Banking reform isn’t the complete solution – it’s also about culture, culture, culture


 

We must not forget that much of the destructive behaviour in our financial sector comes from visions, paradigms, and shared meanings between employees, which are out of sync with society, writes Jonathan Orde

Earlier this year, a senior Goldman Sachs banker, Greg Smith, published in the Wall Street Journal the reason he was leaving Goldman Sachs. The environment was, he argued, destructive and toxic.

Michael-Douglas-Gordon-GeckoDecent client-servicing values had been replaced by an aggressive ‘money making at all costs’ culture. To be a leader in this environment, you had to put firm profits above the interests of your clients.

We have our own experiences of a morally wrong and corrupt corporate banking culture when it comes to Barclays and LIBOR.

As The Economist states:

When a trader asks a colleague to submit false information in order to boost his profits, the correct answer is not “done…for you big boy”.

Earlier this month, the Young Fabians Future of Finance Network discussed banking reform with Shadow Chief Secretary to the Treasury Rachel Reeves.

A key issue, as the stories above highlight, is the extent to which banking reform which attempts to impose a structural solution on a cultural problem can be effective.

The substance of the proposed Banking Reform Bill has been widely reported; its key function is to ringfence retail deposits from riskier investment banking activities. This process, it is argued, will allow banks to fail safely. Retail deposits will be protected in the event of a failure – therefore, government does not need to guarantee them. As the implicit government guarantee is removed, the price of taking risks increases – theoretically, making investment bankers think twice.

However, the bill (in its current state) would not have saved Northern Rock from its culture of risk-taking in purchasing sub prime mortgages in the US – Northern Rock was a purely retail bank; i.e. it had no retail funds to ringfence from riskier investment banking.

Northern Rock proves even retail banks with the wrong culture can create systemic risk to the economy. Any bank can make poor lending decisions – whether in the mortgage market or through over zealous lending to individuals and small businesses. As and when the global economy picks up, banks will start lending again, looking to make money.

Changing culture is no easy feat. It starts at the top, requires boards and shareholders to hold management to account, and, as is increasingly apparent, the threat of criminal prosecutions. It also takes time – but things are changing.

As a young trader, the infamous Dick Fuld (the last and final CEO of Lehman Brothers), approached his supervisor to approve a trade.

On the phone at the time, his supervisor told him:

“I will sign your trade, when everything on my desk is cleared.”

Fuld replied:

“Do you promise?”

Fuld then swiped his hand across his supervisor’s desk, sending papers everywhere.

This degree of aggression was reflected in Lehman’s disastrous strategy of over-leverage; Fred Goodwin’s ruthlessness at RBS earned him the nickname ‘Fred the Shred’.

The type of leaders we have, and their background, has a huge impact on culture. The new CEO of Barclays comes from a retail backing background, rather than an investment banking one. Commentators are already saying this represents a marked change from the past. Jenkins, and Stephen Hester, the CEO of taxpayer-owned RBS, have both publicly acknowledged bankers, and their culture, need to change. Admitting there is a problem is often the first step to real change.

Shareholders, too, are having an important impact on culture. Graph 5.1 below from the High Pay Commission speaks a million words; source: HPC Discussion Paper, “What are we paying for? Exploring executive pay and performance” (p. 26, pdf).

Graph 5.1:

Average-share-incentive-gains-of-FTSE-350-lead-executives-cf-stock-market-indicators
This year there have been substantive challenges to rewards for failure. Activist investors have threatened a £60bn merger between Glencore and Xstrata, partly on the grounds of bonus payments with no link to performance. Pay at FTSE companies has also been challenged by shareholders.

The more demanding shareholders become that bonuses will only be linked to performance, the greater the incentive for more informed risk taking. Demanding shareholders need to be matched with a full time, enquiring and challenging board.

Perhaps the most powerful method of preventing the sort of behaviour seen at Barlcays is through criminal prosecutions. Bankers, at the top of society, can be seen to manipulate financial indices with little fear of criminal prosecution; at the bottom of society, it’s a different story: during the riots, a youngster was jailed for six months for theft of a case of water from Lidl.

This situation is hard for the public to understand, and hard to explain. Labour must look at the range of criminal sanctions available and how they can be implemented. During the riots, courts operated 24 hours a day; the same commitment to prosecuting financial crime would help retain our status as a world leading financial centre.

The City is too big to fail. It is too important for our economy through jobs and tax revenue. That is why banking reform should not be seen as a complete solution.

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