Cleaning up the stockyards of banking

Regulators and shareholders must become more powerful for the culture in banking to change

PUBLISHED : Tuesday, 10 November, 2015, 6:52pm
UPDATED : Tuesday, 10 November, 2015, 7:07pm

Appeals to reform the “culture” of banking, most recently by New York Federal Reserve president William Dudley, amount to an abrogation of responsibility and a counsel of despair.

Kicking off a closed-door, yes closed-door, meeting of regulators and bankers on cleaning up finance in New York last week, Dudley argued that “context largely drives conduct” while at the same time reiterating calls for a cultural change led from within the industry.

This is partly true but fundamentally backward.

Culture doesn’t simply grow out of the good wishes and intentions of people at banks, much less what they say in public. It is shaped by the system of rewards and punishments awarded and meted out, a responsibility which falls squarely, if not entirely, on regulators.

People at banks make calculations, they are good at it.

Therefore if we have a system, which it seems we do, the sum result of which is episodes like that of the London Whale or money-laundering scandals, then the thing to do is not to blame math. Culture won’t change those calculations, regulation and enforcement will.

Bankers need to fear that breaking the law doesn’t just threaten their pay cheques, but their liberty

Appeals to culture didn’t reform America’s meat-packing industry more than 100 years ago, the Federal Meat Inspection Act of 1906 did. Or rather vigorous enforcement of that act did. Given the agency issues in the financial system, in which employees at varying levels can abuse position for personal gain at public and shareholder risk, this is even more true.

Yet the meat inspecting done under the Dodd-Frank legislation put into place in 2010 has had seemingly little effect.

“Dodd-Frank apparently did little to curb misconduct, a possible source of systemic risk,” Dudley said at the meeting. “If the people managing capital cushions and liquidity buffers view these tools as sufficient mitigants for the costs of misconduct, or if powerful incentives encourage workarounds of the new regulations, then the connection between post-crisis reforms and greater financial stability becomes threatened.”

To be clear, there is a central role that insiders must play in the cultural change that is needed, but they must play that role not because they think it is right to do so, but because they fear what will happen if they do not.

Bankers need to fear that breaking the law doesn’t just threaten their pay cheques, but their liberty, while the banks themselves and their boards must fear for the continued existence of their institutions. Change that and culture will change.

Remember, banks in a system of fiat money can only exist at the pleasure of the sovereign state in which they operate. Yet the very tone Dudley used in framing the discussion last week betrays the extent to which he is not dictating terms but negotiating.

One section of the discussion at the conference was dedicated to engaging bank employees, “especially those who are sceptical of the benefits or practicality of reform”.

Feedback from the frontline is always welcome, though to be taken with a grain of salt, but the pork barons of Chicago in 1906 didn’t clean up the stockyards because they thought people would eat more bacon if it was trustworthy, they did it because the alternative was dire.

Much of the problem stems from the failures of the US Justice Department, which under Eric Holder used kid gloves in punishing banks out of fear of the economic consequences of ruining a too-big-to-fail bank. That decision failed to take into account something bankers well understand: leverage.

If a truly devastating outcome isn’t possible for a bank, fines simply become a cost of doing business. This very likely will continue to be true even after new bank capital rules for the largest banks are fully implemented in 2022.

Without leverage in the relationship, regulators resort, as they appear to have done, to a worst of both worlds arrangement: because they can’t count on banks to self-enforce out of a desire to continue to exist, regulators instead end up micro-managing internal proceedings.

You have to have a certain sympathy for the complaints of bankers, faced with squads of regulators on site who sometimes meet more often with directors than directors meet as a board. Banks must feel they are being nibbled to distraction by minnows.

In truth, two constituencies, regulators and shareholders, must become more powerful and more willing to exercise power for the culture in banking to change.

Until then, just as in Chicago before 1906, worms will continue to appear in the meat.