Financial Regulatory Forum

Reforming banking’s risk culture requires breaking “accountability firewall”

By Guest Contributor
September 11, 2013

By Henry Engler, Compliance Complete

NEW YORK, Sept. 11 (Thomson Reuters Accelus) - If there is one part of the cultural makeup of Wall Street that remains firmly in place despite the financial crisis and subsequent avalanche of regulations, it is the reticence among those who lose money to come clean early.

Many of the most spectacular losses in recent years — whether the JPMorgan “London Whale” episode, the UBS “rogue trader” incident, or Jerome Kerviel’s manipulation of internal systems at Société Générale — have all had one thing in common: concealment of trades gone badly wrong, or at a minimum, a lack of transparency and early acknowledgement of losses. And if one can point to a single reason for such behavior, it is the well-known fact that raising the red flag would mean the individual responsible would be shown the door.

The blowup at JPMorgan was noteworthy not just for the size of the loss ($6.2 billion), coming in a unit that was supposed to hedge risk, but also for senior management’s role in cultivating a culture that discouraged individuals to identify problems.

“Ina (Drew) never wanted to hear bad news,” said a JPMorgan bank executive familiar with the management style of the former Chief Investment Officer where the loss was incurred.

In a lengthy piece by the New York Times last year that examined the failure of controls at JPMorgan, CEO Jamie Dimon said: “Honestly, I don’t care what second-guessers say in life If anyone in the company knew, they should have said something. No one came to us beforehand and said we have a problem we should be looking at.”

Dimon’s comment could well have been made by other chief executives. In a scathing review of banking practices by the UK Parliamentary Committee on Banking Standards earlier this year, the panel highlighted a disturbing lack of awareness and accountability by senior managers:

“Too many bankers, especially at the most senior levels, have operated in an environment with insufficient personal responsibility. Top bankers dodged accountability for failings on their watch by claiming ignorance or hiding behind collective decision-making… Ignorance was offered as the main excuse. It was not always accidental. Those who should have been exercising supervisory or leadership roles benefited from an accountability firewall between themselves and individual misconduct, and demonstrated poor, perhaps deliberately poor, understanding of the front line.”

The “accountability firewall” might well have been facilitated by management practices that hindered the type of information flow necessary in an effective risk culture. In a separate survey by the London School of Economics, the findings of which are due to be updated in coming weeks, researchers pointed to the fear of punitive action as a primary concern. The study quoted one individual who summarized the views of many:

“One of the things that helps greatly with the flow of information through the organization is how it’s reacted to when it gets to the next level. So being able to report risks openly and honestly without getting your head bitten off from the second that’s done is crucial […] For example, if I told you something that might be happening you do not want your directors on your back saying ‘What have you told them? Why?’ So managing the flow of information through an organization to ensure key stakeholders are properly engaged is quite important […] to avoid the wrong reaction happening.”

What has led us to this state of affairs? And how might it be corrected?

Excesses of short-termism

Establishing a robust risk culture is a subject that management consultants have written volumes on. And when one scours the long list of recommendations, embedding risk awareness across the organization and fostering an environment in which people are comfortable challenging others without fear of retribution are critical components.

But this ideal state would appear far from the current reality at many institutions. In understanding what has led us to an environment of fear and lack of accountability, some argue that the finance sector has taken short-termism to the extreme. The enormous pressures that individuals are under to meet their financial targets, and how those goals are wrapped-up in the quest to meet quarterly revenue and profit objectives, create disincentives to identify risk events early.

“The connection that hasn’t been made is how short-termism invites corrupt behaviour — lawful, but corrupt” says Malcolm Salter of the Harvard Business School, who has written extensively on institutional corruption on Wall Street. In order to rectify the problems, many banks have taken a much closer look at compensation policies, but this may not be enough. “Who is modeling the behavior at the banks?” asks Salter. “There is the cultural aspect of the business: how do you change that culture short of the firm having a breakdown.”

In the UK, the Committee on Banking Standards proposed a series of sweeping reforms aimed at establishing much great accountability on senior management. Among these would be the “replacement of the statements of principles and the associated codes of practice, which are incomplete and unclear in their application, with a single set of banking standards rules to be drawn up by the regulators. These rules would apply to both senior persons and licensed bank staff and a breach would constitute grounds for enforcement action by the regulators.”

The rules proposed, and which have been embraced by the UK government, are intended to shift the burden of proof of management failure away from the regulator and onto senior management, who will have to “demonstrate that they took all reasonable steps to prevent or offset the effects of a specified failing.” But the new regulatory standards are only UK-specific. International coordination is needed to guard against regulatory arbitrage.

Indeed, what Salter and others see within the industry are ongoing attempts to “game” the system, and legally circumvent many of the regulations that have been piled on since the 2008 crisis. It is this legal gaming, if you will, that remains problematic when envisioning an enhanced risk culture and ethical banking environment. To change that type of behavior requires the type of leadership from the top that we have yet to see, and a regulatory environment that enforces accountability.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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