Can culture be regulated?

04 Oct 2010

Speech by Hector Sants, Chief Executive, FSA
Mansion House Conference on Values and Trust

Good morning ladies, gentlemen and Lord Mayor, thank you for inviting me to address this conference on ‘Values and Trust’.

As Marcus has mentioned, the public’s trust in the city, in its regulators, and in particular in banks, is at an all-time low following the onset of the financial crisis over three years ago.

The issue of trust is an important one and as I have said before is not receiving the attention it should. 

To date, the post-crisis debate, from a regulatory perspective, has focused more on the economic purpose of financial markets and institutions, and the economic role that regulators and governments, through formal standards and supervision, play in shaping the market.  

It is crucial that we improve behaviours and judgements.  To do this we must address the role that culture and ethics play in shaping these.

I believe that until this issue is addressed we will not be able to prevent another crisis of this magnitude from occurring again, and will never fully restore the trust of society in the financial system.

Trust is won or lost by ones actions and it is only by demonstrating one has changed that trust can be restored. 

Prior to addressing my central theme, I would just like to note that I believe there is a general consensus on the way the rules should evolve and that over time a new prudential framework will be established.  This will have:

• more and better quality capital for all banks;
• additional capital for the large systemic institutions;
• a stronger link between risk and capital, particularly at the trading book level;
• a tougher and more effective liquidity regime;
• improved recovery and resolution tools, particularly for large systemically important institutions; and
• greater structural transparency and reduced operational and counterparty risk in the trading market.

The recent agreement at Basel covered the first phase of this financial reform focusing on capital.  The second phase of the work will, in my view, be more important.  This will cover the need for further capital and resolution tools for large systemic institutions and the need for an effective regulatory regime for managing liquidity risk and limiting leverage. 

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In my view it is critical that this second stage comes to fruition.  If we do not deliver on liquidity and leverage and solve the problem of ‘too big to fail’ banks, we will not be able to deliver on the key requirement of the Basel reforms: namely ensuring that tax payers never have to foot the bill again.

May I also note, as Marcus has mentioned, that the FSA agrees it is important that this new framework results in an international level-playing field.  However, it is important to recognise that the FSA’s role in policy-setting is largely one of an influencer, not a decision-maker, as the decisions are made in the international and European fora, not at a national level.

The FSA should thus primarily be judged on the effectiveness of its supervision.  A few remarks if I may on our progress.   

Over the past two years, the FSA has radically overhauled both its supervisory philosophy and its capability to deliver it. 

However, no set of economic rules or supervisory architecture can ensure failures are eradicated – at least none that are affordable and continue to allow innovation and risk.  Behaviours and judgements must also be addressed and until this happens we will not achieve our goal of restoring trust.

More must be done.

I am sure all of you here would recognise, it is those who manage the financial institutions, who make the judgements, who should be held responsible for them and for restoring the trust between the financial sector and the public.  However, that does not absolve the regulator from addressing this issue and today I would like to focus on the role of the regulator in facilitating the right culture. 

This is best addressed through three questions:

1. First, should the regulator seek to regulate culture at all?
2. Second, even if the answer to the first question is yes – given this would require regulators to make judgements, are these judgements too difficult to make?
3. Third, even if you believe the regulator should and could judge culture, how would the regulator facilitate or enforce the adoption of its judgements by firms?   

But before addressing these three practical questions, I would like briefly to examine the central background assumption: namely that poor cultures in firms were a key driver of the crisis.    

I would argue that some of the causes of the crisis were deeply rooted in behavioural or cultural issues that resulted in actions and decisions that, with the benefit of hindsight, were not the ‘right’ ones.  Indeed, there are examples of actions and decisions by senior management that can be seen to be at the root cause of their firms’ demise.

Worryingly, as I have said recently, even after all the ‘supposed’ lessons learnt exercises, we are still seeing some decisions by senior management in major firms that we judge not to be prudent.

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Furthermore, we all know that most major institutions have a ‘set of values’ to which they ascribe – however, in many cases there is a gap between what they claim to do and what they actually do.  These values also tend not to be aligned or ‘lived’ by the employees, meaning the firm does not ‘practice what it preaches’. 

The conclusion I draw from these observations is that poor cultures often drive poor decision-making and that cultural change is essential if the industry is to minimise the probability and severity of the next crisis and regain the trust of society.

Let me now return to my three questions, namely:

• Should the regulator seek to regulate culture? 
• If yes, are these judgements too difficult for it to make?
• And what are the tools which we could use if we were to facilitate or enforce the adoption of these judgements?  

Turning to the first question – when I joined the FSA, as I have mentioned before, I was told by senior management that ‘the FSA does not do ethics’.  However, I would assert that regulators have an obligation to consider the question of whether they should have a role to play in relation to judging the ethics and culture of the firms they regulate.

I am sure we all recognise that:

• society expects its bankers and financiers to behave ethically and to behave with integrity;
• society expects institutions to have the ‘right’ culture to facilitate ‘good decision-making’; and
• society also should know that regulatory rules, even when combined with effective supervision, are not sufficient to ensure the probability that future failures are minimised.

Given this background I would go further than saying regulators should consider the issue.  I believe regulators cannot avoid judging culture.   Historically, many have argued that financial regulators should stick to policing the hard facts and compliance with their rule book, which can be settled, if necessary, in the courts.

However, every other aspect of the regulatory framework is under scrutiny and we should not shy away from debating the culture question.  Furthermore, historically, many non-financial regulators have seen culture as a legitimate area of focus.

So, in answer to the first question, I would assert that regulators should recognise culture as a legitimate area of intervention.

So, turning to my second question: is it realistic for a regulator to make these types of judgements, which are, in effect, judging the judgements? 

Normally at this point the word ‘ethics’ enters the debate.  There is a view that the right behaviour stems from decision-makers having the right ethical framework, and thus judging culture requires the regulator to make ethical choices.  I think this word – ‘ethics’ – is not precise enough and carries too much baggage for regulators.  

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The better focus for regulators is culture, which no doubt reflects the ethical framework of the organisation.  I am not, however, proposing that a regulator defines or prescribes ‘an acceptable culture’.  Acceptable cultures come in many different forms.

For regulators, the starting point should be that we want the firm to have a culture which encourages individuals to make the appropriate judgements and deliver the outcomes we are seeking.  At all times we want an institution to act with integrity.  The regulator’s focus should therefore be on what an unacceptable culture looks like and what outcomes that drives.  It should not be on defining the culture itself.

It is neither feasible nor desirable for the regulator to specify the type of culture a firm has, nor the measures and metrics by which this should be assessed.  What should matter to the regulator are the outcomes that the culture delivers and that the firm can demonstrate it has a framework for assessing and maintaining it. 

To be completely clear, a box-ticking approach to regulating culture will not work.  The regulator must focus on the actions a firm takes and whether the board has a compelling story to tell about how it ensures it has the right culture that rings true and is consistent with what the firm does.

What are the tools we can use to make these judgements? 

There are academic studies in this area ¹, which provide a useful starting point to design a framework to judge culture.  Culture is primarily a function of individual behaviour.  Behaviours can be assessed through three elements:

• the character of the individual;
• the judgements of the individual; and
• the outcomes of their decisions.

It would be feasible to assess all three. 

There are assessment frameworks for judging character which firms could use.

It is more difficult to judge the judgements, but it is possible to judge whether the culture encourages the right judgement. 

For example:

• Do management model good behaviour, i.e. make their values ‘live’?
• Do management articulate a clearly understandable strategy?
• Do management offer guidance and training to assist in good decision-making – for example, on ensuring the fair treatment of customers and effective risk management?
• Do management incentivise good behaviour and deter poor behaviour and how?
• Do management encourage the required diversity to facilitate challenge to ‘group-think’?
• Do management articulate their vision of the right culture?  (Here, I would say, there is linkage between the brand of their institution and its culture.)

Some would argue that regulators are not equipped to make such judgements.  However, current practice suggests otherwise.  The FSA’s existing policy and supervisory framework already recognises the importance of culture in the delivery of good regulatory outcomes.  For example, culture is used in the assessment of conduct risk and supervisors make behavioural judgements when assessing senior-management decisions.  Additionally, our authorisation regime requires adherence to the principle of ‘acting with integrity’.  Society thus already accepts the need for regulators to make such judgements.

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Whilst the issue of the regulator judging the judgements might be debatable, the outcomes of these judgements are certainly very tangible and assessable against a regulator’s objectives.

So, if it is the case that regulators can judge culture, let me turn to the third question of intervention.

I think we already have the means of intervention – for example:

• influencing the composition of management;
• influencing the incentives for good behaviour;
• requiring high standards of effective risk-management;
• influencing the training and competence regime; and
• deterring poor behaviour.

On influencing the composition of management, the FSA has already revised its authorisation process to include judging technical competence as well as probity.  I would suggest that judging integrity is feasible.  As I mentioned earlier, there are acceptable assessment practices for doing this.  It would be possible for the FSA to place greater emphasis on this characteristic as part of the authorisation process.

On the topic of incentives, may I digress a moment.  The FSA’s role is to ensure compensation structures do not encourage poor risk-management practices.  We have taken the lead, around the world, in implementing the remuneration code to ensure this problem is addressed.   This will continue to be a major focus for us.

However, remuneration practices (bonuses) have been a symbol – a lightening rod of society’s lack of trust in bankers – and to address the trust issue, this state of affairs has to be recognised and resolved. 

I believe that unless bankers demonstrate sensitivity and exercise restraint in this area, trust will not be restored. 

I would suggest that the way forward on remuneration is to recognise that the remuneration structure needs to reinforce the concept of employers as the ‘custodians of the firm’.  The incentive structure should generate a sense of long-term ownership.  Financial institutions too often see themselves as ‘renting human capital’ over the short term.  It should be the other way round: the human capital is being entrusted with the firm’s capital and brand over the long term.

We could also encourage firms to give greater weight to behavioural characteristics in the compensation process.  Our supervisors already look at some elements of the structure of remuneration – for the sales forces, for example – and this could be extended.

On influencing training, the FSA’s regime requires firms to ensure that individuals receive the appropriate training.  This can undoubtedly play a significant role in modifying behaviours.

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On achieving deterrence, credible deterrence is already high on our agenda.  A poor culture at a firm often manifests itself in failures of governance or management – and in response to such failings, we have taken, and will continue to take, tough action. 

For most firms that action shall be taken through the board.  The ‘tone from the top’ remains critical and if a regulator is concerned, its first action should be exhorting the CEO and the board to take the necessary remedial actions.  I would hope in most cases boards would respond to such warnings.  If not, regulators may well have to resort to the stick of the authorisation process and, if necessary, push for those individuals to be changed or, where necessary, require them to be.

However, our interventions alone will not solve the problem.  As I said, trust is won or lost by ones own actions, so the responsibility for addressing this issue rests with us all. 

Boards have a greater role to play.  Historically, there has been insufficient discussion and challenge in this area. 

Boards need to show leadership.  Boards should ensure that their firms have the right culture that permeates throughout the organisation.

A culture, however, should not be confused with ‘atmosphere’.  Of course, a dealing room will have a different atmosphere to that of a retail branch.  However, both can have the same culture and ascribe to the same ethical values.

To this end, I would particularly encourage boards to have a structured process for reviewing their firm’s culture, identifying its drivers, and the behaviours and outcomes it delivers.  This process could be allied to reviewing employee engagement, customer satisfaction and brand perception, as these are all interlinked. 

If we are to really bring about a change in culture in our institutions, this needs to be driven by their boards.

To this point, may I express my strong support for the initiative shown by Marcus and 16 other city leaders, in their joint letter published last Wednesday, recognising their personal responsibility in relation to culture.

In summary, I do believe that determining an ethical framework is for society as a whole, not an unelected regulatory agency.  In that sense, it is right that the FSA ‘does not do ethics’, or as Howard Davies once put it: it is not for ‘the FSA to seek to act as the conscience of the square mile’.

However, regulators have a central role to play, which should be to ensure firms have the right culture for their business model – the right ethical framework – to facilitate the right decisions and judgements and we should intervene when we find those frameworks are lacking.

Finally, may I return to the central theme of trust.  Trust has been lost between the financial community and the rest of society.  The principal agents for restoring that trust must be the firms themselves. 

However, I believe this goal will not be achieved without far greater recognition of the importance of this topic across governments, regulators and firms around the world and I hope this conference is an important step in that direction.

Thank you again Lord Mayor for giving me the opportunity to speak on this vital topic.

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¹www.ethicability.org