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Monday, August 11, 2014

A “Safe-Harbor” for Ethical Conduct at Banks



By Roy C. Smith

The NY Fed said recently it would hold a “workshop on bank ethics and culture” in the fall. It is stepping up pressure on banks to exercise better leadership to prevent abusive conduct that still seems prevalent in some institutions long after the lessons of 2008 were absorbed. How it should do so is still in doubt.

Alleged rigging of LIBOR and foreign exchange markets, efforts to aid clients in evading US taxes, and conflicts of interest and inadequate disclosure related to dark pools operated by banks have been at the core of recent events that have upset regulators.

Most of these allegations have involved foreign banks operating in the US, but recent settlements of federal charges related to the sale of mortgage-backed securities by JP Morgan and Citigroup (and prospectively Bank of America) have kept US banks in the arena.

The Fed is suggesting that part of its annual stress test evaluations of big banks will include queries into their ethical and cultural fitness.  If the threat of additional multi-billion dollar lawsuits hasn’t been enough to get the attention of bank CEOs, then possibly failing a stress test should be. The combined power of the Justice Department and the Federal Reserve to punish discretionary findings of a qualitative nature is certainly an important game changer for the US banking industry.  But is a new reality.

The banks might argue that they have been unfairly required to shoulder most of the blame and financial responsibility for the economic effects of the financial crisis. Much (though not all) of what they did was to seek innovative but untested approaches to creating new products or client accommodations for which there was considerable demand by knowledgeable financial institutions.

The banking industry is global and very competitive, and individual banks must be innovative and accommodative to survive. They are also corporate entities seeking to maximize profits in accordance with the law and ethical norms. In times of market ebullience and technical changes such as CDOs and high frequency trading, what the law and ethical norms may be can be quite unclear.

The Fed probably takes the view that much of what actually happened was the result of the banks loosing control over the actions of their employees who were aggressively taking as much advantage of the bubble as they could to boost the banks’ profits and their own compensation. The ethical and cultural tone of a bank needs to be set at the top, the Fed has been telling executives, according to The Financial Times, which all of the bank CEOs, of course, say they do.

What the ethical and cultural workshops will accomplish is unclear. Such events have a history of being of little value, but, with some effort by the Fed, the forthcoming ones could be quite useful.

The Fed could begin by defining the standards it wants banks to meet. These should begin with the requirement that all banks strive to achieve a culture that values high ethical conduct and insists on treating all customers and clients fairly. The effort to do this is auditable to a reasonable degree.

The Fed could say that it will provide a “safe harbor” for banks (i.e., it will hold them harmless) if they can demonstrate that they have adopted and enforce policies that make unit heads and mid level management responsible for the integrity of products and marketing and sales procedures. Those that involve potentially injurious conflicts of interest, or rely on loopholes or technicalities to make it to market, need to be nipped in the bud. Violators must be stopped at the point of origination, and dealt with appropriately. Compensation policies also must be modified to allow generous bonuses for problem averting activities, but, as with all bonuses, with meaningful clawback provisions.

The safe harbor idea could be adopted by the ECB as well. It has a similar need to upgrade ethical standards.

Making mid level managers responsible for playing defense and well as offense may be a change that will require additional training over time, but will produce better senior managers. There are thousands of these people in every large bank, so a lot of management development work will be necessary to reprogram them.  Today banks are hiring thousands of new compliance officials to manage the new regulations they must accept, but these people are not the core future management of the bank, the mid level people are. Hiring more compliance people should not be in lieu of empowering mid level operating people.

The mid level guys are also the ones the banks depend on the to make adjustments to products and services so as to adapt to the new regulatory and market environment and to position their banks for the future.  Perhaps they need a way to discuss new product ideas confidentially with the Fed, either just before or after a new approach is introduced.  If the Fed challenges the new idea, the bank should be allowed to withdraw it with impunity.

For banks to be active and competitive they need also to be healthy and economically viable. Investing in greater defensive empowerment of the mid level could be economically very advantageous if it means banks can avoid the massive legal costs of the past few years in the future, and if the effort enables the banks to regain the reputational value that has been lost.

The largest capital market banks have been struggling for years to regain economic viability and to restore their reputations. They could benefit from some helpful understanding from the Fed, which, particularly in view of its enhanced discretionary powers, should advocate roll-back of restrictive regulations put on in the heat and darkness of Dodd Frank but not really necessary to maintaining banks’ fitness and properness in the future.

All this is good stuff to discuss at a workshop, but finding common ground for a workable safe harbor is the real objective.

From Financial News, 11 August, 2014

 














1 comment:

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