Thoughts on Reputation and Governance in Banking
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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 are 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. They 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.
Read abridged article as published in American Banker.
Ingo Walter is the Seymour Milstein Professor of Finance, Corporate Governance and Ethics and Vice Dean of Faculty.