Thursday, April 23, 2015

How Can the Banking Industry Regain the Moral and Ethical High Ground?

There is no question that the reputation of the banking industry took a big hit during the global financial crisis. It became clear to taxpayers that some banks that took on too much leverage and risk and lost big would get a free pass by being bailed out. It also became clear the rules didn't really apply to those who were "too big to fail."

At the recent Asian Banker Summit in Hong Kong, the Chief Executive of the Hong Kong Monetary Authority (Norman TL Chan) talked openly about what he thinks led to the problems and offered some ideas on how to regain some lost high ground with the public. It's an interesting speech with a lot of good ideas which you can read by clicking here. But, at the end of the day, he sums up what is the most important change that needs to take place. He says bank managers need to "change their mindset from what can we get away with to what is the right thing to do." Below are some quotes from the speech.

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Moral and ethical high ground: trust and respect

"Returning to the theme of the Summit "regaining the moral and ethical high ground" - what do we really mean here? I think, in a word, "trust". With "trust", comes "respect".
In the past, banking was regarded as a reputable profession and bankers were highly trusted and respected both by their customers and by members of the public more generally. This was not surprising as basically customers entrusted their life savings to their bankers and the preservation and safety of their hard-earned money was in the hands of those bankers. Although nowadays customers still place their life savings with banks, bankers no longer enjoy the same high degree of trust and respect from society, especially after the Global Financial Crisis. What has changed so dramatically to bring the reputation of bankers so low?"
"Well, the modality and governance structure of banking have changed a great deal over the last century. More importantly, these changes have created an incentive system that leads to a misalignment and disconnect between the interests of the owners of banks (i.e. the shareholders), bank management and customers."
. . . .

"Business profiles and activities have also changed over time. Simple deposit-taking and lending businesses have been combined with investment banking, securities and capital markets, and even proprietary-trading activities, to form large, complex organizations, raising clear issues of cultural compatibility across businesses with very different objectives, time horizons and employee profiles. In an environment where near term profits are very highly prized and rewarded, it is all too easy to see how the more aggressive of the approaches introduced into the mix (with the power of traders rising in line with trading profits in buoyant markets) might prevail in shifting a culture from a client focus to one that is overly defined by financial performance.

It is interesting, when comparing and contrasting cultures within banking, to consider for a moment Glass-Steagall and its separation of commercial and investment banking to prevent commercial banks from trading securities with their customers' deposits.
Passed during the Great Depression, following a number of bank runs which destabilized the US economy, Glass-Steagall's motivation rested on: real or perceived conflicts of interest, in the form of collusion between banks and their affiliates with the affiliates borrowing from the banks to buy securities and then selling securities to repay the banks' debts and worries that banks would engage in risk-taking speculation, trading with customers' deposits rather than lending to promote economic growth. The "firewall" created by Glass-Steagall was gradually weakened over the years and, as you all know, was eventually repealed in 1999. 
Some argue that this repeal contributed to the Global Financial Crisis. Joseph Stiglitz, the Nobel prize winner, summed it up thus: "Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people's money very conservatively-.. Investment banks, on the other hand, have traditionally managed rich people's money - people who can take bigger risks in order to get bigger returns." 3
When repeal of Glass-Steagall brought investment and commercial banks together, it would appear from the events over the last decade or so that the investment bank culture came out on top. The prevailing business strategy becoming pursuit of the high returns that could be obtained only through increasing leverage and risk-taking."
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"So where do we go from here? As I mentioned earlier, while bank regulators clearly play an important role in influencing banking operations, it is really up to the industry to decide what it can and should do to regain the trust and respect that banks once enjoyed. We should bear in mind bank regulators are a consequence of the emergence of modern banking. However, as discussed earlier, the modality and incentive system for banking were very different in the old model of banking : there was a high degree of alignment of interest between bank owners, bank management and bank customers, which has over the years been significantly eroded.

Again, don't get me wrong. I am not advocating that we should go back to old-fashioned banking. It is far too difficult, if not impossible, to turn the clock back this far and to do so might mean the loss of some beneficial innovations over the years. However, there is considerable public interest in ensuring that banking, which remains the predominant channel of intermediation between savers and borrowers in our society, functions efficiently and effectively, with a high degree of professionalism and strong ethical standards."

.  .  .  .  .

"For sure, regulators will continue to pursue further changes in banking. This is ongoing and there is still some way to go. In the process, there will be arguments, frustrations and inevitably pushback. No doubt the new standards and regulations will lead to some changes in the behaviour and business models of banks. However, I do not for one moment believe that regulators and regulatory measures alone can possibly redress all of the problems stemming from the misalignment of interest amongst the various stakeholders in banking. Regulators can set standards and provide some external checks and balances. But there is no substitute for internal governance and controls that are designed to achieve the desired behavioural change across the entire firm. In this context, it is crucial that we have buy-in from the owners, directors and management of the banks.

Only when the public sector and the owners, directors and managers of banks share the same goals and objectives can we induce the desired outcomes on a sustainable basis. Only when shareholders cease to put unreasonable pressures on bank management to keep on improving RoEs can regulators feel comfortable that the bank is not incentivised to take the short-term view on business growth and profitability. Only when bank management is not rewarded based on short-term financial performance can we be less concerned that bank managers will take excessive risks for near term bonus or share option value. Only when board directors understand that they are accountable not only to shareholders but also to customers and society more broadly through the regulatory agency can we be confident that effective governance and internal controls will be put in place. In short, banks need to own the common goal and to promote the appropriate culture, values and practices across the firm, which are to put the safety of the bank and the interest of depositors and customers ahead of the banks' own commercial interests, just as the old fashioned bankers did in the past. Only when this happens will bank managers and employees change their mindset from "what can we get away with" to "what is the right thing to do". Only when this happens can the banking industry regain the trust and respect that bankers used to enjoy in the not so distant past."

My added comments:

When I read this speech it reminds me that values do matter. We can pass thousands of laws and hire tens of thousands of regulators. But unless people are willing to go back to some very basic values like the golden rule (Do unto others as you would have them do unto you), we can't expect a lot to change at some banks.

It's also important to point out that it is wrong to paint an entire industry with one brush. There are good bankers who are doing good things in the world. Through this blog I have had the priviledge to meet some. They don't need the public spotlight to go about doing good in the world. They just quietly work behind the scenes to try and make things better. Let's hope they prevail as the future unfolds.

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