Wall Street's "Performance-Enhancement" Scandals

Antonio Fatás reads the article by Luigi Zingales and realizes he has has seen this type of hopeful denial before:

Financial markets and professional cycling, by Antonio Fatás: Luig Zingales writes a very interesting article about some of the new scandals in financial markets (the insider-trading trial of Raj Rajaratnam). ... From the article you can see that there is a sense of disbelief about what is happening:

"It is so difficult to imagine that successful executives would jeopardize their careers and reputations in this way that many of us probably hope that the accusations turn out to be without merit."

This quote reminds me of a recent one by Alan Greenspan regarding the behavior of financial institutions prior to the crisis (from October 2008):

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."

Despite his disbelief, Zingales admits that there is some recent evidence that supports the idea that personal networks can be a source of excess returns in financial markets. But he remains positive when he looks at the industry as a whole:

"After ten weeks of a trial like this, it will be easy for the public to conclude that all hedge funds are crooked, and that the system is rigged against the outsiders. Fortunately, this is not the case. While there are certainly some rotten apples in the hedge-fund industry, the majority of traders behave properly, and their legitimate research contributes to making the market more efficient."

This debate reminds me of what has happened in the sport of professional cycling... In recent years, there have been a large number of cases of professional cyclists testing positive for performance-enhancing drugs. When the first cases came out there were two reactions:

1. Those who assumed that this was a generalized phenomenon and concluded that most cyclists were guilty.

2. Those who had the belief that this was just a few riders violating the rules but, overall, this was a clean sport. Their logic was that if doping was so generalized, how is it that we have not heard about it before?

Over the last years, we have witnessed an increasing number of scandals in this sport and ...[this] has shifted public opinion towards the belief that doping was (and might still be) a generalized practice in this sport.

I see a parallel with what we are seeing in financial markets as a result of the more recent scandals. Yes our prior is to believe that generalized corruption will be eliminated by market forces and regulation. But when we think about all the evidence that has surfaced during the last years regarding the behavior of financial institutions and those who lead them, our beliefs start shifting and at some point it is not simply a matter of questioning individuals. We start questioning the whole system, the incentives and the ways in which some become winners in this very competitive market (as competitive as the world of professional cycling).

The difference between cycling and finance is that while we can choose not to watch the next Tour de France but we cannot choose to live in a world where the behavior of financial institutions does not affect our society.