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Corporate Culture and Adverse Selection in Banking

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JP Morgan’s $13 billion regulatory settlement is the latest case of banking indigestion attributable to long-tail liabilities stemming from practices almost a decade old – well over $100 billion so far, with more to come. Most people thought the global financial turbulence would have passed by now - a time-span longer than World War II - even allowing for lethargic growth in the world economy and the need to patch a lot of financial potholes.

Meantime, banks like Morgan are painfully adapting to new rules of the game designed to make the system more robust, the inevitable costs being passed along to customers and long-suffering shareholders. One can hope the high tuition pays-off down the road in better financial stability.

Still, memories are short. Redirection of financial flows through the shadow banking system, creation of new products, persistent regulatory faultlines, and renewed erosion of due diligence in some markets show the persistent need for vigilance. Meantime, banks have been called on the carpet for an amazing variety of transgressions that encompass fixing Libor and foreign exchange benchmarks, aiding and abetting money laundering and tax evasion, rigging metals and energy markets, and an assortment of fiduciary and consumer protection abuses. Most of these allegations are independent of the crisis legacy, and have surfaced despite what were thought to be adequate legal and regulatory safeguards. All of them first came to light at individual banks. But most of them later turned out to be “industry practice.”

Andrew Haldane of the Bank of England, among others, has suggested we look to “cultural” factors in modern banking for at least part of the answer. Banking culture is a product of individuals who act collectively in a firm that operates under a combination of market discipline and regulatory constraints. In turn, banks comprise multiple subcultures that range from transactions processing and retail banking to corporate finance and interprofessional trading – subcultures that are distinctive in terms of the professionals they attract and the performance pressure to which they are exposed. Financial markets can sometimes be so efficient that overstepping the rules offers one of the few routes to serious profit – as they say, “no conflict, no interest.”

So who chooses to be what kind of banker probably has a lot to do with the raw material that forms the immediate culture within which people work – together with a “superculture” that sets the tone for the whole firm.


There is no reason to believe that people who choose “banking” as a profession are any more or less responsible than the population at large after adjusting for education, age, experience and other factors. But they have chosen to join an exceptional industry that works with other people’s money and places exceptional fiduciary demands on them.

No doubt the vast majority of bankers meet the implied “fitness and properness” requisites. But more than a few evidently do not. Taken together, the record suggests there’s a significant subgroup that is attracted to the banking industry as a unique fast-track route to exceptional income and wealth, one that is rarely open to peers in engineering, medicine and (except for a infinitesimally small cohort) science and technology. Unlike these high-performance professions, some parts of banking have enabled large and immediate personal rewards that effectively derive from wealth-redistribution rather than wealthcreation.

Supply and demand for financial “talent” seem to meet in tight-knit banking subcultures that populate hypercompetitive markets, in which the temptation to trespass on off-limits regulatory or behavioral territory is palpable and selfreinforcing, both within banks and through chat-rooms and high job mobility between them. Per a classic e-mail between two traders, “What’s the worst that could happen? We make $200 million and then we get fired.”

The result? Potentially toxic subcultures reinforced by earnings pressure from senior management and gaps in defenses – the risk and compliance controls that tend to operate at an inherent disadvantage and often seem underinvested. And when things go seriously wrong, the collateral damage spreads to lots of innocent colleagues, clients, shareholders and taxpayers.

Adverse selection suggests that banking may be attracting more than it’s fair share of people who end up in the wrong business for the wrong reasons and create the wrong cultures. There is plenty of scope for problematic professional conduct that turns out to be “industry practice,” but there also seems to be scope for firms that get in trouble and those that don’t.

What next? Here are some options: Tougher due diligence on who gets to do what in banking businesses that are prone to conflicts of interest and compliance issues – biometric testing has been suggested, only half in jest. Zerotolerance telegraphed by senior management and boards who walk the talk. Targeting civil and criminal enforcement actions on the specific individuals involved (those closest to the action) instead of those farthest away (shareholders). Compensation schemes that handcuff bankers to the future financial performance of their firm (already well advanced at most banks). Boards’ willingness to leave on the table some incremental financial performance to achieve reduced regulatory and reputational risk, admittedly a tough balance to execute. None of this is easy, and there are no free lunches. Hard to prove, but the payoff could be handsome indeed.

–Ingo Walter

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