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How Scandal Became Crisis

That large financial institutions ought to behave in an ethical manner seems perfectly obvious. But how bad behavior lay at the core of the current financial crisis may not be so apparent. I suggest that the medium of transmission from scandal to crisis followed two paths: loss of trust and abandonment of customers.

Trust

When a corporation behaves ethically, it might be functioning well or poorly, and it might be a good or bad firm to invest in, but at least we know how it will behave: It will obey the law, treat its employees respectfully, be honest in its public disclosures, honor its commitments, be a good citizen in the communities where it operates, and so on. But when a corporation (or, God help us, an entire industry) behaves badly, we have no idea what to expect. One day they are shoving mortgages down our throats and the next day you can't get a mortgage to save your life. One day they are standing behind ARS auctions and the next day they are nowhere to be seen. One day they are honestly disclosing their financial condition and prospects and the next day they are lying through their teeth. One day they are innocently selling us subprime paper and the next day they are quietly shorting that paper behind our backs.

Financial firms, much more than other firms, live and die on trust. The very definition of a bank is a firm that borrows short and lends long. A bank might take customer deposits—offering customers instant liquidity—and loan them to ...