Jul 21 2014

The Conduct Costs Project – Description and Suggested Prescription

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Hugh D Bryant
Reader (Licensed Lay Minister) in the Church of England;
former Solicitor and Marine Underwriter

Roger McCormick and his colleagues in what is to become the ‘CCP Foundation’ (see http://blogs.lse.ac.uk/conductcosts/contacts-2/) have produced research which shows that fines and damages paid and estimated for misconduct, in the 10 banks which they have studied, in the last 5 years have amounted to £157 billion worldwide. In the UK alone this amounts, on average, to nearly £6 billion per annum.

These figures are now being analysed further to identify whether any of the banks under review are improving their performance: and to identify criteria by which performance in this area can be compared, across different countries, markets and types of bank.

It is however clear that conduct costs, or rather the cost of misconduct, are a very significant impost on the cost of trade and the efficiency of the banking system, and are therefore, as a matter of public policy, a mischief which urgently calls for a remedy. Indeed even the bankers themselves recognise that there is an urgent need for public trust in their activities to be restored.

Given that such misconduct is clearly a bad thing, how is it to be stopped? McCormick tells a story to bankers and others at his seminars. Imagine you are on one side of a transaction, and you notice that your counterparty has made a serious mistake, which they have not noticed. The result of the mistake is that you will do much better out of the transaction than you would have done if the other side had not made their mistake.

What do you do? Keep silent and pocket the profit, or point out the mistake – and get what you would reasonably have expected to get out of the transaction, but no more.

Today, McCormick has said, many of those, to whom he puts the story, find it difficult to answer. It might be thought that their chief objective is to make money, to maximise profit. It is not part of their objective to do this in an ethical way. Instead, their only thought of ethical considerations is whether they will, by acting in a particular way, lay themselves open to regulatory sanction. The criterion is not whether it is bad to do something, but whether a policeman will catch me if I do it.

But regulators, almost by definition, offer no solution: we are, after all, trying to reduce the amount of fines and penalties. If we simply say that regulators should regulate less strictly, it would reduce the fines, but it would not necessarily improve the conduct. (We can observe in passing that in identifying the mischief which is banking misconduct, we have defined it by the amount it costs rather than by its moral badness – but it nevertheless remains a serious mischief.)

What is to be done? Lawyers will be familiar with the alleged antithesis between what is lawful, and what is morally right. The existence of that antithesis is, it could be said, a major factor in facilitating banking misconduct. It might look as though bankers’ conduct is determined not by any consideration whether something is morally right, but rather whether it is legally permitted – or whether, even if it is unlawful, whether there is a risk of being caught out by a regulator.

It seems that the only way to obviate conduct costs entirely is to improve conduct – morally. If it were true that a course of action needed to be both lawful and morally right, this would leave no room for moral arbitrage of the kind which McCormick’s story brings out.

How can this be brought about? I suggest that, as well as experts in the upholding of professional standards – such as members of the International Accounting Standards Committee, say – it would be helpful to invite the Archbishop of Canterbury, Justin Welby, to widen the scope of his activity, for example in the St Paul’s Institute, so as to include advice to and involvement with the Conduct Costs Project.

Posted by: Posted on by Tania Duarte

Jul 21 2014

Conduct Costs Project

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Readers will note that the Project is now simply called the Conduct Costs Project.
This reflects the anticipated transfer of the Project to a new, independent social enterprise vehicle under the management of the Project’s core team. (There is no change in personnel, objectives or modus operandi). Further details will be announced in the near future.

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Jul 1 2014

Conduct Costs Project’s findings 2009-2013

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We are pleased to publish the Conduct Costs Project’s findings for the five year period ending 2013.

We would like to thank LSE for its generosity in allowing the CCP to continue to use this webpage as the “host” for this material until the CCP is able to set up its own website. (This is expected later this year, following the transfer of the CCP to a new social enterprise vehicle.)

Questions about the latest findings should please be addressed to Roger McCormick at rsmccormick@btinternet.com.

Heartfelt thanks to the many people who have continued to support this project. Please stay with us!

Roger McCormick
Tania Duarte
Chris Stears

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Apr 17 2014

LSE Conduct Costs Project – Lunchtime Workshops

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Slide1

For additional information, please see Invitation [PDF].

Posted by: Posted on by Tania Duarte

Mar 24 2014

Bridging the divide between Conduct Risk, Conduct Costs and Materiality*

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Calvin Benedict
Research Associate at Seven Pillars Institute for Global Finance
and Ethics Qualifications: BCon (Hons) in Commercial Law – 1st Class

*I am most grateful to Professor Roger McCormick and Christopher Stears for their comments on earlier drafts. I alone am responsible for any errors.

The analysis of this paper is structured in two parts. Part A examines the Financial Conduct Authority’s regulatory focus on conduct risks, including definitional issues and its relationship to conduct costs. Part B presents my view on the materiality of conduct costs. The materiality discussion looks at the evolution of corporate reporting to accommodate shareholder and stakeholder needs, the impact of public interest and danger of ‘accountability’ arbitrage. Continue reading

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Mar 3 2014

Conduct Costs Project 2014

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There are now four parallel teams working alongside LSE on this project. They are based in France, Italy, Portugal and Israel. The banks they are covering are shown below.

Picture1

Fig. 1 – Banks covered by teams.

Picture2

Fig. 2 – Banks covered by country (HQ).

 

We would like to add more teams to the project, so do get in touch if this interests you.

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Feb 25 2014

LSE CC Project’s Response to the Banking Standards Review Consultation Paper

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Following the CC Project’s initial reactions to the Banking Standards Review Consultation Paper,  the Conduct Costs Project team publishes here the complete LSE Conduct Costs Project Response (PDF).

Roger McCormick, Chris Stears and Tania Duarte

 

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Feb 14 2014

Banking Standards Review, Consultation Paper – CC Project’s Initial Response

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Roger McCormick
Christopher Stears
Tania Duarte

1.    The status of the “new organisation” (the “organisation”)

1.1.    We broadly agree with the Consultation Paper’s (“the Paper”) governance, disclosure and public reporting proposals.

1.2.    We agree that its independence will be crucial to its credibility. It must not be (or look like) the “same old, same old” dressed in new clothes. This goes to its place in the overall social/political/industry structure and also to the composition of its governing body and relevant committees. It should be fiercely independent, sceptical of tradition and able (and feel encouraged) to ask awkward questions, not just of banks but also of regulators, politicians and others who may influence or be affected by bank conduct and behaviour.

1.3.    This leads us to the conclusion that the organisation should not report to the FCA, the PRA or any body of politicians (such as a Parliamentary Committee). It has to report to someone, however. We would tentatively suggest it reports to the Governor of the Bank of England. Although the Governor is, of course, part of the regulatory structure, we feel that there is more public confidence in his/her independence and freedom from “regulatory capture” threat and political agendas than is the case with the alternatives.

1.4.    We do, however, see the importance of the organisation having strong links with regulators. Subject to our comments at 2 below, we suggest that the organisation seek a Memorandum of Understanding with the regulator(s) covering matters such as mutual assistance and exchange of information. The organisation might also benefit from establishing a ‘Regulatory Liaison Committee’ charged within overseeing the MoU and maintaining a synergy between the organisation’s objectives and the regulatory system.

1.5.    We would like to see some representation from “challenger banks” as well as more established commercial/retail banking in the organisation. We would be sceptical about the need for many City  Establishment figures.

2.    The conduct principles being developed by regulators

2.1.    The Paper attaches some understandable importance to these (see, for example, the foot of page 13). Whilst any standards adopted by a bank must of course be in conformity with what regulators require, we feel that the organisation should see such regulatory requirements as a minimum and steer away from an approach that relies too heavily on “reverse engineering” what regulators have laid down into a bank’s own organisational structure and deeming that to be sufficient.

2.2.    Banks should be encouraged to start afresh, notionally, with a “tabla rasa” when devising “ethical” rules for how they wish their staff to behave in the light of the experiences they have had. They should then, when they have developed some substance to such rules, check back against what is required by regulation and ensure that no regulatory requirements have been omitted. The difference in approach is important. One approach involves a mindset that poses, as a first question: what are the regulators making us do? The other poses the first question: what do we think is right? The banks’ “restore trust agenda” (which should be more about deserving trust than simply regaining it) is not about an ongoing struggle to get the compliance function to work effectively. It is about re-thinking, for each person in the bank, why he/she goes to work every day and what makes him/her proud of a job well done.

2.3.    It follows from the above that we would encourage banks to surpass the standards of regulators not merely to “meet or surpass” them. We agree that the organisation should benchmark the banks’ efforts in this area against good practice. We see the organisation’s role in the cross-pollination of ideas that lead to good practice as crucial.

3.    Training

3.1.    Whilst training in conduct matters is, undeniably, a “good thing”, staff should not need to be trained in order to understand the importance of honesty – if they do, the bank really does have a problem. Sadly, however, it is want of honesty that seems to have given rise to some of the most prominent scandals of recent times.

3.2.    Notwithstanding 3.1 above, we do think that all concerned in the industry (including regulators) need to develop a better common understanding (which they should share with the organisation and the public) of where some of the boundaries lie in relation to, for example, “manipulation” and taking advantage of another’s ignorance or error (leaving aside consumers, who are a special case). To use a celebrated example of language from a recent scandal, is it ever appropriate to regard a counterparty as a “muppet” and milk him for what you can get? There is a danger that we set up training programmes for the sake of appearance and overlook some of the fundamental right vs. wrong judgement issues, which still require a more substantive debate in the industry – a debate that might include the continued efficacy and modifying the application of parts of COBS in regard to eligible counterparties.

3.3.    The extent of the need for training in banks should, one would think, depend on how well the staff of any given bank understand (a) what honesty means and how it affects decisions and behaviour in their work and (b) how decisions should be taken in the inevitable “grey areas”. A “programme” of training designed for all banks may, by its nature, be somewhat crude (looking as though it has been devised in a “one size fits all” workshop) and, as a result, not taken very seriously. We do not believe it is being suggested that all banks have the same training programme but we would caution that the idea of assessment of training by the organisation should not lead to this result.

3.4.    Training needs to address the potential confusion for staff that can arise when there is a sharp change in values and the bank’s judgement on right and wrong behaviour. What was OK yesterday, even encouraged, may not be today. And vice versa. No one criticised generous bonuses in years leading up to the Crisis and much of the now-condemned “excessive” and aggressive behaviour was well known and not regarded as a sign of serious moral decay or reputationally problematic for banks (or something to which regulators should respond). Now things are different. And the changes in culture that post-Crisis scrutiny of banks will require is not yet a closed list. The implications for conduct are fundamental.

3.5.    We believe that on-line training should be discouraged (because it is unlikely to be effective) and face-to-face training encouraged.

3.6.    We would suggest that training initiatives should include off-site “schools” where staff from different banks can compare experiences and seminars and workshops are arranged at which examples of best practice, “lessons learned” etc. can be openly discussed. Confidentiality of a bank’s sensitive information needs to be respected but it is a characteristic of a “profession” (if that is what we are trying to set up) that fellow-professionals meet each other and talk about matters of shared professional interest (especially questions of professional ethics) reasonably regularly. (NB These occasions should not be arranged so as to be marketing opportunities for outside advisers).

4.    Benchmarking

4.1.    We believe that the organisation should place banks under a good practice obligation to record instances of conduct failure within a database accessible by the Board, Board Committees, Legal, Risk & Compliance and Sustainability & CSR. The organisation should work to promulgate a minimum level of detail (metrics) to be recorded in relation to a particular conduct failure.

4.2.    Devising a system of regular reporting by banks on matters that relate to their conduct (such as the level of conduct costs experienced) and requiring the reporting to be done in a manner that enables comparisons to be made (even a “league table” to be drawn up) is of key importance.

4.3.    We would like to suggest the following guiding principles in this area:
•    “Concrete” indicators are always preferable;
•    Behaviour counts for more than words;
•    Facts count for more than opinions;
•    Hard evidence of actual experience counts for more than surveys; and
•    “Anecdotal” evidence is unreliable.
4.4.    It follows from the above that we would not place as much reliance on surveys, interviews, codes of conduct and internal reports (or reports commissioned by bank management) as the Paper appears to be suggesting. As will be apparent, we place rather more emphasis on the “story” told by conduct cost history for each bank and are pleased to see that such costs would be part of the benchmarking exercise.

4.5.    A definition of conduct costs will be essential. We have proposed one in the LSE Conduct Costs Blog.

4.6.    We do not understand the reference to “relationships with, and interventions by, the regulators” at the top of p.18 of the Paper. What is this expression intended to cover other than conduct costs?

5.    Disclosure and Reporting

5.1.    We suggest that the organisation looks to hold banks to account on the adequacy of their conduct costs reporting.

5.2.    We would like to see the organisation encourage a much greater degree of transparency, from regulators and banks themselves, about how and why conduct costs are incurred and what measures banks are taking in order to avoid recurrence of the problems that lead to them. It is, in our view, unacceptable for a major UK bank (for example) to announce that it has incurred several hundred million pounds worth of new “legal costs” but “decline to comment” on what they are for. We accept that where a bank makes provision for an as yet unsettled, but nevertheless anticipated, conduct cost, there is a sound commercial necessity for the particulars of that provision to remain confidential. However, as soon as the cost crystallises (the bank settles), the bank should disclose and report on the settlement – irrespective of its balance sheet ‘materiality’. We do not consider the ‘flood gates’ argument to be a sound basis for the opacity in Bank conduct cost disclosure.

5.3.    In connection with transparency, we would make the technical point that traditional accounting requirements as to materiality as a test for disclosure should be disregarded in relation to the disclosure requirements to be imposed by the organisation. Because the major banks are so big, many important costs (even, in theory, a record FCA fine) tend to be, or could be, aggregated into larger, more opaque disclosures than is in the public interest – because they are not considered ‘material’ enough to the balance sheet to warrant specific disclosure. All instances of misconduct should be recorded and reported to the organisation and within the banks’ public disclosures.

5.4.    We would suggest that the organisation should review the adequacy of bank reporting of conduct-related matters within their sustainability reports. We have observed that despite purportedly reporting pursuant to the Global Reporting Initiative Index, banks, in relation to the ‘core conduct indicators’ of EN28, SO8 and PR9, either i) do not report or ii) simply cross-refer to the annual report and accounts. Our various interviews with banks have not produced any credible defence of the excessive secrecy in this area and the lack of frankness on this topic  in a document such as a Sustainability Report seems to us to work against the very image (of being a responsible corporate citizen) that banks are trying to project in that document.

5.5.    We would suggest a code of practice for conduct costs disclosure and reporting, at least similar to that previously provided to the organisation.

5.6.    Our experience suggests that much of the information on conduct costs is not currently easily found in the public domain and that banks will have to be required, in clear terms, to produce that information (which they are currently reluctant to do) if a comprehensive picture is to be produced for any one bank or the industry as a whole.

6.    Membership of the organisation

6.1.    We broadly agree with the approach suggested in the Paper, i.e. membership at bank level, at least initially. We do think, however, that a consequence of this is that the organisation must take positive steps to be accessible to the many communities that make up large banks and not channel all communication through “senior management”. These communities could include (a) those who work on the sustainability and CSR sections of the bank (b) the younger employees (c) those who work in retail branches (d) those who have recently joined the bank and (d) those who work overseas.

7.    Other

7.1.    We would like to know what is proposed as a sanction for banks who do not meet the expectations of the organisation. Could this tie in, in some manner, with the rules regime of the regulators? Or does that make the organisation little more than a “meta-regulator”?

7.2.    Consideration should be given to the organisation being given immunity from suit.

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Feb 13 2014

A professional banker? Behavioural change and conduct costs

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Christopher Stears
Lead Research Analyst, Conduct Costs Project, LSE
and Candidate for PhD, Institute of Advanced Legal Studies

The disparate backgrounds, interests and incentives evident amongst individuals working within global financial institutions will cause the greatest difficulty in engineering an appropriate culture or more specifically, controlling behaviour and promoting ‘good’ outcomes. It is precisely this issue, being a product of consolidation and growth (geographically, in speciality and in complexity) of banks over the past couple decades that has lead one commentator to observe that “there is no such thing as the banking profession” (John Gapper, Financial Times 13 February 2014).

An appropriate culture can have an influence, but (and equally in regard to a code of conduct) it  is without teeth unless individuals fear the cost of misconduct (or a poor customer outcome) more than they stand to gain from the potential benefit. Human beings rarely act altruistically. Incentives drive positive behaviour. At its simplest, ‘expectation’ (of internal and external clients) should meet with ‘obligation’ – requiring a fiduciary duty has been meted out as a means to achieve this (although the efficacy of imposing a fiduciary standard, in certain relationships, must be questioned).

One must also consider the corollary of positive behaviour, that is avoiding bad behaviour. This is where we must also focus our efforts: increasing the cost of pursuing self-interest at the expense of the client or in violation of the spirit (as well as the letter) of the law. Principles and enforcement work well and efforts to militate the moral hazard resulting from vicarious liability etc are making good headway.

The Banking Standards Review consultation paper sets out a vision to hold banks (and individuals) to account on the basis of both conduct and competence. The mission will dovetail with the objectives of the regulators; and regulatory synergy in this regard is essential. For us at the CC Project, we believe that the BSR’s intention to benchmark banks’ conduct performance is given its due weight, although, we would emphasise, that surveys, interviews, codes of conduct and internal reports, while providing some qualitative feedback, will be no substitute for the ‘story’ objectively told by a banks conduct costs over time.

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Feb 10 2014

Banking Standards Review – Consultation Paper

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Attached is the Consultation Paper of the Banking Standards Review, published today.

Posted by: Posted on by Roger McCormick