Category: Banking Culture

Remarks by Mr Alberto G Musalem, EVP of the Integrated Policy Analysis Group of the Federal Reserve Bank of New York, highlight why cultural reform in financial services is important. He argues: First, cultural problems are the industry’s responsibility to solve. Second, a bank’s implicit norms-especially those reinforced through incentives-must align with the public purpose of banking. Third, the reform of bank culture should aim to restore trust.

The New York Fed has, for the last two years, been part of an international dialogue on the reform of culture in the financial services industry. Why culture? Let’s begin with the following hypothesis: environment drives conduct. What each of us learned from our parents governs some of our behavior, but not nearly as much as any of us who are parents would like to believe. Place ordinary people in a bad environment, and bad things tend to happen. That said, place someone in a good environment, and good things tend to happen. This is just part of being human. We observe and adapt.

Before continuing, I would like to clarify that the views I express today are my own and may not reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.

Part of any organization’s environment is its culture. Some have labored over a precise definition of the word “culture.” Bill Dudley, the President of the New York Fed, has offered the following description, which works for me: “Culture relates to the implicit norms that guide behavior in the absence of regulations or compliance rules – and sometimes despite those explicit restraints. Culture exists within every firm whether it is recognized or ignored, whether it is nurtured or neglected, and whether it is embraced or disavowed.”¹

The New York Fed’s interest in reforming culture is a product of events since the Financial Crisis. Take, for example, the manipulation of LIBOR and foreign exchange rates, much of which was collusive. Each of those episodes involved misconduct affecting wholesale markets on which the real economy relies. Both cases shared an underlying, flawed outlook. Bankers failed to see beyond their immediate financial goals. They ignored the broader social consequences of their decisions on the firm and its customers, as well as on consumers, producers, savers and investors. The same flawed outlook may have contributed to the Financial Crisis.

There are many more examples. One bank was fined for doing business with Sudan despite economic sanctions imposed for engaging in genocide. Another bank manipulated electricity markets in California and Michigan. Other banks helped U.S. citizens evade taxes. I will not review the full litany. Notably, none of these recent episodes had anything to do with capital levels or liquidity ratios. The many post-Crisis reforms to bank balance sheets – including the Dodd-Frank Act and new standards developed by the Basel Committee on Bank Supervision and the Financial Stability Board-provided necessary bulwarks against systemic risks. Capital and liquidity requirements, and the enhanced testing surrounding them, have made banks and the financial system more resilient to stress. But those new laws, regulations, and standards have done little to curb banker misconduct. Each post-Crisis episode demonstrates a narrow cultural focus on short-term gain and disregard of broader social consequences.

Last year the New York Fed challenged the industry to consider many factors that have contributed to recent, widespread misconduct. There are no simple answers and that discussion is continuing. This year, by contrast, our focus has been more on solutions-what’s working, and what is not. In both years, we have offered three messages to the industry.

First, cultural problems are the industry’s responsibility to solve. The official sector can monitor progress and deliver feedback and recommendations. In fact, many individual supervisory findings are often symptoms of deeper cultural issues at a firm. But the banks themselves must actively reform and manage their cultures.

Second, a bank’s implicit norms-especially those reinforced through incentives-must align with the public purpose of banking. Gerald Corrigan, more than three decades ago, presented a theory of banking based on the principle of reciprocity. Banks receive operating benefits unavailable to other industries because they provide important services to the public. For example, financial intermediation is enhanced through deposit insurance and access to the discount window. Public benefits, though, are not a gift. They are part of a quid pro quo. In exchange for receiving valuable operating benefits, a bank’s implicit codes of conduct-that is, its culture-must reflect the public dimension of the services that banks provide.

Third, the reform of bank culture should aim to restore trust. The bedrock of the financial system is trust and the word credit derives from the Latin notion of believing or trusting. We saw seven years ago that the public’s trust is critical in a crisis. The repair of the financial system would not have been possible without public support. If another crisis were to happen tomorrow, would there be that support?

A lack of trust-or, more accurately, low trustworthiness-also imposes day-to-day costs.⁸ For starters, there are fines. Then there are the legal costs in investigating allegations and defending lawsuits. Internal monitoring also becomes more expensive as rules become more extensive. Some might say that the proliferation of rules since the Financial Crisis is inversely proportional to a decline in the industry’s perceived trustworthiness. The choice between rules and standards depends on the trustworthiness of the regulated. A more flexible, standards-based legal regime requires a degree of trustworthiness that, in recent years, banks have not demonstrated.

Those are the measurable costs of low trustworthiness. There may be other, longer-term costs that are more difficult to price. Let me raise just two. If employees perceive a firm as untrustworthy or disloyal, will they choose to work in that firm? And, if they do, how will they behave toward the firm and its stakeholders?

I am encouraged that the industry seems to understand the importance of reforming its culture. Consider for a moment the following data points. In September 2013, shareholders of a major U.S. bank requested that the bank prepare “a full report on what the bank has done to end [its] unethical activities, to rebuild [its] credibility and provide new strong, effective checks and balances within the [b]ank.” That request was forwarded, by the way, by a Catholic nun. The bank responded through its attorneys that the nun’s proposal was “materially false and misleading” and “impermissibly vague and indefinite.” Fast forward to May 2015. The Federal Advisory Council-a panel of bankers that advises the Federal Reserve System-reported that “Regulators and the banking industry have worked extensively to restore financial stability through a series of mechanisms and rules that establish appropriate levels of capital, liquidity, and leverage. . . . As often as not, however, the challenges faced in recent years have been behavioral and cultural; post-crisis episodes such as LIBOR and foreign exchange manipulation provide hard evidence that there remains work to be done.” This is clearly an encouraging difference in perspectives.

The public sector, too, has paid increasing attention to culture. The Group of Thirty, the Basel Committee, the European Systemic Risk Board, and the Financial Stability Board have issued papers on culture, governance, and misconduct risk. The Fair and Effective Markets Review-a joint project of the Bank of England, the Financial Conduct Authority, and Her Majesty’s Treasury-has called for heightened standards for market practice in matters affecting the public good. And in the last year, we have seen emerging approaches to supervision that aim to address culture, conduct, and governance. In particular, the central bank of the Netherlands-De Nederlandsche Bank-has pioneered new techniques for the supervision of corporate governance, especially for assessing the group dynamics of boards and senior management.

Culture also features prominently in criminal enforcement. The U.S. Department of Justice requires its prosecutors to determine “the pervasiveness of wrongdoing” at a corporation before seeking an indictment. According to its prosecutors’ manual, “[T]he most important [factor in making this determination] is the role and conduct of management. Although acts of even low-level employees may result in criminal liability, a corporation is directed by its management and management is responsible for a corporate culture in which criminal conduct is either discouraged or tacitly encouraged.” Individuals, including senior managers, also face criminal liability for their conduct. Recent guidance from the U.S. Department of Justice places greater emphasis on individual culpability. And the recent convictions of two traders for rigging LIBOR, one of whom served as the Global Head of Liquidity and Finance at a major bank, may send a powerful message to bankers about the consequences of their misconduct.

The new acceptance of culture as an important area of focus was evident at a workshop that the Federal Reserve Bank of New York hosted on November 5. Christine Lagarde, Managing Director of the International Monetary Fund, and Stanley Fischer, Vice Chairman of the Board of Governors of the Federal Reserve System, headlined a contingent of over 20 public sector authorities from around the globe. They were joined by the CEOs, senior executives, and board members of global financial institutions. Together, they discussed methods of reforming culture and the continuing challenges in this effort. In my view, the workshop offered a number of useful insights, chiefly:

• Culture is a soft concept that is hard to measure, and perhaps harder to manage and sustain. But it is as important as capital and liquidity, and should receive continuous and persistent attention.
• A bank’s culture must be consistent with public expectations and promote behavior that considers the firm’s many stakeholders, including the public. Also, a positive, constructive culture can be an important pillar aligned with the execution of a firm’s business strategy.
• Culture cannot be set by fiat. Leadership is indispensable, and requires more than a “tone from the top.” Managers of all levels must take action to promote a greater sense of personal responsibility and stewardship among employees. The next generation of financial leaders will reflect the expectations of leaders today.
• Despite firm-wide statements about values and codes of conduct, banks may have several dissonant sub-cultures. “Silos” or “tribes” as they are sometimes called, appear in most if not all of the episodes I described earlier. By sharing best practices across the industry, firms might identify common warning signs of problems within sub-cultures and behaviors that are incompatible with the firm’s values.
• Diversity of thought and background are valuable cultural assets because they generate better questions and decisions, contributing to effective challenge. A diversity of views, though, must be complemented by a sense of common purpose. Certain basic principles-fair treatment of customers and employees, for example-cannot be open to debate.

The Federal Reserve Bank of New York recently launched a webpage that collects resources on bank culture. We’ve included the papers by the Group of Thirty and other organizations that I have mentioned, and summaries of our two workshops on culture. I hope you’ll take a look.

To conclude, the Financial Crisis and subsequent scandals revealed deep and continuing flaws in the culture of banking. The responsibility to address these flaws rests with the banks themselves. Many industry leaders have initiated reform programs within their firms. It is important to keep the momentum going. Reform requires relentless and sustained effort: from the top of an institution to its most junior employees, and across all of the institution’s business activities. Reform must include the full scope of an employee’s career, beginning with recruiting and continuing with annual performance management, compensation and promotion decisions. We in the official sector will be looking to the industry to fulfill its end of the bargain-to act consistent with the public well-being, to value long-term stability over short-term gain, and to take account of all stakeholders in making decisions.

Banking regulators are turning their attention to the core values, culture and conduct of financial sector firms, because just lifting capital ratios will not provide adequate safeguards. Therefore the opening remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at “Reforming Culture and Behavior in the Financial Services Industry: Workshop on Progress and Challenges” are interesting and relevant.

Welcome to the New York Fed and to a discussion of how culture and conduct might be improved within the financial services industry. I am pleased to see all of you here today – there is tremendous breadth of experience and responsibility within this room. We need to take full advantage of this opportunity. I encourage all participants to be candid and on-point, because the task of reforming culture is formidable.

Untrustworthy behavior on the scale that we have witnessed in financial services does not arise in a vacuum. Social science research makes it clear that context largely drives conduct. This is not a new insight. Adam Smith observed centuries ago that, independent of personal sentiment, we often behave according to what we “[see are] the established rules of behavior.” We observe the activity around us, assess the norms of conduct and generally adapt to those norms in our own behaviors.

Banking is not exempt from this universal propensity. Gerry Corrigan noted three decades ago that the “implicit codes of conduct” that govern banker behavior exist apart from “explicit regulations.” He posited that these implicit codes must align with the public good – an obligation that banks owe in exchange for the benefits “uniquely available to [that]particular class of institutions.” This, in Corrigan’s view, was what made banks “special” – the reciprocal benefits and responsibilities that support and constrain an industry essential to public well-being.

Corrigan’s premise is not an antique concept from a bygone era of banking. Then, as now, there are public purposes of banking – including financial intermediation, corporate valuation, facilitating investment opportunities, providing credit and creating market liquidity. These activities underpin the economy and financial stability. Reciprocity – in other words, the expectation of a quid pro quo in the relationship between society and the financial services industry – is the basis of public trust in financial institutions. There is, however, a widespread sense that this principle has been compromised.

Industry responsibility

Two years ago, I noted that recent scandals in banking evidenced “deep-seated cultural and ethical failures.” Many of the industry’s leaders now agree. According to the Federal Advisory Council of the Federal Reserve System, a group composed of senior representatives from the industry, “as often as not […] the challenges faced in recent years have been behavioral and cultural; post-crisis episodes such as LIBOR and foreign exchange manipulation provide hard evidence that there remains work to be done.”

Last year I argued that “the solution [to cultural problems] needs to originate from within the firms, from their leaders.” I view today’s workshop as a progress report on the industry’s efforts. This is an opportunity for us to discuss collectively what is working, what is not, and the next steps that are needed.

We should take care, though, not to confuse cause and effect. The banking scandals that followed the financial crisis are evidence that something fundamental is wrong. I would encourage each of you to consider not just specific examples of misconduct, but the patterns within them that point to underlying causes. I suspect we will see a strong overlap with those factors that contributed to the financial crisis. I think your focus should be less on the search for bad apples and more on how to improve the apple barrels.

Role of the official sector

Dodd-Frank strengthened bank balance sheets, and banks have become more resilient to systemic shocks. This is a positive development. At the same time, it is also important to mitigate the sources of systemic shocks. Dodd-Frank apparently did little to curb misconduct – a possible source of systemic risk. If the people managing capital cushions and liquidity buffers view these tools as sufficient mitigants for the costs of misconduct, or if powerful incentives encourage workarounds of the new regulations, then the connection between post-crisis reforms and greater financial stability becomes threatened.

In the last year, we have seen emerging approaches to supervision that aim to address culture, conduct and governance. These methods are being developed in a number of jurisdictions. I am pleased to welcome representatives of 15 foreign supervisors and other official sector agencies who are joining the many representatives of U.S. supervisory and regulatory agencies here today. The topic of culture and conduct has truly become a global dialogue. We have a lot to learn from each other.

One question on the minds of many in the official sector is, “what is the most effective way to promote reform?” Sharing ideas on leading practices, challenges and the opportunities for industry collaboration is a start – but it is not the end. Financial firms need to act on this information, and the official sector should hold institutions accountable for demonstrating sustained, observable progress.

Overview of agenda

Let me now give a brief overview of today’s agenda. The first panel will present the Group of Thirty’s recent report on banking conduct and culture, which calls for fundamental and sustained change. As you all know, the Group of Thirty is a forum consisting of senior public officials and private sector bankers. Its purpose is to facilitate non-partisan discussion of issues that threaten global economic stability and economic progress. It speaks volumes that the Group has focused its work in recent years on effective governance, the role of supervision, and on conduct and culture.

Each of the four remaining panels will address one aspect of the multidimensional nature of cultural change.

• In the first panel, we will hear about engagement with employees – especially those who are skeptical of the benefits or practicality of reform.
• In the second panel, we will discuss accountability – not only in the sense of being “held accountable,” but also in the broader sense of promoting responsibility and stewardship. I am particularly interested in designing incentives – both the carrot and the stick – that yield conduct aligned with the public purposes of banking.
• The third panel will focus on skill development – particularly on recruiting and training as levers for sustained cultural change.
• And the last panel will focus on leadership and industry collaboration. A prime element of leadership, within a firm and across the industry, is character – behavior anchored in values consistent with the public’s legitimate expectation of trustworthiness.

Our keynote speaker today is Christine Lagarde, the managing director of the International Monetary Fund. Christine Lagarde has been outspoken in her view that “financial leaders [must] take values as seriously as valuation, culture as seriously as capital.” This makes abundant sense to me – culture and capital each promote financial stability. Thank you for joining us. I am also grateful to Stanley Fischer, the vice chairman of the Board of Governors, who will speak with Christine Lagarde following her remarks.