The wet British summer was a rough time for major UK banks.  The Barclays LIBOR settlement provoked a huge backlash.  The Serious Fraud Office has now launched two Barclays-related criminal investigations. HSBC was the subject of a scathing US Senate case study.  Standard Chartered was denounced by New York’s DFS.  Both must still settle with the US federal authorities. All this invites two questions.

Q.1:  Have standards got worse, at least in the UK?

Actually, no.  This summer’s affairs need to be seen in the context of a much longer standing and pervasive dysfunction, which has manifested itself in various forms over decades in both retail and wholesale markets – for example, the pension mis-selling scandal of the late 80s and early 90s, and the more recent mis-selling of payment protection insurance (PPI), and of interest rates swaps to small businesses.  The FSA’s 2011 thematic study of how banks fulfil their AML obligations showed some banks turning a blind eye to very high levels of money-laundering risk.  A reckless attitude to risks and rules, and indifference to customers’ interests has been widespread for a long time.  What has changed more recently is the level of public sensitivity, as a result of the financial crisis itself, followed by the crisis of public finances and negative real rates of return on savings and investments.

Q.2:  Is the UK worse than other major financial centres?

This seems unlikely.  The LIBOR affair spans several jurisdictions -  US, UK, Canada, Japan, Switzerland, EU, Singapore.  Concern about how interest rate swaps have been sold has surfaced in Italy, Australia and the US, as well as the UK.  AML work by FINMA in Switzerland suggests a picture reminiscent of the UK one.  Why would UK banks be uniquely ill-behaved?  But the UK does have some intensifying factors – the scale and international orientation of its financial sector, and the transparency of its regulatory enforcement processes.

What all these episodes have in common is that they show profit, commission and bonus-seeking being put ahead of bona fide compliance and customers’ interests.  This simple observation points us towards an important component of behavioural and cultural change.  Incentives, sanctions and accountability are important elements of the structural framework which fosters or inhibits cultural change.  The individuals who work in the banking sector are often more interested in making money than in public service or other forms of job satisfaction.  That does not make them immoral or even out of the ordinary.  If the standard of behaviour has been poor, it is because people have responded to pressures and incentives pushing and pulling them that way.  The important thing is to change culture as expressed in behaviour, and to recognise that carrots and sticks have a large part to play in that connection.  Moral exhortation, role-modelling and “the tone from the top” are all relevant, but they are unlikely to change culture as manifested in behaviour unless the material incentives and disincentives point the same way.

Sanctions

A critical question is whether there is enough deterrence in the system.  Are sanctions against delinquent banks heavy enough to persuade the whole sector to behave itself?  A crude application of the economic theory of deterrence would tell us that the sanction should (i) exceed the profitability of the wrongdoing and (ii) be multiplied by a factor derived from the improbability of being caught and selected for enforcement proceedings.  So, for example, if the profitability is  $10 million and the chance of being caught and proceeded against is 5%, the penalty should be more than $200 million.  Since this model postulates that each bank is nothing more than an amoral calculator of risk and reward, realistically some banks, with a degree of morality, will be successfully deterred by lower levels of penalty.  Even so, one might ask if any regulatory jurisdiction outside the US is close to the level of penalty needed for deterrence across the whole population of banks.  And if they were, there might be seriously problematic prudential implications, especially in the context of the current drive to strengthen capital buffers.

So it is not surprising that there has been a renewed focus in recent years on coupling corporate accountability with that of key individuals, as a means of countering individual irresponsibility and moral hazard.  But what is desirable in principle is also hard to achieve in practice – especially in relation to senior individuals.  It can be very difficult, for the purpose of regulatory enforcement, to reconstruct what was a senior individual’s sphere of responsibility, and what their personal duties were within that sphere.  And while institutions are often prepared to negotiate a settlement, senior individuals are usually much more inclined to contest the case against them to the bitter end.

As a result, regulatory enforcement of individual accountability is a big drain on resources, and resource-constrained regulators are unlikely to be able to take on many cases against the top dogs, however much we might wish otherwise.

Perhaps then the answer is to place more reliance on criminal justice as a means of calling wrongdoers to account?  That this would play well in public opinion is beyond doubt.   And some of the recent regulatory cases in the UK certainly look as though they might have featured as problem questions in a criminal law exam paper.  One was characterised by the relevant Tribunal as a case of “systematic dishonesty”;  another was described as “alleged theft, plain and simple”.

But again we are looking at a very costly commodity – criminal justice – and at public agencies with limited and sometimes diminishing resources to expend on what are likely to be very hard-fought cases.  There is unlikely to be scope for a step-change in criminal deterrence.

My overall conclusion on sanctions is that in most jurisdictions they could and should be tougher, and by being tougher would be more effective in forestalling banking delinquency.  But the potential of this approach is inherently limited by the high cost of enforcement proceedings especially when contested by senior individuals, by prudential considerations – and by the fact that it is merely an external constraint on the motivations and behaviour of the people in question.  Sanctions may contain behaviour, but they do not address the underlying impulse.

Incentives

Against this background,  regulation of the incentives that motivate the business behaviour of individuals in the first place becomes a critical ingredient in effecting  cultural change in the financial sector.  Recognition of this point has been slow and piecemeal. 

The most advanced effort is probably the Financial Stability Board’s Principles & Standards on Sound Compensation Practices, which fall to be implemented throughout the G20, including Australia and the UK.   The FSB expressly characterises its Principles & Standards as designed to achieve “lasting change in behaviour and culture within firms”.  Their focus is on aligning the material incentives of key individuals in the firm – the so-called “material risk takers” – with the prudent long-term interests of the firm itself.  A critical device for bringing this about is the requirement that payment of a substantial proportion of variable compensation – in other words bonus – should be deferred for at least three years,  and that a substantial proportion of bonus should take the form of equity, to give the recipient more of a stake in the long-term performance of the firm.

All this, though, has a purely prudential purpose.  The main focus is on systemically significant institutions, and on risks to their capital and liquidity. 

What the FSB Principles & Standards don’t address is the interface between firms and their customers.  There has been historic reluctance to interfere with the remuneration structures for advisers and salespeople (for example because of competition policy concerns), even though the distorting and detrimental effects of commission bias have been recognised for decades.  Provided they are supervised and enforced with energy, the commission bans shortly to be implemented in Australia (the ASIC ban on conflicted remuneration), and the UK (the Retail Distribution Review, now coupled with proposed guidance on Risks to customers from financial incentives) have the potential for significant behavioural and ultimately cultural impact.

In contrast, the motivational impact of incentives on attitudes to money-laundering risk and compliance with sanctions regimes has attracted much less attention, though the FSA has now said that it will take an ongoing interest in the effect of remuneration structures on how bankers handle money-laundering risk.

Regulatory initiatives on remuneration structure are not a quick or easy way of effecting culture change in banking.  Coverage of a larger proportion of the banking population may well be needed.  They will undoubtedly be complex, and elaborate anti-avoidance requirements will evolve.  And they will require intensive monitoring and enforcement by regulators to be mirrored by better governance arrangements inside institutions.  Nevertheless the potential of the technique - changing the rules of the game for financial sector players by changing the structure of the rewards they may gain and the forfeits they may incur – as a means of changing behaviour and culture warrants the investment it will require.  For the behaviour of bankers is to a large extent a response to the remuneration structures within which they work.

This approach offers the prospect of more thorough-going culture change than could be achieved by staking everything on the imposition of exogenous sanctions.  If banks and bankers are to be brought to believe that they are guardians of the public interest, and not just of profitability, the threat of external sanctions and the reshaping of internal incentive structures will both need to be deployed.

EDITOR'S NOTE: PROFESSOR FERGUSON IS A FORMER HEAD OF DEPARTMENT AT THE FINANCIAL SERVICES AUTHORITY, CURRENTLY ON SABBATICAL AT THE CLMR. THE VIEWS EXRESSED HERE ARE HIS OWN AND ARE NOT TO BE ATTRIBUTED TO THE FSA.