CASE 10
Banking Industry Meltdown: The Ethical and Financial Risks of
Derivatives
This case covers the history of the pervasive yet, risky financial instrument, the derivative. It covers
Barings Bank, an earlier case of risky trading, as well as UBS, Bear Stearns, and Lehman Brothers—all
casualties of the recent economic crisis on Wall Street. Using these institutions, this case covers the
various applications of derivatives, why they spiraled out of control, and the ethical implications
involved in their use.
Some further explanation of derivatives might be helpful for instructors. Derivatives are financial
instruments whose value changes relative to underlying variables; to reduce risk one of these variables
is assets. The main types of derivatives are futures, forwards, options, and swaps. Derivatives can be
based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange
rates, or indexes such as a stock market index, consumer price index (CPI), or even an index of weather
conditions. For example, a farmer and a grain storage business enter into a futures contract to exchange
cash for grain at some point in the future. Both parties have reduced their future risk. For the farmer
it’s the uncertainty of the future grain price and for the grain storage business it’s the availability of the
grain at a predetermined price.
Some believe derivatives lead to market volatility because enormous amounts of money are controlled
by relatively small amounts of margin or option premiums. One can equate the job of a derivatives
trader to a bookie taking bets on people making bets. Speculators or hedgers can dramatically change
the values of wealth by using arbitrage opportunities and placing bets on the volatility underlying
securities. Arbitrage is defined as attempting to profit by exploiting price differences of identical or
similar financial instruments, on different markets or in different forms. As a result, investors can
suffer large losses or returns from small movements in the underlying asset's price. Derivatives
(especially swaps) also expose investors to counter-party risk. For example, if a business (A) wants a
fixed-interest loan, but banks only offer variable rates, the business swaps payments with another
business (B) who wants a variable rate; this creates a fixed rate for Business A. However, if Business
B goes bankrupt, Business A loses its fixed rate and has to pay the variable rate. If interest rates
increase to the point were Business A cannot pay back the loan, it causes a chain reaction of failures.
Derivatives may also pose high amounts of risk for small or inexperienced investors. Because
derivatives offer the possibility of large rewards, individual investors may find them attractive. But the
basic premise of derivatives is to transfer risk among parties based on their willingness to assume
additional risk, or hedge against it. Many smaller investors do not comprehend this until they lose their
money. Warren Buffett, the world’s second richest man, stated that he regarded derivatives as
“financial weapons of mass destruction” because derivatives so heavily leverage debt. Marriner S.
Eccles, U.S. Federal Reserve Chairman from 1934 to 1948, stated that too high a level of debt was one
of the primary causes of the Great Depression. However, some believe derivatives have significant
benefits. Under normal circumstances, derivatives should not adversely affect the economic system as
a whole.
The 1980s marked the beginning of swaps and other over-the-counter derivatives. Soon every large,
and even some not-so-large, corporations were using derivatives to hedge. New products were rapidly
created to hedge the now-recognized wide varieties of risks. As the problems became more complex,
Wall Street turned to mathematicians and physicists to create and analyze these new, exotic
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Case 10: Banking Industry Meltdown: The Ethical and Financial Risks of Derivatives
instruments. However, complex mathematical analysis cannot account for all the unknowns that exist in
the real world, and many did not predict the problems on Wall Street in late 2008.
Because this case is so complicated, it may help to show students the following Frontline episode,
which outlines what happened on Wall Street in the fall of 2008 that caused such large firms to fail so
spectacularly (http://www.pbs.org/wgbh/pages/frontline/meltdown/). This show is one hour long and is
available for free on PBS’ website. It helps to clearly lay out what went wrong with some of these
financial companies, and it underscores the high level of risk in which each was engaged.
Accompanying the show, PBS has created a supplementary lesson guide for those instructors interested
in taking their students’ learning further (http://www.pbs.org/wgbh/pages/frontline/teach/meltdown/).
DISCUSSION
1. What are the ethical risks associated with derivatives?
Derivatives, due to their complexity and the many (opaque) ways in which they can be used, carry with
them a high risk of abuse. Prior to the Wall Street meltdown in 2008, many traders who were using
derivatives did not even fully understand how they worked or the risks involved. In fact, in many cases
no one knew the risks of using derivatives because no one calculated those risks. The danger of using
highly complex financial instruments that are difficult to track is that few people are aware of the
dangers. Traders bought and sold derivatives without adequate concern for how tenuous they were, or
how highly leveraged the system was. Most financial institutions did not have a large enough cash
buffer to cover losses when derivatives to go bad. We witnessed the outcome of this scenario in fall of
2008 when many institutions went under or were rescued by the government after making risky
decisions involving derivatives.
As of 2008, $62 trillion worth of credit default swaps existed in the financial system. That is more than
four times the GDP of the entire U.S. economy. In 2009, new proposals from the Obama
administration have suggested requiring derivatives be publicly traded on electronic exchanges or a
central clearinghouse; mandating traders and players to put up minimal capital reserves to cover losses;
and empowering regulators to demand more information and to crack down on market manipulation.
Systemic risk is the danger that the failure of one financial institution will trigger a cascade, which
happened in late 2008.
2. What is the difference between making a bad business decision associated with derivatives and
engaging in unethical conduct using derivatives?
In this case, a lot depends on intent. Many traders likely made bad business decisions involving
derivatives without knowing the full implications of these instruments. They did not intend to do harm,
but were rather bowing to the pressures of the job and desires to perform well. However, many other
traders likely made business decisions knowing that they were risky. These traders were out for profits
and rewards, and did not care about the long-term repercussions of their actions or the ethical risks they
were taking. In the latter case, one can safely say that the trader was acting unethically. Upper-level
management and boards of directors should also be held accountable for the risk-taking occurring in
their organizations. Many students will likely argue that management should be informed enough to
know when actions are excessively risky.
Students should be made aware that a major issue in derivatives was mortgages, particularly subprime
mortgages. It is unethical for someone to borrow money knowing they cannot pay it back, and it is also
unethical to give someone a loan who cannot repay. Although potential homeowners should know if
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Case 10: Banking Industry Meltdown: The Ethical and Financial Risks of Derivatives
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they can afford a house there is often an expectation on the part of the borrower that they would not get
the loan unless the broker or banker thought they could pay for it, because people trust mortgage
brokers or bankers as gatekeepers. In this case, the gatekeepers had large incentives to let people
borrow and they did not have a vested interest in whether or not the person applying for the loan could
pay for it or not. This was unethical in several respects.
First, it is unethical to sell a product or service to someone who cannot afford it. Mortgage
brokers/bankers know that they are considered gatekeepers and have a responsibility to do the right
thing for the person applying for the mortgage and the lender they represent. Greed for commissions
pushed some mortgage broker/bankers to falsify information on mortgage applications in order to push
them through. In some cases, to increase their commissions, they also convinced people seeking
mortgages, to take out loans in higher amounts.
Wall Street as a whole was experiencing problems with systemic unethical behavior. Home loans
started to become "securitized" or packaged together and sold to investors. Wall Street had developed a
way to extract yields from these mortgage packages that would entice investors. They took these
mortgage pools and created riskier derivatives with the knowledge that the mortgage pools themselves
were risky. This was unethical and those in charge on Wall Street must have known. Even if credit
ratings were not appropriate for the nature of the risk of these instruments, Wall Street knew they had
created more risk and were selling that risk to investors. This is wrong without full disclosure of the
actual likelihood of defaults on the underlying assets.
Students also should know that it is unethical to package and sell investments that they know are riskier
than represented, even if their clients are supposedly sophisticated buyers. If buyers were truly aware of
the full risks of these instruments they would have been discounted before buying them or they would
have refused to purchase them. Wall Street’s motivation for creating these derivatives and nondisclosure of all the risks boils down to simple greed.
3. What kinds of investment decisions drove Barings Bank, UBS, Bear Stearns, and Lehman
Brothers to financial disasters?
The short answer to this question is that they were all decisions motivated by short-term profits over
long-term growth, and in many cases, by greed. These institutions used derivatives to take debt off their
books, essentially hiding the risk from public view. However, risks remained. Many of these failed
institutions had leveraged their debt to 50 or more times the amount of available capital. That means
that for every dollar of assets a financial institution possessed, it had 50-60 (in some cases more) dollars
in debt. In this scenario it is small wonder that loan defaults and the like sent many institutions into a
tailspin. They simply did not have the capital to cover their losses. A large problem with many failed
firms is that the risk was isolated in a silo. One department was conducting extremely risky investment
decisions without the consent or knowledge of the firm as a whole. This is where transparency would
be particularly useful. Many corporations must work to improve oversight so that departments do not
“go rogue.”
Conflicts of interest between these financial institutions, their auditors, bond rating companies, and
even legislators, all also played a role in allowing risky behaviors to go unabated for far too long. Also,
unrealistic expectations that the housing and stock market booms would continue on indefinitely fueled
the investment frenzy, making the problem worse when everything came crashing down. Finally, many
have argued that rules governing financial institutions were simply not pervasive or enforceable enough
to do much good. Many rules were more like guidelines that allowed corporations to pick and choose
with which ones they would comply.
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Case 10: Banking Industry Meltdown: The Ethical and Financial Risks of Derivatives
4. How can an ethical corporate culture with adequate internal controls, including ethics and
compliance policies, prevent future disasters in financial companies?
While it will always be difficult to regulate something as large and dynamic as the financial industry,
most people agree that something has to be done to reduce systemic risk, increase transparency, and to
avoid silos in which unethical/illegal activities can occur without the knowledge of gatekeepers and
other stakeholders. This question is very open-ended and should require students to think about the
topic. In order to adequately answer this question, students will likely have to do some research on the
financial industry, what has happened since 2008, and of recent legislative issues related to addressing
problems uncovered during the financial meltdown. Students should pay particular attention to what has
changed recently. Are things that were previously considered acceptable now unethical, are actions that
were unethical before, are now illegal? Instructors many want to ask: How are these regulatory shifts
changing the financial industry, and do they think these changes will help?
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