It seems as obvious as a thumb in your eye that corporate culture can have a real bearing on the risks associated with a particular financial entity. Take Bernie Madoff’s little operation, for example. Although Bernie played his cards close to his chest, you couldn’t be an employee of his long term and not get sucked in to his machinations, either as an innocent dupe or as a compliant collaborator. The rot started at the top.
The problem for regulators, however, is nicely expressed in the thought that King Duncan gives voice to in Macbeth on being told of the former Thane of Cawdor’s treachery: “There's no art to find the mind’s construction in the face. He was a gentleman on whom I built an absolute trust,” Duncan says. The old king then promptly goes on to place his trust in Macbeth, and that did not turn out well for him either. So the moral of the story appears to be that we either muddle along, taking things at face value until something implodes and the rot bursts through, or we find some more effective way of probing the surface to find the rot underneath.
Actually the Madoff example rather twists in our hands here, because the problem with that operation was not that there was no clue to his wrongdoing, but rather that the SEC was deaf to all warnings (and there were plenty), mistaking an upright manner for an upright man.
Hector Sants, chief executive of the about-to-be-abolished Financial Services Authority, recently stepped up boldly to address precisely this issue of how a regulator can probe beneath the surface of a financial services firm to detect crippling flaws in the culture beneath. (The UK Coalition Government has committed to abolishing the present regulatory regime which consists of the FSA, the Bank of England, and the Treasury, with the Chancellor George Osborne promising to have a new regime in place by 2012.)
Regulation up to and during the crash, Sants says, was “a retrospective form of regulation”, with intervention being based on clear evidence that something had gone wrong. By definition, this regulatory approach was never designed to stop firms from going wrong. It was there to act when they had demonstrably gone off the rails. The problem with this approach was that when significant numbers of large firms all went off the rails, so to speak, simultaneously, the regulator was left looking like he was asleep at the wheel.
The new approach to regulation at the FSA (while it continues to exist) is much more proactive. However, Sants acknowledges that it is still a long jump from this approach, which looks at business models and analysis and makes forward projections, to an approach that say, does 360 degree interviews with a corporate and then judges that there is much amiss with the kingdom. In fact model analysis is a very long way indeed from the regulator diving in and making judgements based on a "culture appraisal" that would require a change at board level and a change of strategy and tactics. This would be hugely interventionist and would beg the question of how on earth a regulator could presume to know better than management how to set the goals, strategy, and corporate ethos for a particular organisation.
However, Sants believes that common sense will carry a regulator quite a long way forward here. “We are all still seeing some decisions by management in major firms that we would judge not to be prudent,” he says. The need for regulatory action goes up several notches, he suggests, when the regulator sees a real gap between what a firm preaches, and what it practices.
So where does the regulator start? Sants suggests that a good starting point is the various codes issued by professional bodies:
“These codes make clear that individuals are expected to act with integrity. And that leaders are expected to foster a culture which encourages the right behaviours.“For regulators the starting point should be that we want the firm to have a culture which encourages individuals to make judgements and deliver the outcomes we want and that at all times we want an undertaking to act with integrity. The regulator’s focus should therefore be on what an unacceptable culture looks like and what outcomes that drives.”
This is strong stuff. The point here is not simply that a regulator should be expected to know a bad apple when they see one, but that they should know the conditions that lead to apples going bad and take preventative measures. Executed in a common sense fashion, this sounds excellent, but in the wrong hands we could wind up with an Orwellian nightmare world of cultural correctness. We are heading off down interesting trails here…
Further reading on financial regulators and financial regulation
- US Financial Regulation: A Hopeless Tangle, or Complexity for a Purpose? by Lawrence J. White
- Why Organizations Need to be Regulated—Lessons from History, by Bridget Hutter
- Hedge Fund Challenges Extend Beyond Regulation, by Kevin Burrows
- Bankers square up to regulators over economic fallout of Basel III, by Ian Fraser [blog post]
Tags: banking , corporate culture , Financial Services Authority (FSA) , regulation , UK