Marcus Killick comments on the nature of financial regulation since the credit crisis and lays out why legislative and regulatory change is fruitless without a change in culture in significant parts of the finance sector.
New legislation imposing controls and regulations is never popular on those it affects. The Mines Act of 1842, which prohibited all females and boys under 10-years-old from working underground in mines, was unpopular both with the mine owners and with many of the women who had previously got employment underground. One Member of Parliament who was against the adoption of the Bill stated “be careful, the Bill will deprive many children from work”. The House of Lords amended the Bill to reduce the minimum age from 13 to 10.
Similarly, the legislation we now see being or shortly to be imposed upon the finance sector would not have been achieved voluntarily by the industry itself. It stems, in part from outrage at the abuses the general public perceives that have occurred and need to be curtailed. Bankers’ bonuses and proprietary trading have now become a cause célèbre to politicians and pundits alike. Solve these and we remove the problem, they seem to argue.
In this article I will seek to argue that, whilst outrage at abuse is justifiable, it cannot be allowed to become a thoughtless knee jerk reaction against those regarded as causing the recent economic crisis. However, nor can necessary changes be allowed to wither on the vine as political appetite wanes in the face of concerted industry opposition and threats. I will also argue that legislative and regulatory change is fruitless without a change in culture in significant parts of the finance sector.
Finally I will argue that it is vital that action is taken on a truly international front. Single states, even multiple states, such as the EU, working together, will find enforcement difficult unless the international community as a whole is carried along.
So has there been a knee jerk reaction? Clearly the media remain fixated with the bonuses continued to be offered in the finance industry. National and international regulators are now seeking to impose controls on their payment. Yet the two are not the same. Some in the press and public simply oppose paying more to those they consider are already overpaid for what they do. This should never be the role of a regulator. We are not empowered to make political or moral decisions on whether a trader or bank CEO is paid too much or too little. That power is in the hands of the shareholders and the board.
So what is a regulators role in the bonus issue? Our role is to ensure that the bonus structure does not create additional risk. Does the bonus structure encourage short termism? Does the size of it weaken the capital position of the firm? Will it focus on certain measures (such as sales) which may encourage behaviour which is not in the consumers’ interest (eg, miselling)? In many ways the bonus debate is similar to the commission v fees debate which has gone on for decades.
The next problem is the economic need for the banks to return to lending. This appears to be one of the preconditions for the bailouts many banks received. On the face of it this seems sensible. Small businesses are suffering from the lack of available credit to expand or indeed operate their firms. The housing market is inhibited by the lack of available mortgages.
Hang on; surely the availability of easy credit was one of the causes of the crisis in the first place. It funded the bubble which vastly overpriced houses and allowed consumers to spend on a persistent basis more than they could afford. Businesses grew or were acquired on the back of massive debt. Do we seriously want to return to this?
Similarly, at the same time as we are requiring banks to lend more, we are increasing the level and type of capital they must keep. Inevitably this will impact their ability to lend. We cannot both lend and capitalise to the level that are being demanded. A third way needs to be found.
Surely what is needed is a cultural change, in both the industry and the consumer. The consumer has to realise that there is a price to pay for a, spend today, earn tomorrow approach. The industry is realising that their business did not give them the right to unaccountabilty and that they have social responsibility in how they lend.
The issue of the ‘casino banks’ has also proved popular - banks ‘betting’ their own capital in the market to improve their profitability. Arguments have been put to split banks up. Again, it is not clear how much of this is good risk management going forward and how much is punishment. We actually do not know if splitting banks will create more or less systemic risk. Many large banks survived without state intervention. Many jurisdictions used to feel more comfortable with licensing the largest banks than their smaller brethren. Was size really that important or did the culture of the bank, once again, have more of an impact.
Again we cannot simply legislate or regulate our way to a solution. Requiring boards of a bank to all have banking qualifications (an early, now dropped, suggestion) misunderstands the issue. It did not matter if they were qualified bankers, lawyers or accountants, if a board does not exercise proper corporate governance, it will fail.
By proper corporate governance, I do not simply mean correctly constituted board sub committees and separating the role of Chairman and Chief Executive. I mean that the board collectively understands the business it is in and the risks it faces. It has become palpably clear that highly respected, experienced and qualified boards had simply no understanding of the products their firms were selling or investing in. Credit derivatives were simply one manifestation of this.
Of course regulations can be made requiring a board to have risk committees etc, but many of the failed institutions had just such committees. The problem, again is not regulatory, it is cultural. Risk cannot be mitigated unless it is understood and a board cannot understand risk unless they are willing to spend time doing so.
Similarly, those that create an aggressive culture of infighting between individuals and divisions in some belief it will create a stronger organisation have proved to be somewhat deluded - ‘The Apprentice’ may make for good television but it makes for lousy risk management.
So how do we change the culture in many of our financial firms? Well, there are large numbers of highly successful firms which do have a true risk management culture. Indeed, it wass these who seemed to best weather the crisis. Banking associations, qualifications and shareholder pressure can all help towards this, but can regulators themselves impose cultural change simply by regulation?
The answer is no, but regulators do have an important role, as supervisors. It was not the 1842 Mines Act by itself that changed things; it was the inspectors being given the power to see that it was being enforced (although their power was originally very restricted) and the cultural change in society which made sending children down the pits unacceptable. In the financial field, some regulators have tended to shy back over recent years from onsite inspections of firms. Others still tend to conduct old style “tick and bash” checking of compliance with individual regulations. The latter may work for assessing adherence to conduct of business regulations and indeed are important in protecting the public from poor advice and other misselling, but they will not work as effectively when it comes to assessing senior management culture towards risk.
To ensure a board has an understanding of risk, regulators themselves must be properly trained and understand the business the firm is in. This is not easy but it can be achieved. Similarly making a firm accept that there is a cultural deficiency in their risk management is not as simple as pointing to a breach of a regulation. It is often a judgement call, but the better trained the regulator the better that judgement call is likely to be.
Finally, but linked, is the issue of multilateral rather than unilateral or bilateral action by regulators. Without this there is always the risk of regulatory arbitrage and a race to the bottom by some jurisdictions to encourage businesses to relocate there. On this the history post the crisis has been generally positive. Supervisory colleges for key banks and insurers have or are being established, the international standard setting bodies have reacted promptly and far more effort is being put into ensuring effective cooperation between regulators. There is much still to be done, but at least the prognosis to date is good.
Cultural change is never easy. It takes time, consistency and commitment. Some will not change and therefore it will need to be enforced upon them. Some will disapprove, seeing it as further state interference on the financial community. Surely however, it is preferable to the other alternative of still more expensive and bureaucratic regulation of questionable benefit. If the finance industry embraces the former, it may avoid the worst of the latter.
Marcus Killick OBE
Marcus is an English Barrister and member of the New York State Bar as well as a Chartered Fellow of the Chartered Institute for Securities and Investments and a member of the Chartered Management Institute (Diploma in Management and Leadership) and the Chartered Insurance Institute, Marcus was awarded the OBE in the 2014 New Year’s Honours List Marcus was also Chairman of the Gibraltar Investors Compensation Scheme and the Gibraltar Deposit Guarantee Board as well as the Group of International Insurance Centre Supervisors Prior roles include Chief Executive Officer of the Gibraltar Financial Services Commission, Deputy Chief Executive of the Isle of Man Financial Supervision Commission, Head of Banking and Investments at the Cayman Island Monetary Authority and Director in KPMG's Financial International Regulatory Services Team. Marcus was one of the founding directors of the United Kingdom Association of Compliance Officers (Subsequently renamed the Compliance Institute).