On the heels of a taxpayer-financed rescue of the industry following the financial crisis, outrage in the UK at banking sector misconduct led to the 2012 Parliamentary Commission on Banking Supervision (PCBS). “Trust in banking can only be restored when it has been earned, and it will only have been earned when the deficiencies in banking standards and culture, and the underlying causes of those deficiencies, have been addressed,” the commission concluded in its 2013 final report, ‘Changing Banking for Good’.
Ten years on, banking sector overseers worldwide have pushed for many of the changes called for by the report, with a clear focus on firm culture, governance and individual accountability. But we tend to lose sight of the fact that the PCBS took aim at bank supervision, not bank management. Recent turmoil has once again returned attention to the central role of banking supervisors in changing banking for good.
In a speech last month, Financial Stability Board (FSB) chairman and president of the Dutch Central Bank, Klaas Knot, argued that the failures of Silicon Valley Bank and Credit Suisse illustrate yet again how “poor internal controls, risk culture and governance are at the root of other deficiencies in banks”. Agustín Carstens, head of the Bank for International Settlements, echoed this view. “The main cause of recent bank crises was the failure of directors and senior managers to fulfil their responsibilities,” he said.
But Mr Carstens also argued that “banking supervision needs to up its game”. In another June speech, European Central Bank supervisory board chair Andrea Enria argued: “If the recent turmoil teaches us one supervisory lesson above all, it is the importance of ensuring banks have sound internal governance and risk management.” Mr Enria described this as “the one priority area that both banks and supervisors should be focusing on”.
The question supervisors are wrestling with today is this: before crisis reveals failure, how are firms to demonstrate effective risk governance – particularly of non-financial risks that flow from organisational culture and the conduct it promotes – and how are supervisors to test for this proactively?
Looking back
None of this is new. “The scale of misconduct in some financial institutions has risen to a level that has the potential to create systemic risks,” then-FSB chair Mark Carney argued back in 2015. At his urging, the FSB convened a work group to study the issue. After conducting industry stock-take exercises, the FSB work group identified 10 themes of central significance, with culture listed first among them.
“While an effective governance framework can improve a firm’s culture, culture can also defeat measures taken through governance frameworks when individuals continue to act in accordance with a culture that tolerates or rewards misconduct,” the FSB concluded. And, noting that supervisors were “in a unique position to gain insights on culture at firms, given their access to information and individuals across the firm, as well as the results of supervisory work”, the FSB argued that supervisors could do much to promote culture as a conduct risk mitigant.
In 2018, the FSB produced ‘Strengthening Governance Frameworks to Mitigate Misconduct Risk: A Toolkit for Firms and Supervisors’. It stipulated that this was not to be taken as offering specific guidance nor as recommending any particular approach to addressing the interplay between culture and governance. Rather, leaving practical detail to others, the FSB offered vague suggestions.
Firm leaders should “articulate desired cultural features that mitigate the risk of misconduct”, the toolkit recommends. They should “identify significant cultural drivers of misconduct by reviewing a broad set of information and using multidisciplinary techniques” and then take steps “to shift behavioural norms to mitigate cultural drivers of misconduct”. Supervisors, meanwhile, should develop programmes “focused on culture to mitigate the risk of misconduct”. In this, they should draw upon “a broad range of information and techniques to assess the cultural drivers of misconduct at firms” and engage in a dialogue with firms thereafter “with respect to observations on culture and misconduct”.
Unsurprisingly, these vague suggestions have elicited relatively vague reactions. Until now.
Looking ahead
“It is abundantly clear that regulatory and supervisory reform is on the way,” said Federal Reserve governor Michelle Bowman in a speech on June 25.
“Governance is another word for culture,” Michael Barr, the Fed’s vice-chair for supervision, argued at a recent New York Federal Reserve conference on banking governance and culture reform. Close attention to culture is thus “central” to the role of bank supervisors, Mr Barr added.
Earlier this month, the Basel Committee on Banking Supervision (BCBS) launched a public consultation on revisions to its Core Principles for Effective Banking Supervision. Issued in 1997 and last updated in 2012, the principles establish minimum standards for the sound prudential regulation and supervision of banks.
It is time to operationalise the FSB’s 2018 toolkit
In its proposed changes, the BCBS has placed emphasis on corporate culture in connection with corporate governance and risk management. “Assessing the robustness of banks’ risk culture and business models is a key component of effective supervision,” it argues. Supervisors must assure that “a sound risk culture is established throughout the bank”. The question is: how?
In 2009, the Fed’s Mr Barr co-wrote a book chapter entitled ‘The Case for Behaviourally Informed Regulation’. “Human behaviour turns out to be heavily context-dependent, a function of both the person and the situation,” he and his co-authors wrote.
While undoubtedly correct, awareness of this simple lesson from behavioural science fails to appear in most policy-making and management thinking. But if we are to succeed in changing banking and bank supervision for good, this must be our starting point. And such insights must be married to data technologies if they are to be applied with speed, scope and scale.
It is time to operationalise the FSB’s 2018 toolkit. This will require collaboration between firms, supervisors, academics and technologists, and orchestrating such collective action will require determined leadership. This will have to come from supervisors themselves, because they cannot expect individual market participants to promulgate solutions to systemic prudential risks. Ten years on from the PCBS report, it has become clear that changing banking for good implies changing supervision for good as well.
Stephen Scott is founder and CEO of Starling Trust Sciences, a predictive behavioural analytics platform.
