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01/12/2015

The Best Defense to Litigation Is a Good Bank Culture


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

And yet six major banks recently agreed to a $4.3 billion settlement with US, UK, and Swiss authorities over charges that the banks had failed to prevent traders from attempting to manipulate the market. In all three countries, it is possible that criminal charges against individuals may follow.

The settlement is the latest in a long line of massive legal actions that hold banks responsible for the activities of their employees. Prosecutorial efforts to hold shareholders liable for myriad problems that bank employees have caused seem to have no end in sight. The goal of these actions is to prompt boards and their managers to reform banking cultures. If banks want to avoid more floods of litigation in the future, they'll have to act fast.

Charging corporations for the conduct of their employees was unusual until 1999, when Eric Holder, at that time the 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 His memo — which has been superseded by a series of others in the years since — set standards that the government followed in suits against Enron, WorldCom and other corporations caught in scandals during the early 2000s.

The basic idea is that corporations are expected to provide a culture of good citizenship and appropriate business practices that comply with the law. Prosecutors who are considering bringing charges against corporations are supposed to consider a number of factors. These include the pervasiveness of wrongdoing within the company, whether it has a history of misconduct, whether the company makes timely and voluntary self-disclosures of wrongdoing to regulators and cooperates in investigations, and the existence and adequacy of the company's compliance programs, including management efforts to prevent, identify and discipline wrongdoing.


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The proliferation of settlements in an array of financial markets in recent years makes it clear that banks must show they have made credible and persistent efforts to keep their people in line. They must be able to demonstrate that they have organized themselves into proactively watchful and compliant organizations, with thousands of middle managers who are well trained, motivated and rewarded for spotting and fixing trouble before it happens. This functional approach to controlling behavior is the essence of the much-discussed cultural issue in banks. (It does, however, force banks to confront the difficult question of how to reward people appropriately from the bonus pool for things that don't happen as opposed to things that do.)

Banks and their boards of directors are beginning to get the message. They appreciate that cases against them may have even worse consequences if their cultures are perceived pervasively and historically tolerant of misconduct.

The good news is that banks can turn things around. On desks like foreign exchange, improving the culture requires pruning the ranks of chat-room miscreants and re-training those who remain. Meanwhile, people selected for management must be inculcated with the idea that they can and will be rewarded for how well they play defense as well as offense.

Internal whistleblowers must be encouraged, not marginalized — which is in itself a real challenge. And ad-hoc committees at the operating-unit level need to be able to thrash out and resolve conflicts of interest and compliance issues as they arise.

All this requires a major reworking of middle management responsibilities and accountability. That's tough. But it can be done, and done effectively, if banks have the necessary will and the resources. The latest series of FX settlements suggests that major banks don't have a lot of time to lose.

–Roy C. Smith and Ingo Walter are professors of finance at New York University's Stern School of Business.

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