Ingo Walter
The
epic financial crisis of a few years ago inflicted immense damage on the
process of financial intermediation, the fabric of the real economy, and the
reputation of banks and bankers. Even today, some five years later, little has
happened to restore financial firms to their former glory near the top of the reputational
food-chain in most countries. For
reasons of their own, many boards and managers in the banking industry have
little good to say about the taxpayer bailouts and the inevitable regulatory
tightening. In the words for former Barclays CEO Bob Diamond, "There
was a period of remorse and apology for banks. I
think that period is over. Frankly, the biggest issue is how do we put some of
the blame game behind us? There's been apologies and remorse, now we need to
build some confidence.”
There have been some notable exceptions,
of course. In the middle of the crisis Josef Ackermann, former CEO of Deutsche
Bank and Chairman of the International Institute of Finance (the preeminent
lobbying organization for the world’s largest banks), noted in 2008 that the
industry as a whole was guilty of poor
risk management, with serious overreliance on flawed models, inadequate
stress-testing of portfolios, recurring conflicts of interest, and lack of
common sense, as well as irrational compensation practices not linked to
long-term profitability – with a growing perception by the public that banking
was the playground of “clever crooks and greedy fools.” Ackermann concluded that
the banking industry had a great deal of work to do to regain its reputation,
and hoped that this could preempt damaging regulation. It was already too late
for that.
Crisis-driven
reputational damage at the firm level can also be inferred from remarks by
Peter Kurer, former Supervisory Board Chairman of UBS AG, who noted at the
bank’s annual general meeting in April 2008 that “We shouldn’t fool ourselves.
We can’t pretend that there has been no reputational damage. Experience says it
goes away after two or three years.”
Perhaps it does, perhaps not. But the hemorrhage of UBS private client
withdrawals at the height of the crisis and immediately thereafter suggests
severe reputational damage to what was then the world’s largest private bank.
The
number of financial firms -- ranging from Santander in Spain to Citigroup in
the US and Union Bancaire Privée in Switzerland -- that have reimbursed client
losses from the sale of toxic Lehman mini-bonds, collapsed auction-rate securities,
and investments in Bernard Madoff’s Ponzi scheme suggests the importance of
reputational capital and the lengths to which financial firms must go to try to
restore it. And at the personal level the world is full of disgraced and
sidelined bankers whose hard work, career ambitions and future prospects lie in
tatters.
Whether at the industry, firm or personal
level, the reputational costs of the financial crisis five years ago were
enormous. So it’s all the more curious that banks have run into an even greater
firestorm of reputational losses more recently. Consider the following questions:
• Is it acceptable to mis-sell worthless payment
protection insurance to retail mortgage and credit card customers?
• Push in-house products to investor clients against
superior (better-performing or cheaper) third-party products?
• Invade segregated customer accounts and borrow the
money for your
own
operations?
• Facilitate
clients’ evasion of taxes legally payable in their countries of residence?
• Launder money for drug dealers and arms traffickers
and facilitate violations of bilateral and multilateral trade and financial
sanctions?
• Sell securities to institutional clients which you
know will collapse in value – and then use your proprietary trading platform to
speculate against them?
• Use an investment advisory relationship to earn
kickbacks from product vendors?
• Design
off-balance-sheet structures for clients solely for purposes
of financial misrepresentation?
• Exceed your internal
or regulatory risk exposure limits and cover your tracks?
• Submit false
Libor numbers and trade against them – and work in cahoots with other banks and money brokers to implement the
scheme?
• Redefine a bank’s
central exposure hedging platform as a profit center and
circumvent established risk controls to
generate additional earnings?
There are many others. Each has the
name of a major bank attached to it, sometimes several banks. Most of the
offenses seem to intentionally violate established regulations and legal statutes
- or just defy common-sense definitions
of what is fair, appropriate and ethical.
Banks and bankers, some would argue,
have lost their way in carrying out their key role as efficient allocators of
capital and creators of improved social welfare. They seem more like wealth-redistributors,
from their clients to bank employees and shareholders, all the while
privatizing returns and socializing risks on the back of taxpayers when things
go badly wrong. Fair assessment or not,
it’s no wonder the industry as a whole and individual banks have seen their
reputational capital erode.
What might explain this? After all,
some of the best educated, most highly talented and morally upright people in
the world work for banks and do their best to serve clients, owners and other
stakeholders well.
It could be the changed competitive
market structure in global banking, in which more intense competitive pressure
and heavily commoditized markets have made it increasingly difficult to deliver
ambitious promised returns to shareholders and attractive bonus pools to
employees. This creates incentives to migrate banking activities to less open
and less transparent markets, where transaction costs and profit margins are
higher. These are markets that have become increasingly problematic as a result
of greater product complexity and erosion of
transparency, with efforts to reform them often resisted furiously by banks and
their advocates.
It could also be that, in such an
environment, the definition of “fiduciary
obligation” - the duty of care and loyalty that has traditionally been the
benchmark of trust between banker and client - has morphed into redefining the
client as a “trading counterparty,” to whom the bank owes nothing more than
acceptable disclosure of price, quantity and product. A deal is a deal, and
what happens later is only of limited concern in a world where the “long term”
is after lunch.
Compounding the effects of the market is
the changing nature of the banks themselves, which might be considered both a
cause and a consequence of crisis-related and subsequent reputational issues. If
bank size, complexity, imbedded conflicts of interest, and the ability to
manage and govern themselves were contributory factors leading to the recent crisis,
then these issues are even more problematic today – if only as a result of still
bigger and broader financial conglomerates emerging from governments’ efforts
to stabilize the system. In the ensuing restructuring process some important things
can easily get lost, with thousands of people from competing institutions newly
hired and others dropped from the team. Whatever affirmative culture and
perspective once existed can easily get washed-away in the tide.
Such factors are sometimes complemented
by banks’ underinvestment in risk management and compliance (the “defense”) and
its perennial disadvantage in questions of judgment and engagement against
revenue- and earnings-generation (the “offense”). Usually this “tilt” is compounded
by levels and systems of compensation designed to emphasize bonus against malus.
Reputational capital is lost by people, acting individually and collectively.
So what drives people carries big consequences.
Nor can boards of directors be let off
the hook. They are supposed to set the tone that dominates everything a bank
does, and how that is projected into the marketplace. In some cases factors
like poor industry knowledge or lack of technical background of directors,
dominant or “imperial” chairmen, and a boardroom sociology that puts a premium
on “teamwork” can be at fault. And who is supposed to control boards?
Presumably it’s individual investors and fiduciaries, which control share
voting rights. Perhaps most important are institutional investors who fail to
use the power of the proxy to challenge errant boardroom behavior – possibly
because they themselves face conflicts of interest and do business with the same
banks in which they exercise voting rights.
And not least, banking regulators seem
to have plenty of problems understanding and approving conventional risk
indicators and management practices in large, complex banks. Understanding the specific
reputation-sensitivity of activities in the firms they regulate at the
business-line level just may be too much to ask.
Frederick the Great of Prussia has
often been quoted as pronouncing that “Banking is a very special business which
should be the province of very special people.” By “special” he presumably
meant people who were honest and trustworthy to a fault, with a keen eye to
their fiduciary obligations in handling other people’s money, and to do so in
confidence.
Maybe banking today attracts some
rather un-special people who liberally use terms like “share of wallet,” “asset
gathering,” “guaranteed bonus,” “caveat emptor” and “Muppets” in connection
with the work they do every day. Dynamic, fast-moving businesses where these characteristics
are highly valued have become increasingly important in banks over the years.
So the bacterium gradually infests larger parts of the organization, and the
reputational erosion that follows gets to be viewed as an inevitable consequence
of the new world of banking. Meantime, educational institutions
enthusiastically churn out more young talent with much the same mind-set.
Unfair? Probably. But it doesn’t take too many bad apples.
Anyway, who cares? Reputational losses
occur from time to time in any business, no matter what the industry. They eventually
go away. And they are usually much less problematic when pretty much all of the
players are doing the same thing.
One would like to believe that market
discipline transmitted through the share price can be a powerful deterrent. But
this depends critically on the efficiency and effectiveness of corporate
governance, and we observe that banks continue to encounter serious reputation
losses due to misconduct despite their impact on the value of the business.
If
market discipline fails, the alternatives include civil litigation and external
regulation aimed at avoiding or remedying damage created by unacceptable
financial practices. Yet civil litigation seems ineffective in changing bank
behavior despite “deferred prosecution” agreements not to repeat offenses. This
again suggests continued material lapses in the governance and management
process.
Dealing
with operational and reputational risk can be an expensive business, with
compliance systems that are costly to set up and maintain, and various types of
walls between business units and functions that impose opportunity costs on
banks due to inefficient use of information and capital within the
organization. And intractable conflicts of interest may defy sustainable
control, and possibly require structural remediation involving withdrawal from
activities that are too problematic to keep under the same roof. These are not
popular topics among bankers. Nonetheless, it seems that operational,
compliance and reputational issues contribute to market valuations among the
world’s major financial conglomerates that fall well below valuations of simpler,
more specialized financial services businesses.
As
demonstrated by the kinds reputation-sensitive “accidents” that seem to occur
repeatedly in the financial services industry, neither good corporate
governance or stakeholder legal recourse or more intrusive regulation seems to
be particularly effective in stanching reputational losses in banking. Maybe they
just “a cost of doing business” in this industry? One would hope not. The same
argument in the pharmaceutical, petroleum or food industries would be considered
appalling by most people.
Bottom
line? Managements and boards of financial intermediaries need to be convinced
that a good defense is as important as a good offense in determining
sustainable competitive performance. The also need to walk the talk. Admittedly
this is extraordinarily difficult to put into practice in a highly competitive
environment for both financial services firms and for the highly skilled professionals
that comprise the industry. A good defense requires an unusual degree of senior
management attention and commitment. Internally, there have to be mechanisms
that reinforce the loyalty and professional conduct of employees. Externally,
there has to be careful and sustained attention to reputation, perspective and
balance, in addition to ongoing competitive performance.
In
the end, it is probably leadership more than anything else that separates
winners from losers over the long term – the notion that appropriate
professional behavior reinforced by a sense of belonging to a quality franchise
constitutes a decisive competitive advantage.
