition on virtue ethics and Deidre McCloskey’s recent advocacy in The Bourgeois Virtues.

A.24. Consequentialism, or Utilitarianism, has been closely associated with neo-classical economics since its emergence in the early nineteenth century. John Stuart Mill, who along with Bentham and Sedgewick is associated with the emergence of the philosophy, argued that

[Political economy] … is concerned with him solely as a being who desires to possess wealth, and who is capable of judging the comparative efficacy of means for obtaining that end. ... [It presupposes] an arbitrary definition of man, as a being who inevitably does that by which he may obtain the greatest amount of necessaries, conveniences, and luxuries, with the smallest quantity of labour and physical self-denial with which they can be obtained. [Mill , On the Definition of Political Economy, and on the Method of Investigation Proper to It, Paras. 38 and 46].

Mill’s approach resonates with Tennyson’s “nature red in tooth and claw” and Darwinian metaphors of survival of the fittest. Alfred Marshall would complete the synthesis of economic and Darwinian ideas in the late nineteenth century. [Backhouse, Thomas].

A.25. The ascendancy of these theories coincides with the decline in the public perception of bankers. This was personified in the collapse of the bank Overend, Gurney and Company. Established in 1800 and run for most of the early 1800s by the prominent Quaker Samuel Gurney, it rescued banks in the crisis of 1825 and became known as the “bankers’ bank”. After Samuel Gurney’s retirement the bank transferred its capital from being primarily in liquid assets, such as cash, into investments in railways and other long term projects, which appeared to offer better returns. However this strategy exposed the bank to a liquidity crisis that it resolved by issuing equities into a buoyant stock market in 1864–1865. However in 1866 the railway bubble collapsed, bringing down the bank.

A.26. A watershed in the ascendency of consequentialism in England is the case Buttle v Saunders [(1950), 2 All ER 193]. Saunders managed a trust for Buttle, and had agreed to sell a piece of land owned by the trust for £6,142 to a Mrs Simpson. Before the transaction had become legally binding, another person offered the trust £6,400 for the land. However, Saunders believed “my word is my bond” and declined the higher offer in favour of the original agreement with Mrs Simpson. The beneficiary of the trust, Buttle, took Saunders to court, and the court ruled in favour of Buttle

The only consideration which was present to [the trustees] minds was that they had gone so far in the negotiations with Mrs Simpson that they could not properly, from the point of view of commercial morality, resile from those negotiations.

The Court ruled that “commercial morality” had no place in financial transactions, which should be governed by the utilitarian principle.

A.27. Alongside these theoretical developments, gambling became illegitimate. The 1774 Life Assurance Act outlawed many practices associated with insurance that are now considered to be wagers and established the concept of an “insurable interest”. In 1808 there was a House of Commons Select Committee that investigated the “evils of gambling” and this lead (slowly) to the suspension of lotteries as a form of public funding in 1823 (the last draw being in 1826). In 1845 there was a Gambling Act and this lead to the case of Grizewood v Blane [(1851) 11 C.B. 526] in 1851 where Blane’s successful defence for non delivery on a forward contract was on the basis that derivative contracts were wagers, and so illegal.

A.28. From this point on, derivatives existed in a nether world, they were regarded as licit if written on an physical commodity that might be delivered on execution, but “contracts for difference”, where cash would change hands contingent on the prices of assets, were not protected by law. This situation was similar to the differentiation of usury and interest in the medieval period.

A.29. Despite this legal ambiguity derivative contracts were widely traded. By the first decade of the twentieth century they were becoming the subject of academic interest, not just in Bachelier s well - known thesis but also in the work of the Croatian Vincent Bronzin, and of popular discussion, such as Samuel Nelson’s 1904 book The ABC of Options and Arbitrage. Samuel’s book describes the global interaction (incorporating Berlin, Paris, London and New York) between financial practice (exploiting arbitrage in both commodity and financial markets), mathematical theory (which was less important to American’s like Nelson than Europeans) and technology (the practices relied on fast telegraphic communications).

A.30. The markets closed on the eve of the First World War, and while speculation on currency options in the US was popular in the years after the peace, the markets did not recover in Europe before the Great Depression and then the Second World War. Bretton Woods re-established fixed exchange rates in 1944 which held for at least a decade. Currency speculation increased in the 1960s as the 1944 world-order changed as the US paid to fight in Vietnam as the German and Japanese economies went into overdrive.

A.31. Bretton-Woods collapsed in 1972; this had an immediate impact on interest-rates. In the 27 years between 1945 and autumn 1972, the Bank of England changed its lending rate 43 times, in the 27 years after 1972, it changed them 223 times, about every 45 days. A key economic factor had gone from being fairly stable to being a random process. Similarly, as the US dollar fell in value, price setting mechanisms in commodities, notably oil, collapsed.

A.32. It was in response to these geo-political changes that derivatives re-emerged in financial markets. It is simplistic to claim that derivatives emerged either as mechanism for financiers to access profit opportunities or in response to academic developments. Derivatives were a natural, in the sense that they were not invented but re-introduced, solution to a fundamental change in the economy, switching from a broadly deterministic system into a random one. This point is often missed even by the majority of British mathematicians who do not have a firm grounding in probability theory.

A.33. Care should be taken in comparing regulatory frameworks that were successful between 1930 and 1972 with what is desirable now. This is because the economic environment between the Great Depression and the Nixon Shock was somewhat benign, with state control of key indicators. To appreciate this, observe that it is easier to manage a baby before it becomes mobile, you can safely leave a 3-month old in the middle of a double bed for a few minutes, you could not do the same with a 9 month old.

A.34. Similarly one should be aware that much economic theory was laid down in the century after 1820 when science treated uncertainty as a lack of information (characterised by Laplace’s Demon) rather than a fundamental feature of life that would drive the economy. This is not just true of neo-classical economics but also of Marxism. The exception to this was aspects of Austrian economics (Schumpeter), American Institutionalism (Knight) and Keynesian economics which all placed uncertainty at the heart of economics. Derivatives are a pragmatic solution to dealing with randomness in the economy, and many would argue that randomness is a fundamentally important aspect of growth generation.

A.35. A few years after Buttle and Saunders, Milton Friedman published the Methodology of Positive Economics, arguing that economics should be an “‘objective’ science, in precisely the same sense as any of the physical sciences”, an impersonal way of arriving at the objective truth and free from “normative” ethical arguments. This was part of the Mont Pelerin Society’s programme that would become famous for providing the intellectual foundations for US and UK economic policies in the 1980s.

A.36. This coincided with a period when economics was transforming from a broadly qualitative science, as it had been in 1925, into a quantitative one. This process was accelerated by the experience of policy makers in the Second World War. The influence of mathematical sciences in winning the war was significant (eg radar, logistics/operations research, code-breaking) and was a common feature of the US, UK and USSR. Before 1935 it would have been unusual for a general to support the use of mathematics in warfare, by the end of the war, General Eisenhower was calling for more scientists to support the military [Schrader p 64]. Significant areas of contemporary financial economics have their foundations in the interface of mathematics and the military (eg quadratic programming in portfolio optimisation, the use of stochastic processes and stochastic control).

A.37. While economics adopted the formalism of mathematics, mathematicians have often been sceptical about how economists were using the discipline. In 1947 the economist Paul Samuelson published Foundations of Economic Analysis, which laid out the mathematics needed to understand economics. The mathematician John von Neumann was invited to write a review of Foundations but declined because “one would think the book about contemporary with Newton” Von Neumann, like many mathematicians who looked at economics, believed economics needed better maths than it was being offered [Mirowski, p 134].

A.38. In 1948 Samuelson published the first edition of his most famous work, Economics: An Introductory Analysis, which was the first successful description of Keynesian economics, as opposed to Freidman’s monetarism, to a U.S. audience and is probably the most influential economics textbook ever written.

A.39. Together, Friedman and Samuelsson encapsulate mainstream, neo-classical, economics, which is a positive and mathematical science, in accordance with the requirements of Analytic Philosophy.

A.40. However, many mathematicians are concerned as to the use mathematics is put to in describing economics and financial markets. This was the central thrust of the opinions included in a submission from the leading Professors in Financial Mathematics for the Science Minister (Lord Drayson) on 2 March 2009. The failures in finance were a consequence of an abuse of mathematics rather than its use in finance. One episode reported in the submission concerned a mathematician who was involved a discussion of banking regulation, and was dismayed to find the discussion focused on the legal meaning of the statements in Basel II, not a discussion of the robustness of the mathematical models being proposed.

A.41. The Turner Review of 2009 highlighted the shortcomings of the quantitative technique known as Value at Risk (VaR). VaR had come in for severe criticism from mathematicians in 1999 [Artzner et al .] and the whole approach being taken by regulators was criticised by an alliance of mathematicians and finance academics [Danielson et al .].

A.42. Another mathematical object that featured in the Basel regulations was the “Vasicek single factor model of portfolio credit loss” (which is related to “The formula that killed Wall Street“). While parts of the methodology, which was developed by a private firm, were published and well understood, there were significant gaps in the theory. In response, in 2003 a mathematician employed by the U.S. Federal Reserve [Gordy], looked at the approach to see if, mathematically, it did what it claimed to do. Gordy concluded that the formulae in the proposal to revise the Basel accord would do what they claimed to do and were a rational extension of the existing system. However, he also raised the question, were these revisions actually up to the task presented by modern finance.

A.43. Modern probability theory was championed in the US by William Feller and Joseph Doob in the years after the Second World War. In a presentation of the theory to fellow mathematicians, Feller considers how economists might use the theory by making the point that

Any [random] process defined by a system of differential equations ... with constant coefficients will be ... ergodic” [First Berkeley Symposium on Mathematical Statistics and Probability p 417]

ie to say a system is ergodic is to say it is based on unchanging parameters. Ergodic systems can be random, but random in a stationary way (as a coin toss or dice roll is).

A.44. Feller immediately goes on to discuss the implications of ergodicity in economics with reference to Pareto’s theory on income distribution. Feller finishes this discussion with the observation that

if the [ergodic] hypothesis should prove false, this would not disprove Pareto’s claim, but at least it would produce doubts in certain respects.

From the perspective of mathematics, ergodicity is helpful in simplifying things, but it is not a requirement, and furthermore, non-ergodic systems are more interesting to mathematical researchers.

A.45. The implication is that if economics is going to address difficult issues it should not (must not) confine itself to ergodic systems, and there is a strong case for economics not to rely on simple maths but to drive the development of maths (as it has historically) (Non-ergodic systems are important in the physical sciences, particularly in signal processing, and are well studied.).

A.46. The question why is mathematics important is often answered circularly—because it is important in a modern, knowledge based economy. It is sometimes difficult to find an explanation as to why mathematics is important in a modern, knowledge based economy.

A.47. The role of mathematics in science is to provide proof were experimentation is not available. This point was first made by Henri Poincare [The Value of Science, pp 184–185] and explains why mathematics is important in many branches of physics, such as astrophysics or in identifying the Higgs Boson, which was a mathematical object up until it is discovered(?) by expensive machinery. This is the origin of the observation that mathematics is rarely useful, because it operates at the frontiers of knowledge where conventional techniques of everyday experience (machines and instruments) are not available.

A.48. Mathematics developed this role because of its properties as a language. Fibonacci’s Liber Abaci was a success because it enabled merchants to record, disseminate and improve techniques for managing their affairs, mathematics is employed in modern science because it similarly enables scientists to summarise and disseminate ideas that can be improved through collaboration. Mathematics is not essential in science, compare Darwin’s development of biology without mathematics with Mendel’s contemporary work employing mathematics, but it facilitates the process and enables collaboration. Mathematics is a social science.

A.49. Just as spoken language evolves, mathematics also changes. Mathematics changes in response to our knowledge; Euclidean geometry is replaced by Riemanian geometry as technology develops outside mathematics.

A.50. Mathematics is essential in finance because it is not possible to experiment in the economy and the economy is too complex to be addressed without collaboration.

A.51. Samuelson is closely associated with using mathematics in economics, in particular the “maximising expected utility” paradigm in economics. This synthesises consequentialist ethics with mathematics and the US economist Prof Deirdre McCloskey describes the approach in the context of virtue ethics as “prudence only”.

A.52. However the use of mathematics in economics relies on a mathematical model. One of the challenges facing modern science is that in the absence of experimental verification there is always doubt and uncertainty about the model employed. The debates about climate change are as much about disagreements over models as over data. Generally in finance and economics, choosing a model chooses the result. Employing mathematics only creates an appearance of objectivity, the choice of model is often subjective and the results of the model are consequently subjective.

A.53. For example, one often hears of “contagion” in relation to financial crises. If the banking system is modelled as one susceptible to contagion the solution will be to create firewalls and concentrate risky activities. This was exemplified by the change in the UK’s meat processing industry since the Foot and Mouth epidemic of 2001: a network of small local abattoirs has been replaced by a handful very large regional abattoirs in order to be better able to contain contagion. If the banking system is modelled as a communication network, with loan agreements taking the place of messages, the solution will be to build a distributed network with many pathways between different nodes. The Internet, designed by the US military as a communications network that would survive a nuclear strike, is a classic example. Hence, modelling banking as a system subject to contagion would suggest a banking system of a few large, well protected banks, whereas modelling it as a communication network will result in a system of lots of small banks, none too big to fail. A single network is typically more stable than smaller networks with a few interconnections between the two, suggesting splitting the banks into retail and wholesale institutions might not be optimal. This is one example of the scientific minefield that policy-makers must navigate.

A.54. The Government’s Scientific Advisers should be assisting policy makers in navigating the modelling landscape, it is not obvious that the Treasury s Chief Scientific Adviser is in a position to do this.

B. Regulating the Markets

B.1. The Parliamentary Commission on Banking Standards has been set up in response to the LIBOR setting crisis, an episode of widely accepted dishonesty, in the context of on-going financial turmoil. The theme of ethics figured prominently in The National Commission on the Causes of the Financial and Economic Crisis in the United States, which concluded that “there was a systemic breakdown in accountability and ethics” in the financial markets leading to the crisis of 2007–2009. A key aspect of professional standards is professional ethics.

B.2. Addressing ethical issues can be done in one of three main ways, through consequentialism, deontology or virtue ethics (see A.9, A.21—A.23).

B.3. Consequentialism and deontology have proved popular over the past century because they appear to be amenable to codification. However the successive failures of financial regulation, going back to 1697, suggest that deontology is ineffective. Similarly, consequentialism suffers from the problem that the model determines the answer, how the benefit is calculated is usually a subjective judgement (see A.50—A.51).

B.4. From the perspective of deontological ethics, LIBOR fixing might not be considered immoral, since there was no rule or clear obligation being breached—LIBOR is not a statutory instrument. Similarly a consequentialist might argue that underreporting LIBOR was utilitarian during the Crisis. This point was made in a letter from Mr Paul Langtry published by the Financial Times on 9 July 2012 with the observation that

Time is a great healer and things may look better in five or 10 years. Thus I would not blame either the BoE, Barclays or the other bank rate setters. In fact they have probably saved the financial system and capitalism for the foreseeable future.

However the fact that the Parliamentary Review is taking place suggests that the LIBOR underreporting was immoral, and this immorality is captured within virtue ethics as a breach of trust (faith) and a lack of honesty (fortitude, justice and faith).

B.5. The Basel II regulations, as examples of international financial regulatory frameworks, can be seen as combining consequentialism and deontology, setting down rules and obligations that a financial firm needed to follow with the consequence that “market discipline” would punish them if they fell short. Basel II proved a failure as its rules were poorly set and the consequences were illusionary. (see A.41—A.43, A.46)

B.6. This leaves the option of virtue ethics, which is concerned with, amongst other topics, moral character, moral education, moral judgement, relationships, and what sort of person one should be and how we should live. This approach does not lend itself to direct legislation, but rather to the creation of communities with shared cultures (in the sociological sense).

B.7. Virtue ethics, which are associated with the successful development of British finance in the eighteenth century, is closely related to professionalisation. Professional bodies create an ethical framework that extends beyond a specific firm. In the case of established professions, the professional body provides a focus for the interaction between the practice, in industry, and the academic theory. Professional bodies also provide a linkage between society as a whole and the professional practice, in a way that trade bodies cannot.

B.8. The Parliamentary Review is concerned with “professional standards”. This immediately raises the question whether or not banking is a profession in the same way that Accountancy, Law, Medicine, Insurance or Teaching are professions, being state regulated professions, or Engineering is a profession with world wide expectations that professional engineers are “chartered”.

B.9. The British Bankers Association is a trade body; its membership is firms not individuals with individual responsibility. The English Institute of Bankers was founded in 1879 and given a Royal Charter in 1987 and has transformed itself into the Institute of Financial Services, which is a “division” of the IFS School of Finance, focusing on awarding qualifications. The closest to a professional body for bankers is The Chartered Institute of Bankers in Scotland, who have a Professional Standards Board. However, this organisation has only around 4,000 members, and so can hardly claim to be the professional body (the Institution of Chemical Engineers, representing a smaller constituency, has 32,000 members).

B.10. A lack of a professional body will have a direct impact on standards, it will also have an affect on skills. It has recently been reported that “risk management” competencies in finance are some 20 years behind engineering industries.

B.11. As part of the liberalisation of financial regulations following the establishment of the Financial Services Authority, there was a relaxing in regulations regarding “appropriate qualifications” of personnel in banking. Essentially participants in wholesale markets (intrabank dealings) do not need to have the level of qualifications a consumer facing participant is required to hold. The belief was that the firms would only employ “suitably trained” personnel who had one of a range of qualifications.

B.12. The plethora of qualifications acceptable to the FSA creates opportunities for “regulatory arbitrage” in the same way that a plethora of exam boards in England has led to problems, recently highlighted by the Commons Select Committee on Education in their report The administration of examinations for 15–19 year olds in England published 3 July 2012.

B.13. This lack of a clearly defined profession being at the heart of wholesale finance has resulted in a lack of attributes that one would associate with a profession, in particular there is no core body of knowledge possessed by participants. This means that there is no firm foundation for communication and understanding between participants. It has a second order effect that there is often homogeneity, and not diversity, within a single organisation. This arises because groups select colleagues who share their perspective, creating an environment that supports “group think” and hinders scientific scepticism.

B.14. For example, consider the important word “risk”. The primary definition in the Oxford English Dictionary is

(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.

Within statistics, following De Morgan in 1832, “risk” is synonymous with the “mean square error” between a parameter’s estimate and its true value, and an estimate with the lowest “risk” is chosen. Within economics, following Frank Knight’s 1921 Risk , Uncertainty and Profit “risk” is a knowable probability, such as the chance of rolling a six with a dice, this is a distant cousin of the statistical definition. An “uncertainty” is an immeasurable probability. This is different to John Maynard Keynes, who used the term “cardinal probability” for a mathematical probability and “irreducible probability” for an unknowable probability. Keynes introduced these terms in A Treatise on Probability, also published in 1921. Mathematicians often use “chance” for Knight’s “risk”, following from de Moivre’s 1718 text The Doctrine of Chances.

B.15. Hence, a group comprising of a trained engineer (using the conventional definition of risk), a Chicago trained economist (using Knight’s definition) , a Keynesian economist, a statistician and a mathematician, all of whom might be working for the same team in a bank, do not use the fundamental term “risk” in the same way.

B.16. There are aspects of modern finance that that should be classed as a STEM (Science Technology Engineering Mathematics). In 2009 BIS published The Demand for Science , Technology , Engineering and Maths Skills, which provides some important statistics. Of recent graduates in Physical, Mathematical, Computer Sciences and Engineering, 11% were working in finance 44 months after graduation. Of graduates of Mathematical Sciences, 10% of the above group, 33% were working in Finance, the biggest single employment sector of mathematicians. This contrasts with the whole population of these graduates, only 7% of all Physical, Mathematical, Computer Sciences and Engineering graduates work in the area while only 21% of all maths graduates work in finance. The fact that a higher proportion of recent STEM graduates work in finance reflects the increasingly “technical” basis of finance.

B.17. The Royal Society’s Hidden Wealth Report notes (section 3.2) that

The tools [enabling recent financial innovation] have been created by mathematicians, physicists and engineers, many of them with PhDs. Senior academics report that, in recent years, some 50% of the engineering graduates from Imperial College and other top UK engineering departments have gone straight to work in the City of London

reflecting an over-representation of STEM graduates from the elite universities in finance.

B.18. Recent research on what qualifications are important in investment banking suggest PhDs/MScs are as prevalent as MBAs from prestigious business schools.

B.19. The high levels of pay in the derivatives markets from 1990 reflected a “profit share” to a limited number of people who had the skills to manage the new technologies supporting derivatives markets. If such skills shortages had been experienced by traditional STEM based industries, the professional body would have lobbied government for increased funding, for Masters degrees for example. This did not happen in finance and the few MSc courses in “Financial Mathematics” (as a generic term for mathematical finance, quantitative finance, financial engineering, computational finance) that did emerge were premium fee courses at a handful of universities. Apart from at Heriot-Watt, before 2006 there were no dedicated undergraduate degrees in “Financial Mathematics”. At this there was no business case for universities to supply the training and limit the demand for premium fee post-graduate degrees, with the introduction of higher fee levels in England, this situation has changed.

B.20. The scarcity of skills in the technologies supporting derivatives markets has resulted in a complete lack of transparency in finance. Consumers, whether traditional investment bankers, asset managers, insurance companies, public or private corporations and individuals, of sophisticated products rely on the sellers, making them susceptible to mis-selling (they are not informed investors).

B.21. Furthermore developments in finance go un-scrutinised in a way that would be impossible in other technologically based industries. Robert Peston, the BBC’s Business Editor who was at the centre of the reporting of the Crisis, famously initiating a run on Northern Rock, has been reported by an LSE academic as saying

“I was very concerned about the explosive growth of CDOs (Collateralized Debt Obligations) and I tried to explain them through my reporting. Doing so was a challenge, when even bankers creating the CDOs were unable to describe them in terms that make sense to non-specialists.”

Given that the general public are comfortable with Relativity Theory, Quantum Mechanics and the Higgs Boson, there is no reason to believe they cannot understand derivative contracts and the mathematics behind asset pricing. I regularly explain the basics of derivative pricing to sixteen year olds.

B.22. In the UK there is a relatively narrow popular definition of “science” as relating to the physical and life sciences; science in the popular imagination is concerned with ergodic systems. A more conventional definition of science is as the “speculative, agreed–upon inquiry which recognises and distinguishes defines and interprets reality and its various aspects and parts, on the basis of theoretical principles, models and methods rigorously cohering”. The purpose of science is to enable a degree of foresight that is necessary for moral responsibility. Hence, for there to be moral responsibility in banking, there needs to be a science of banking, for there to be a science of banking their needs to be a public debate about banking. If there are to be sound professional standards in banking, the practice has to remove the veils of mystery that surround it.

B.23. It might be argued that professionalization of banking will restrict access to careers in banking. It would be interesting to see if today, banking has a more, or less diverse, population in middle and senior management positions as compared with established professions (law, medicine, accountancy, and engineering).

B.24. I am not knowledgeable on legal issues or the details of regulatory structures. However, I feel that the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority created by the Financial Services Bill are only a partial solution.

B.25. Most professions have a professional body running in tandem with the statutory structures. There is the Legal Services Board and the Law Society, the General Medical Council and the medical Royal Colleges, the Financial Reporting Council and the actuarial, accounting and auditing professions. This distinction has emerged following, for example, the Clementi Legal Services Review and the Morris Review of Actuarial Standards. The bodies established in the Financial Services Bill correspond to bodies under the Legal Services Board and the Financial Reporting Council; the complementary professional bodies do not exist.

B.26. The FSA’s Financial Conduct Authority : Approach to Regulation describes company culture as follows (p 32)

Firms’ culture: the FCA will place particular focus on firms’ culture as a potential root cause of poor outcomes for retail or wholesale consumers, recognising its determining role in a firm’s regulatory behaviour. .. The FCA will expect boards to provide continuing oversight, particularly at times of significant change.

and later (p 37)

The FCA will seek to assess whether applicants have a good understanding of how to ensure good customer outcomes through corporate culture, appropriate conduct risk management and product design.

B.27. While recognising this important component of regulation, the FSA provide no clear indication of what constitutes good “corporate culture” and how it can be created. This submission maintains that good “corporate cultures” will be created by a strong profession.

16 August 2012

Prepared 19th June 2013