It is 10 years since the most serious banking crisis in generations. Along with other forms of misconduct since, one impact is that trust and confidence in banking has been eroded. David T Llewellyn FRSA looks at what has been done and what still needs to change.
According to the authoritative Group of Thirty, a charity which aims to deepen understanding of economic and financial issues: “the reputation of banking and the broader financial sector has deteriorated since the financial crisis, and is now at an historical low in terms of trust on the part of clients and customers”. There is also criticism that those responsible for the crisis and other bank misconduct seem not to have been adequately punished if sanctioned at all. While this is not altogether true, we can understand why the perception has arisen.
Four types of misconduct can be identified: cavalier risk management, mis-selling of financial products to potentially vulnerable consumers, violations of national and international rules on (for instance, money laundering) and manipulation of financial markets. In other words, the crisis of 2008 is not the only factor. Other much-publicised examples of misconduct include: the mis-selling of PPI and pensions, instances of rogue trading, the manipulation of LIBOR, and examples of money laundering. As a result, massive fines have been imposed on banks but who exactly pays the fine is a central issue.
This erosion of trust and confidence is important and specific in a number of ways. First, we do not purchase some financial products frequently and this means there are limited opportunities for us to learn from experience. Second, there is a principal-agent relationship between financial firms and their customers, where financial institutions are charged with making decisions on our behalf. Third, the value of many financial contracts are not known at the point of purchase and so it is not always clear precisely what we are buying. And, given the long-term nature of many financial contracts, such as pensions and investments – where trust is particularly important – the behaviour of the financial firm after the transaction has been made impacts on the ultimate value of the contract. Finally, there is often a lack of transparency in complex financial contracts.
We can look at a multitude of specific factors that have led to bad behaviour by financial firms and many of these have been analysed to explain why the crisis occurred. Indeed, where I work, we have a post-graduate module devoted entirely to this! But is this the right approach? Ultimately, these issues arise from the central culture of the bank and the degree to which individuals within it are held accountable.
Of course this is true of all organisations in relation to corporate responsibility. The culture of any firm or any organisation is important to understanding individual and collective behaviour; it creates business standards, influences employees’ attitudes and behaviour and establishes norms of behaviour. This is turn provides a link with consumer trust and confidence. This is particularly important in relation to the pivotal role that financial firms in general, and banks in particular, play in the economy.
Allison Cotterall, the Chief Executive of the Banking Standards Board, defines culture as: “Collective assumptions, values, beliefs and expectations that shape how people behave in a group”. The focus on the group is important; we know from a study of identity economics by the Nobel Prize winner George Akerlof that people behave differently in different environments. We all of us have multiple identities: in the family, amongst friends, in a group and so on. Our behaviour is often different in each case as our behaviour shifts towards those norms that are associated with the more salient identity at the time. We can assume that those bankers who attempted to illegally rig interest rates would not take money from the collection box at their church service on Sunday.
The 2008 banking crisis has spawned the biggest change ever in the regulatory regime. My experience is that it is a necessary but not sufficient condition for good behaviour. There needs to be a greater focus on underlying culture because if this is hazardous no amount of regulation will prevent misconduct.
At the heart of many instances of misconduct (including the failure of risk management in the run up to the banking crisis) are a combination of hazardous culture, perverse incentive structures within financial firms, weak internal governance arrangements, and a lack of individual responsivity and accountability. No amount of regulation can compensate for bad ethical behaviour. Although the Financial Conduct Authority has argued that culture has been at the root of conduct failures, it has not become a central issue in the supervisory process. The importance of culture has also been recognised by banks, many of which have culture change programmes in place.
But who should be held responsible for bad behaviour, the financial firm or the individuals who made decisions? Anthropomorphisation is a word that no-one ever uses but all of us assume it. The tendency to assign human characteristics to inanimate objects or institutions can lead to a wrong approach to, for instance, understanding bank behaviour and where sanctions should be applied. Banks do not make decisions: but individuals within banks do.
Corporate culture and individual responsibility interact in a complex way: behaviour can influence culture and established culture influences individual behaviour. This raises questions about effectiveness. What is likely to influence future behaviour more, a £10 million fine on the bank (ultimately the shareholders and customers themselves) or a £50,000 fine on individual employees? Perhaps the focus has been wrong and should be more on individuals than firms (in practice perhaps it should be both).
There are five main influences that can create ‘bad’ behaviour. First, the culture of the firm. Second, the culture of the industry. Third, peer group pressure on individuals, especially those new to a firm. Fourth, specific incentive structures (for example, sales targets where a person’s salary or bonus is determined by the number of sales made irrespective of whether they were appropriate to the innocent buyer). And fifth, the internal governance arrangements in place and, within this, the scope for individual accountability.
While deeper reform is needed, it is difficult given the complex interaction between corporate culture, individual responsibility, and official regulation and supervision. Within this nexus culture needs to become a supervisory issue (where regulators should examine underlying culture), and a greater focus needs to be given to individuals including when sanctions are imposed. A welcome move in this direction comes with the Financial Conduct Authority’s Senior Managers Regime, which has recently come in force. Regulators now require that all relevant employees within financial firms are covered by a set of conduct rules and “act with integrity, due skill, care and diligence…and pay due regard to the interests of customers and to treat them fairly…” In addition, “senior management is subject to additional conduct rules requiring them to take reasonable steps to ensure that the business of the firm is controlled effectively.”
As anyone who watches Dad’s Army will know, culture has changed within banks. The local bank manager may have been a pompous fool but everyone had trust and confidence in him and he always acted with utmost integrity at all times. While he managed a much simpler bank than exists today, perhaps there is a case for ‘Come back Captain Mainwaring, all is forgiven.’
David Llewellyn is Professor of Money and Banking at Loughborough University. Until recently he was the Chair of the European Banking Authority’s Banking Stakeholder Group, and formerly worked at HM Treasury and the International Monetary Fund.