Bank Cultures Rely On Effective Controls

By Roy C. Smith and Ingo Walter                                                                     

 

Of all the financial markets that should be resistant to manipulation, the foreign exchange (FX) market surely tops the list. With $5.3 trillion traded daily by thousands of buyers and sellers across the world, this should be a hyper-efficient market.

Foreign exchange is traded in a self-regulated broker-dealer market dominated by large, responsible banks and other intermediaries serving financial and non-financial clients worldwide. It has run seamlessly for decades, including during the global financial crisis of 2008-2010.

The FX playing field is a design masterpiece, blending efficiency, innovation stability and robustness. Equals are treated equally and unequals treated unequally in a transparent, competitive framework that extends from massive dealing banks at the center to nonfinancial firms making wire transfers or hedging currency exposures.

FX traders’ live in a fishbowl where gains and losses are taken as they come and there are no rocks or weeds to hide under. As befits such a business, traders must be as tightly controlled as a Pit Bull on a leash – alternately extending or tightening trading limits with changing market conditions and traders’ skills – controlled by experienced supervisory managers who have been there and done that.

So how could six traders in the FX business -- Citigroup, JP Morgan, HSBC, Royal Bank of Scotland,UBS and Bank of America - agree to a $4.3 billion “settlement” to dismiss charges of FX market misconduct by US, UK and Swiss authorities after a year-long investigation? This is the largest group settlement ever, and the first to target the FX business. The specific charges involved failure of the banks to prevent traders’ efforts to manipulate the FX market - irrespective of whether they succeeded, which quite likely they did not.

To many, the settlement seemed just and appropriate, coming on the heels of similar scandals in the Libor, mortgage-backed securities, commodities and retirement savings markets. Years after the 2008 financial crisis, these same banks, and a few others yet to be dealt with, seem still to be out of control and need to be forced to do their jobs properly. This is a sad commentary on the effectiveness of market discipline.

But to others, the settlement seemed to be an example of bullying and over-reaching by regulators to extract disproportionately large payments from banks to settle charges that a few apparently poorly supervised FX traders misbehaved. Instead of punishing the miscreants, their direct supervisors and, in turn, their senior managers, it is the shareholders of the banks who are stuck with the bill – billions that could have been returned as taxable income to shareholders or used to increase bank capital.

The New Normal

Indeed, the FX settlement is the latest in a long line of massive legal actions against banks as corporate “persons” responsible for the actions of those whom they employ. In this connection, prosecutorial efforts to make shareholders liable for problems caused by employees has been aimed at forcing boards of directors to reform their banking cultures to make them more responsible to the public interest, upon which their banking charters are ultimately predicated.  

This is the real lesson for bank shareholders, and, fair or not, this is the “new normal.” The legal power to sue banks for infractions, supervisory failure and associated cultural dysfunction is undisputed and here to stay. And the system is stacked against the banks. Prosecutors almost never have to prove their cases in court because bank boards fear the reputational damage of a public jury trial and that a “guilty” verdict would open a floodgate of civil litigation. So, they settle on the best terms they can get

The current FX case also demonstrates how US-style litigation has spread to Europe, where the UK’s Financial Conduct Authority (FCA) and the Swiss Financial Market Authority (Finma) have teamed up with US banking authorities. In all three countries, it is possible that criminal charges against individuals may follow.

Holder Factors In

Charging corporations as persons responsible for the conduct of their employees was unusual until 1999, when Eric Holder, at that time US Deputy Attorney General, wrote a memo to federal prosecutors outlining the criteria for bringing such charges. His memo - which has been superseded by a series of others - set standards that the Government followed in suits against Enron, WorldCom and other corporations caught in scandals during the early 2000s.

The basic idea of the Holder memo was that corporations are expected to provide a culture of good citizenship and appropriate business practices which fully comply with the law. It contained several “factors” to be considered by prosecutors in bringing charges against corporations – these included pervasiveness of wrongdoing within the company, a history of misconduct, timely and voluntary self-disclosure of wrongdoing to regulators, cooperation in the ensuing investigations, and the existence and adequacy of compliance programs, including management efforts to prevent, identify and discipline wrongdoing (italics added).

The test for whether a corporation meets these tough standards is not entirely clear, but the burden of demonstrating that it has in fact done so rests with the corporation itself.

Some of the banks involved in the FX settlements - particularly those with a history of employee misconduct in other markets - may have been uncomfortable demonstrating the ability of their management organizations to spot and prevent trouble. No doubt there have been cases of FX trading desks being pressured to boost their profitability using aggressive tactics, failing to examine new “trading strategies” for compliance shortcomings, or failing to listen to whistleblowers.

A New Standard

Given the Holder factors, it is increasingly hard for banks to plead ignorance or incompetence. No longer will it do to say “we have procedures in place, but we cannot be expected to keep track of everything every employee does.”

The proliferation of settlements across different financial markets makes it clear that banks increasingly will have to show they made credible and persistent efforts to keep their people in line. They must now be able to demonstrate that they have organized themselves into proactively watchful, compliant organizations by training, motivating and rewarding thousands of middle managers for spotting and fixing trouble before it happens. Such a functional approach to controlling behavior is the essence of the missing “cultural” issue in banks. It does however beg the question of how to reward these people appropriately for things that didn’t happen as opposed to things that did.  

Even with the best of intensions and commitment of resources things can still go wrong. But if a bank can show it has in good faith done all that any responsible organization could have done to prevent, detect and halt employee misconduct, then it can expect to avoid the kind of litigation that has damages shareholders and undermines its reputation and performance.

Bank boards of directors are beginning to get the message. They appreciate that getting these Holder-type issues wrong can be hugely expensive, and can lead to even worse consequences if their cultures are perceived to be tolerant of misconduct.

The good news is that banks can turn things around. This requires pruning the FX ranks of chat-room miscreants and re-training those who remain. People selected for middle management must be inculcated with the idea that they can and will be be rewarded for how well they play “defense” as well as “offense.” Internal whistleblowers need to be encouraged, not marginalized – itself not an easy thing to do. Department ad hoc committees at the operating unit level need to be able to thrash-out and resolve conflicts-of-interest and compliance issues on the spot as they arise.

This will require a major reworking of middle management responsibilities and accountability for a large segment of a bank’s managerial structure – maybe one in every ten or fifteen employees. But it can be done, and done effectively, if the necessary will and resources are applied.

The latest series of FX settlements  make it very clear that the banks have no choice but to do all this, and do it quickly.

Breaking Up the Banks

By Roy C. Smith 

from Financial News, Nov. 10, 2014

Last month, William Dudley, president of the NY Federal Reserve hosted a “Workshop on Reforming Culture and Behavior in the Financial Services Industry” for about 90 invited senior bank executives, regulators, prosecutors, and academics. This was the concluding paragraph in a lengthy and thoughtful analysis of the dangers of sharp-edged, aggressive “trading cultures” at banks

… if those of you here today as stewards of … large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist.  If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively.  In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively (emphasis added)… The consequences of inaction seem obvious to me—they are both fully appropriate and unattractive—compared to the alternative of improving the culture at the large financial firms and the behavior that stems from it.  So let’s get on with it.  

In other words, if the banks did not change their cultures to prevent “bad behavior”, Dudley warned, they would leave their regulators, alas, no choice but to break them up. 

There is no doubt that in the last decade almost all the major US and European capital market banks were involved in instances of shabby and sometimes illegal business practices, gamed the system to evade the rules and, in the high spirit of the trading culture, did what they could to “rip out the eyeballs” of their “counterparties.” 

Such actions are not to be excused, but the perception of cultural decay and rampant misconduct truly exceeds the reality.  The crash occurred after decades of industry deregulation, consolidation and innovation encouraged by regulators that were inspired by Alan Greenspan to believe that increased competition in financial markets would lower the cost of capital to market users, and that the markets themselves would constrain banks behavior. Consequently, the markets became enormous – the value of securities outstanding in 2007 reached an extraordinary $200 trillion – and liquidity events arising from sudden shifts in such a large market could be overwhelming, as we discovered in 2008.

After 2008, however, it didn't take long for governments everywhere to blame the financial crisis, and the many troubles that ensued from it, on the greedy and reckless cultures of the banks. 

But, how bad was it really, when prosecutors could find no evidence of illegal actions by any senior bank officers, despite extensive investigations. Indeed, most observers of the period now recognize that the banks, notwithstanding their turbo-charging of the mortgage business, were not alone in bringing about the crisis. Regulators and other government officials contributed significantly to the financial meltdown, before, during and after the crisis.

Six years after the event the cultures of the large banks have changed, as Mr. Dudley surely knows. They may not have been fully brought to heel, but certainly they have been defanged. 

Almost all of them have changed top management, purged their ranks of securitisers and others associated with the mortgage business, reduced trading activities, modified their compensation systems, and have tried to persuade shareholders, rating agencies and creditors that they are now better managed, less risky and fully reformed.  

The banks have also had to adapt to the greatest regulatory onslaught since the 1930. One recent report showed that the six largest US banks had already spent $70 billion in complying with all the new rules that affect them, But, unlike the 1930s, banks have also had to cough up $150 billion of shareholders’ capital to settle government lawsuits..

Despite their efforts at reform, most of the large capital market banks’ shares still trade at or below book value and their returns on equity capital remain below its cost.  Such a condition does not bode well for their economic viability or competitiveness  

Indeed, Mr. Dudley really should be more worried about the long-term viability of these banks, which are crucial to the financial system, than the nature of their cultures after all the changes already imposed. 

Further, it is hard to see how the financial system would benefit by converting bank  cultures into ones that are residually risk averse and afraid of getting into trouble.  

When Dodd-Frank was passed, it was criticised for many things, but praised for one – it did not arbitrarily force all large banks to chop themselves up or reintroduce Glass-Steagall to force all of them to leave the securities business.

Its authors understood that the burden of compliance would be high, and may change the industry considerably, but how any individual bank would respond to the new rules was to be left to the bank itself. 

Undoubtedly, some said, the new regulations would result in banks breaking themselves up into more flexible and economically viable units.  One such option was to spin off highly capital-intensive investment banking units, tailoring what remained into a basic, national commercial bank, like Wells Fargo.

So far this hasn't happened. Some banks have pulled back from capital markets, but none have gone so far as to break themselves up.

Knowing this, maybe Mr. Dudley is sending a message that ultimately the banks are going to have to do what the Fed wants them to, which for some of the largest and more complex, is to act more quickly and radically to simplify their basic business models. 

Dodd-Frank has given the Fed a lot of power over banks, and much of it is now being applied on a discretionary basis. It conducts annual stress tests that include qualitative factors that must be met in order to pay dividends and repurchase stock. The Fed also must approve banks incentive compensation plans and their “living wills” for banks to be in good standing (it recently rejected the living wills of 11 major banks, forcing them to resubmit them). 
Now, after Mr. Dudley’s remarks, it appears that the Fed can use any instance of “bad behavior” to determine that a bank is not well managed, “dictating” that the Fed force the bank to “dramatically downsize and simply” itself. With numerous investigations of post-crisis conduct still ongoing (LIBOR, FX), the possibility of more bad behavior surfacing is not insignificant. Such behavior does not have to be proven, or recent, for Mr. Dudley to act.

Though Dudley’s threat was forcefully made, it would be momentous and unprecedented for the Fed openly to force a bank to break up. But the power to do so under Dodd-Frank is certainly there, though the process is complex and can be appealed. 

Mr. Dudley’s cultural workshop may actually be less about culture and more a subtle warning to those banks the Fed considers to be moving too slowly in transforming themselves into the well-managed entities it wants.  Those banks know who they are.  As Mr. Dudley says, they need to “get on with it.”