Culture counts. Doing things right is just as important as doing the right things. That’s one of the lessons that supervisors are drawing from the crisis and from the flaws in conduct and compliance that continue to emerge.
For banks, this lesson is timely. Fines and settlements for misconduct have eroded capital, and remediation has preoccupied management. This is depressing returns and impeding growth.
To create the financial and managerial capacity to pursue a growth agenda, banks have to improve their risk culture. A better culture can help reduce, perhaps even eliminate, costly compliance breaches. That in turn will preserve the bank’s reputation, conserve its capital, and free its management to focus on developing and implementing a strategy that will enable the bank to remain competitive.
What constitutes a good risk culture?
Risk-taking is the essence of banking. Banks add value because they bear the credit, liquidity, interest rate, foreign-exchange and operating risks that individuals and institutions wish to avoid.
A bank’s risk culture encompasses the processes by which it assumes and manages risk. A good risk culture is one that manages risk correctly from the perspective of clients, counterparties and investors. In such a culture, the bank treats customers fairly. It conducts itself with integrity in financial markets. It balances risk and reward, making sure that it is adequately compensated for the risks it takes. It complies with all applicable regulations.
Hence, a good risk culture is about taking the right risks in the right way for the right price. Finally, its incentives both reflect and reinforce this culture.
Risk management framework and risk appetite statement set the script
A good risk culture starts at the very top. The board needs to ensure that the bank’s executives, particularly its CEO, put in place an effective risk-management framework and develop an appropriate risk appetite statement. These documents should explain the risks the bank’s strategy and business model will require it to take, and, just as important, the risks the bank will not take in order to reach its target rate of return on equity. This sets the context in which the bank’s culture will develop. To improve culture, supervisors are demanding that banks focus on four areas:
- Tone from the top: Does the bank’s C-suite, especially its CEO, consistently send the right message on risk? Does the board reinforce this message? Is it communicated effectively across the organization?
- Accountability: Does the bank hold senior managers accountable for managing risk effectively?
- Incentives: Do the bank’s incentives support effective risk management? Or do they encourage contrary behavior?
- Effective communications and challenge: Does the risk message get through? Are escalation paths clearly defined and understood? If the message is wrong, or the delivery goes awry, will someone point this out? If so, will that person be heard and heeded? Making certain that this will be the case is one of the principal responsibilities of the bank’s board of directors.
What remains to be done, and what will be the reward for doing so?
It is much tougher to improve culture than to let standards slip, particularly when and where bad behavior has become the norm. Accordingly, only 39% of respondents to the 2017 EY/IIF risk survey felt that they had reached, or were close to, their target end-state for risk culture. This is only marginally higher than the result in 2016.
What’s the solution? First, each bank needs to stay on message and stick with implementing the measures outlined above to improve culture if it is to convince staff that this is not just another management fad but a change in paradigm. Until people are convinced that change is unavoidable, they see no reason to abandon their habits and routines, however harmful they may be.
Second, banks can — with the support of supervisors — take measures to raise standards across the board. Such market-wide codes lower the threat that staff members at a bank with strict standards may perceive that life is easier and rewards are potentially greater at a bank with looser standards or laxer controls. Correspondingly, higher industry standards remove the rationale for line managers to argue that a better culture will put the bank at a competitive disadvantage.
In fact, the opposite is the case. Banks with a good culture will require less capital, earn higher returns and be able to focus on innovation and improvement rather than remediation and restitution. At the end of the day and on the bottom line, culture does indeed count.