How Much Does Character Count on Wall Street?

Who is responsible for the financial crisis? What is the ruling ethos on Wall Street and in the financial world? Did the Wall Street culture fail, or did flawed human beings make bad decisions?

If human beings bear some responsibility, why has no one been punished? What happened to justice?

Of course, there’s punishment and then there’s punishment. Being criminally indicted is one thing; being ostracized, losing your reputation and good name, is quite another.

The first requires the workings of the criminal justice system. The second requires a culture that promotes good character and sanctions bad character.

Call the first a guilt culture and the second a shame culture.

Yesterday Steven Davidoff offered an important analysis of the cultural ethos that pertains in the financial world. Link here.

He sees a prevailing system that no longer values reputation and good character but will tolerate anything you can get away with.

In a shame culture what matters is your reputation, your character, your good name.

If you get caught behaving unethically by putting your interest ahead of your client’s, then your reputation suffers and people will no longer do business with you.

In a guilt culture, what matters is whether or not you have broken a law, thus, whether or not you can be indicted and convicted by the criminal justice system.

Davidoff is certainly not suggesting that everyone who works in finance has bad character. Yet, he does provide examples of individuals who bore some responsibility for the financial crisis, but who did not lose their reputations.

They were not ostracized; they did not become pariahs in the financial world; they ended up with great new jobs.

Davidoff cites these examples: “Former directors of Lehman Brothers and Bear Steans still serve on the boards of public companies, and one, Jerry A. Grundhofer, a former director of Lehman, is on the Citigroup board. Traders responsible for disastrous mortgage bets have easily found lucrative jobs in finance.

"Or take Daniel H. Mudd, who not long after being ousted as chief executive Fannie Mae was named chief executive of the Fortress Investment Group. At Fortress, Mr. Mudd has been paid a salary and stock options worth more than $30 million in the last two years. This was despite the failure of Fannie Mae while he was at the helm, an event that wiped out almost all shareholder value and has cost the federal government more than $90 billion.”

It isn’t just that these bankers were not sanctioned for their failures; they were rewarded.

Has this always been the case? Davidoff says that it was not: “During the Great Depression, Goldman Sachs was caught up in a scandal involving the Goldman Sachs Trading Corporation. The taint of the scandal drove away business for more than a decade and made the firm extremely focused on reputation.”

Why does reputation no longer matter? Davidoff sees a number of forces conspiring to undermine the value of good character.

In brief, he says that the investment banking business has become less about people, thus less about reputation and character, and more about “size and technology.”

When trading and brokerage became more important than investment banking, the value of reputation and relationships diminished.

This was even more true as trading became mechanized and digitized. The geeks and nerds who were running trading platforms were not sociable people. Their jobs and their compensation did not depend on their contacts, their client relationships, and their good name.

The larger these firms became, the less important single individuals were. Where banking used to be conducted by smallish investment banks with a limited number of partners whose capital was at risk, reputation and relationships were the lifeblood of the business.

When the firms became larger and more public, no single individual could really be held to account for the activities that were being run by quants and trading programs.

One imagines that many senior executives barely understood what the traders were doing.

And there’s more. Davidoff explains: “Again, individuals were less important as size dominated. A client now trades or does business with a bank based on its positions or ability to make a market or loan. The executive at the bank executing the transaction is unimportant.”

This diminished any single executive’s personal responsibility: “These trends have become omnipresent in corporate America generally as it too has exponentially grown. And when these companies failed or otherwise committed a wrongdoing, their size allowed their reputation to be ignored. After all, it wasn’t the executive’s fault that the bad event happened. It was just the economy or other external factors.”

Finally, officers and directors of banks and major corporations are personal friends with each other. They are more likely to excuse friends who might have institutional authority but who did not really know what was going on.

Given that they themselves do not know everything that is going on in their own companies, and do not want to be held accountable for it, they are more than happy to excuse people they consider to be their personal friends.

Given this amoral universe, a universe where reputation does not really count, Davidoff believes that it was inevitable that the government would step in to impose more stringent regulations.

In his words: “In the absence of reputation, the government and regulators act as substitutes to ensure appropriate conduct. The government becomes the enforcer through civil and criminal actions for law-breaking. So what you get is more law to cover for lost reputation.”

Here we have something of a chicken/egg problem. Which came first: the diminishing importance of reputation or the increased regulation?

After all, the banking industry was not exactly unregulated. As many wise commentators noted at the time, the financial industry was heavily regulated. Surely, it was much more regulated than were hedge funds.

It makes some good sense, too. The more you live in a regulatory universe that attempts to control your every gesture and decision, the more you will feel honor-bound to find the fault line in the system, the one thing that they forgot to forbid.

Once you are thinking in terms of what you can get away with because no one has thought to prohibit it, you are not too far away from thinking about which prohibited actions you can get away with because you are unlikely to get caught.

If the financial crisis began in a highly regulated industry, then perhaps the way to restore the industry is to reduce regulations, not to double down with them.