Some confusion.

James Surowiecki says:

The most striking thing about this scandal is that it was predictable—the way LIBOR was designed practically invited corruption—yet no one did anything to stop it. That’s because, for decades, regulators and people in the financial industry assumed that banks’ desire to protect their reputations would keep them honest. If banks submitted false LIBOR estimates, the argument went, the market would inevitably find out, and people would stop trusting them, with dire consequences for their businesses. LIBOR was supposedly a great example of self-regulation, evidence that the market could look after itself better than regulators could.

So that’s exactly what happened right? The market did find out and there was punishment. But then Surowiecki says:

But, if recent history has taught us anything, it’s that self-regulation doesn’t work in finance, and that worries about reputation are a weak deterrent to corporate malfeasance.

The only way I can square the circle is to be persuaded that Surowiecki doesn’t believe what he states when he writes that a critical part of self regulation is post-facto punishment by the market. This seems justified because backwards induction tells us that the credible threat of punishment in the end makes it logically impossible for transgression along the way. So we judge self regulation by whether people follow the logical rules. Regulation, self or not, is supposed to be preventive. If they transgress the self regulation failed and it’s rather irrelevant if the market exacts revenge later.

Bankers believed they could break the rules they agreed to and escape punishment – forever. From that moment the system failed.


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