The Scandal Behind the Financial Scandals

Recent scandals have emerged in London and Chicago's financial system and according to one insider it is "very bad" and trust between buyers and sellers is at a low point. Many financial chiefs are getting worried in an environment like this and, as the author puts it, "views the glass half empty."

Francesco Guerrera
Updated July 16, 2012, 4:21 p.m. ET
Wall Street Journal

Two of the world's financial capitals are hurting.

London, Europe's trading hub, and Chicago, America's bridge between the farm and the global commodity markets, have been rocked by scandals.

The controversy over the London interbank offered rate, or Libor, and the unraveling of the brokerage Peregrine Financial Group Inc. share only their timing. But their collision in the headlines is deepening investors' antipathy toward the financial industry, capital markets and regulators.

Over the past week, I tried to take the pulse of financial elites on both sides of the Atlantic. My question to regulators, bankers and denizens of the trading world: Is this just a blip or are we at a breaking point that calls for a wholesale change in attitudes and rules?

The first answer, from a longtime Chicago-based executive, was a long silence and a sigh. And then: "It's very bad. [Peregrine Financial's collapse] undermines the cornerstone of any market: trust between buyers and sellers. The trading community here is in state of shock."

Another executive refused to talk other than to quote the 65-year-old independent trader and Peregrine Financial customer Peter Brandt, who went from escaping the Colorado fires into the frying pan of the scandal. Last week, he told The Wall Street Journal: "There's not supposed to be that much excitement in life when you get to be my age."

But excitement, mostly of the wrong kind, is what investors of all stripes have been getting, starting with the 2008 financial crisis, via the Madoff scandal, the bankruptcy of MF Global Holdings Ltd. and other assorted messes (R. Allen Stanford's Ponzi scheme, the mortgage settlement by U.S. banks and so on).

With news like this, it is no wonder that ordinary savers have been deserting the stock market, yanking hundreds of billions of dollars from equity mutual funds (see table). Many bank stocks trade at a fraction of their liquidation value.

Investors and politicians seem to view the glass as half-empty. Few in the press or in Washington, for example, have mentioned the fact that failures among the thousands of small brokerages are relatively rare.

In Britain, the action against Barclays BARC.LN +0.82% PLC—the first of many banks likely to be dinged over Libor manipulation—could have been seen as a sign that, sooner or later, the bad guys get caught. Instead, George Osborne, the U.K. Treasury chief, branded it "the epitaph to an age of irresponsibility" for the financial sector.

In this feverish environment, some financial chiefs are getting worried. A top Wall Street banker likened the Libor probe to the 1998 tobacco settlement—a regulatory crackdown that could change the industry forever.

In his view, the furor will lead to the overhaul in banks' practices and attitudes that was expected after the financial crisis but never fully materialized. "It will take a generation or two, but the industry has to regain its moral compass," he said.

While we wait, recriminations will fly. Predictably, a few financial practitioners blamed regulators for failing to spot trouble, pointing to the "light-touch regulation" championed by London for years and the lax oversight of commodity traders by U.S. watchdogs.

Those arguments have some merit. It was ironic to see the U.S. Commodity Futures Trading Commission praising itself for a job well done on Libor only to scramble to explain how it missed the problems at Peregrine Financial. (The CFTC has said it has no direct responsibilities over small brokers).

But blaming the regulators isn't sufficient. As a Wall Street lawyer pointed out, "light-touch" regulation worked well for London for decades (not least when it allowed the City to became a magnet for the lucrative "euro-dollar" market in the postwar years). And, of course, the biggest supporters of fewer rules have been the financial institutions now pointing their fingers at regulators.

A couple of London-based bankers even pined for a bygone era of smaller firms, partnership structures and old school ties, where gentlemen's words were their bonds—an unrealizable, and undesirable, blast from the past.

I am old enough to have caught the end of those days and my recollection is one of very little competition among a handful of banks, high fees for customers and rampant insider trading.

The financial industry and its political masters have to look forward, whether they like it or not.

Perhaps the right answer came from the banker who wished me happy Bastille Day on July 14th: "We are at a 1792 moment," he said. "Remember, the French Revolution was in 1789 but it took three years to proclaim a Republic."

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