Regulation vs Culture

Following recent scandals and allegations of marketmanipulation, can financial services adopt industry-wide culture changes andsweeping reforms, and what have fined firms done to demonstrate theircommitment to change? Alice Attwood reports.

Reverberations of the Libor and foreign exchange benchmarkfixing scandal can still be felt throughout the market and the creation of aregulator focused on conduct is indicative of the focus on employees and theculture embedded within companies operating in the space.

Principles or Rules?

Regulators have been shifting focus from a rules to aprinciples approach to ensure that impending rules are appropriate for theindustry they are governing, as part of an industry drive to change the cultureinvestment banking.

Tracey McDermott, director of supervision and authorisationsat Britain’s Financial Conduct Authority, told FOW: “The idea ofprinciples-based regulation is not new. It has been a key part of theregulatory approach in the UK for many years.

“What principles-based regulation seeks to do is to focus onthe core outcomes. This approach recognises it is impossible to set outdetailed, prescriptive rules for every situation in a fast-moving market andthat rules can, themselves, encourage some people to play to the letter, ratherthan the spirit, of what they are trying to achieve. It places moreresponsibility on firms and those that run them,” she added.

“A universal, one-size-fits-all approach to regulation worksbest for principles based conduct,” suggests president of ACI - The FinancialMarkets Association, Marshall Bailey.

“This leaves no room for uncertainty and means marketparticipants all over – regardless of geographical location – are abiding bythe same rules and held to the same standards of ethics and behaviour. Whenregulation is introduced on a national or regional level, you run the risk ofethical arbitrage,” he added.

As documented over recent years, some financial institutionshave failed to keep to this responsibility. The fallout of the Libor scandalalone lead to shock and awe, and increased scrutiny over financial markets.

Since then, industry bodies have been working to ensure moreeffective checks and balances, as well as market-wide reviews to ascertain thereal scope of the issues.

FEMR

The Bank of England’s Fair and Effective Markets Review(FEMR) - established in June last year - seeks to tackle malpractice andrestore confidence in the fixed income, currency and commodities market, andwas born from the realisation end-users are largely ill-suited to the task ofcombating market misconduct across the fixed income, currency and commodities(FICC) markets.

Opinion has been divided over how best to strengthenoversight of wholesale markets, what approaches are most appropriate and whichregulatory body should lead the charge.

The FEMR’s consultation report released in October last yeardetailed what needs to be done to reinforce confidence in the fairness andeffectiveness of the FICC markets, and to restore trust, following high profilecases of abuse.

Established by UK Chancellor George Osborne, he said of theFEMR: “I am determined to deal with abuses, tackle the unacceptable behaviourof the few and ensure that markets are fair for the many who depend on them.”

Martin Wheatley, chief executive of the FCA said: “Much hasbeen done to tackle the underlying causes of past misconduct, but theperception remains that too often private interests are placed ahead of faircompetitive markets. Rebuilding trust in these markets will take time andrequires firms and the authorities to take action... Given the essential roleof these markets, it is vital that we get this right.”

ACI’s Bailey told FOW: “Regulators are rightly stepping upefforts to tackle trader misbehaviour and place ethics at the heart of theirmarket reforms. There is a clear and urgent need to reform the culture andconduct of the financial services sector.”

McDermott told FOW the FCA will be looking at codes ofconduct in greater depth as part of the FEMR.

The review’s consultation period ran to the end of Januarythis year, with final recommendations set to be made in June.

Extraterritoriality

Extraterritoriality has been a stumbling block forregulators for years. The FCA has been working to meet the challenge ofco-ordinating across borders with international regulators while also forgingahead with plans to combat abusive behaviour in Britain.

McDermott said: “We recognise international solutions areoften better than national ones in cross-border markets.

“However, we also believe that London’s role as a leadingmarket means that it should be seen to be taking the lead in driving for thehighest standards of conduct,” she added.

Cross-border issues remain and the challenge ofextraterritoriality casts a shadow over the market. Yet, while regulators havecommitted to working together, there are requirements and standards that varybetween jurisdictions which have conspired to make this an area of debate foryears to come.

While these issues need attention, operating acrossdifferent jurisdictions ultimately means that greater cohesion betweenregulators is imperative, ACI FMA’s Bailey told FOW. “We believe aone-size-fits-all code of conduct, covering important principles would beappropriate for adoption by all financial markets participants but are mindfulthat regional codes have also been developed across the world which aresometimes tailored to specific markets.”

Wheatley has said the FCA’s new Senior Manager Regimeapproach is better than the current flawed model but the CEO conceded there aresome practical issues: "The challenge is one of practical implementation.It’s not straightforward, frankly, to manage the behaviour of many tens ofthousands of individuals across complex, global organisations.”

ACI FMA’s Bailey added: "Levelling the playing fieldinternationally in this way will provide much needed clarity for financialmarket professionals. It is also beneficial for regulators, as they can measurethe behaviour, ethics and conduct of all participants by the same criteria –regardless of geographical location – and any misdemeanours can be immediatelyidentified and addressed.”

Manipulation

Fines over Libor are still coming; Deutsche Bank in Aprilwas slapped with fines amounting to more than $2.5 billion over themanipulation of London, Euro and Tokyo benchmark interest rates.

The bank was ordered to pay the biggest fine yet over Liborand to terminate and ban individual employees who engaged in misconduct.Deutsche was also required to commit to create a benchmark and index controlgroup which oversees the bank’s Ibor submissions.

The German bank subsequently ramped up its focus oncompliance in recent years. Deutsche’s ’Strategy 2015+,’ announced in June2012, included an ‘Operational Excellence’ programme. Within this, €3.6b hasbeen invested to upgrade technology and operations across the business,including instilling its “three lines of defence” against future conductissues, and upping its front-office supervisory headcount.

Results from an employee-wide survey in 2013 – some 52,000employees – asked for opinions and expectations. These results, as well assenior management discussions, led to the creation of Deutsche’s six ‘corevalues’: Integrity, Sustainable Performance, Client Centricity, Innovation,Discipline and Partnership.

Strategy 2020, updated and launched in April this year,includes a focus on embedding “deep-rooted cultural change,” said the bank,with controls, risk governance, compensation deferral and diversity on theagenda.

Barclays was hit hardest by global regulators when it wasfined over $2.5bn in late May as part of bigger action against six banks overforeign exchange benchmark manipulation which saw them fined over $5bn.

The bank has in recent years taken steps to ‘Transform’ thebusiness, that is: Turnaround, Return Acceptable Numbers, Sustain ForwardMomentum.

“Transform” included a new code of conduct for employees,The Barclays Way, which included training to meet their working requirements:“Every colleague must abide by this and annually attest to having read andunderstood it,” said the bank.

In a speech on ‘Trust and Trustworthiness in Banks andBankers’ in New York last year, Barclays chairman, Sir David Walker, said thebank’s culture is taking shape as it works to embed its values.

“This is a journey to which the best support from theregulator is likely to be in the form of high-level and relatively detachedencouragement rather than prescriptive rule-making, which is all too likely tobe counterproductive,” echoing sentiment from across the industry that a stepaway from a rules-based approach may be more appropriate for the modern tradinglandscape.

More costs to come

Earlier this year a report for Morgan Stanley analysts saidEurope’s banks are facing an estimated $52bn in fines and litigation costs overthe next two years, with RBS and Barclays set to pick up the biggest bills.

"FX settlements underscore (the) need to prove cultureand business models are transformed before returns and payouts can rise,"analyst Huw van Steenis said in the bank’s note.

At the time, Morgan Stanley estimated that UK governmentmajority-owned RBS, will have to pay another $10.6bn on top of the $12.6bnalready paid or provisioned for, while Barclays, could have to pay another$8.3bn, HSBC $7.7bn, Lloyds $6.1bn and Deutsche Bank $5.1bn.

They also estimated that future litigation costs forEuropean banks would include $6.5bn for interest rate benchmarks Libor andEuribor, and $9.4bn related to US mortgages.

Who’s to blame?

Accountability has been creeping up the agenda forregulators. Britain’s FCA in March outlined the thinking behind next year’sproposed Senior Managers Regime, with Wheatley stating that the SMR isimportant because it demonstrates an acceptance that professionalaccountability is a priority because it makes “commercial sense.”

Under the SMR, the FCA has urged City firms and managers toembrace the reform that forces individuals to be more accountable for conducton their watch.

Increased professional accountability - for both individualsand companies - has only increased as a result of high profile scandals.

US Commodity Futures Trading Commission commissioner SharonBowen highlighted in March the increased focus on culture in the industry.

“It’s not just that we need to disincentivise people fromgoing against the rules. I think we also need to improve the culture ofcommunication within financial firms. In a world as complex and convoluted asfinance, it is easy to make mistakes,” said Bowen.

“Every company needs to make it easy to fix or mitigate thosemistakes, and that requires a culture where information about mistakes easilytravels from the bottom to the top and vice versa,” she added.

The link between regulation and conduct is inextricablylinked, Bailey, president of ACI FMA, told FOW, and professional accountabilityis imperative.

“Ultimately, it comes down to the behaviour of individualmarket participants, and the ability of their supervisors to enforce thestandards required through oversight and governance. The actions of thisrelatively small and unrepresentative minority have damaged the reputation ofthe market in the eyes of the public, and the industry must now supportregulators to drive positive cultural change and demonstrate that bad behaviourisn’t widespread across the market,” he said.

Regulation vs Culture

But what is more appropriate - a focus on prescriptiveregulation itself, or the conduct of employees and the culture withinbusinesses themselves.

The two go hand in hand, but regulators are implored byindustry participants to consider the practicalities of potential rules aheadof implementation.

Speaking at The ACI UK - The Financial Markets Association’sSquare Mile Debate in March, Gavin Wells, global head of LCH.Clearnet’sForexClear and CDSClear businesses, warned: “You cannot be prescriptive withregulation. Rules should not be so specific that creativity is lost from withina market, there needs to be a balance between conduct and regulation, and atthe centre of this balance is people.”

David Clark, chairman of the Wholesale Markets BrokersAssociation, said: “Behaviour has changed more than people think. The fines,especially the scale of the fines has scared people. The subsequent impact onindividual behaviour has been huge, and on the whole, underestimated by the media.”

McDermott conceded that while the industry has come someway, conduct has to remain the key focus for financial professionals: “Theissue with FX or Libor was not the technology, it was market participantsworking together in an attempt to game the market. In many ways, it was verytraditional misconduct simply carried out in a different way as a result ofdifferent technology.”

Bailey told FOW: “Regulation alone will not stop badbehaviour, as it is rarely ever harmonised across borders. This means codes ofconduct have a key role to play, and the best scenario would be for such codesto be implemented and backed up by legislation,” he said. 

A trader code?

The foreign exchange and derivatives trade body recentlylaunched its updated code of conduct, the Model Code, and called forinternational co-ordination between national regulators to ensure againstabusive behaviour by bankers and traders.

ACI FMA has said FX market participants should consideradopting a process under which managers periodically supervise FX policycompliance by their staff, indicating the trade body’s focus on conduct andtransparency across the FICC markets.

"There is a clear and urgent need to reform the cultureand conduct of the financial services sector,” said Bailey.

The trade association has acknowledged that there is more tobe done to ensure behaviour changes and global institutions are clear on whatis and isn’t acceptable.

“The idea of the ACI’s Model Code being used as a ‘stamp ofapproval’ adopted by the industry, is worthy of consideration,” a source toldFOW. “At a high level, this already happens, and this framework is already usedby central banks. Official adoption of the code would be a positive thing as itwould create a level playing field.”

WMBA chairman Clarke backed the idea but noted: “Thepotential power in a code of conduct is still not fully exploited. Regulatorshave realised the potential positive impact that a code of conduct can have ontrading behaviour.”

Another market source, who did not wish to be named, toldFOW: “Codes of conduct have always existed but they must be updated and evolveto suit our evolving market.”

“In the traditional voice-trading environment, a trader’sword was his bond; there was an expected and accepted ‘gentleman’s agreement’that was kept to,” he added.

“Many firms have adopted their own internal codes ofconduct, and are required to complete frequent training to ensure they are upto date with requirements; this is common practice nowadays,” said DarrylHooker, head of Icap’s EBS Market. 

Indeed CFTC Commissioner Bowen has called for employeerequirements to “become part of the DNA of the organisation”.

Failure to comply

What is abundantly clear is that the repercussions offailing to meet internal and industry requirements should be severe, throughfines, dismissal, or, if appropriate, imprisonment, to protect companies andthe industry from future violations.

The responsibility to meet such requirements lies withindividuals and companies.

Bowen said: “Each organization should have codes of conduct,rules of ethics, and conflicts of interest that are clear. Failure to adhere tothis standard, absent significant extenuating circumstances, should result intermination of employment.”

Indeed, following the record fines that Deutsche was servedin April, the bank was ordered to terminate and ban individual employees whoengaged in misconduct; ten employees who were involved in the misconduct havealready been terminated, according to documents from regulators.

Reoffenders

However, while fines have been issued over compliancefailures, there have been reoffenders.

“If a company has a number of violations, the sanctions forfuture violations would inherently have to be more severe to discouragerecidivism, and it is possible that more than one person at the company amongsenior management would also be on the hook,” said CFTC Commissioner Bowen.

Bowen noted in March the effect that reoffenders have on themarket as a whole. “Too many times, these settlements and alleged violationsare coming from large actors who have previously run afoul of the rules,endangering the reputation of those actors and the trust that undergirds thelarger financial system,” she said.

“We have a culture problem in finance, full stop, and it’sgetting to the point of endangering firm’s profits and our system’ssustainability and stability,” she added.

Compliance spend

Compliance is now the biggest hiring area in financialservices. A recent PwC study, the ‘State of Compliance,’ said that complianceofficers are still facing challenges in understanding the full scope ofbusiness operations.

PwC supports industry calls for greater education ofparticipants to ensure they are adhering to requirements, noting: “To beeffective, compliance oversight of industry-specific regulations requires bothknowledge of the regulatory requirements and associated expectations—and deepfamiliarity with the business context.”

The survey also noted that in financial services, the topskillset required when hiring for corporate compliance teams is ‘compliance orethics,’ beating applicants with a legal background and industry experience.

“These [compliance] teams are tasked with care-taking thewhole business,” EBS’s Hooker told FOW.

The PwC study said 64% of financial services organisationsreported increased compliance staff levels in the past year.

This is now a requirement for operating within financialmarkets. “While additional checks and balances around compliance may havestarted out as frustrating, they are now woven into the fabric of operations.In fact, it would almost be abnormal not to have this focus now, it’s a part ofdaily life,” added Hooker.

A source told FOW: “Protecting banks from employeebehaviours is now the name of the game, and this is why we’ve seen such anincrease in investment into surveillance and compliance divisions. Banks wouldmuch rather spend £100 million on infrastructure and compliance to protectthemselves than billions on fines.”

What’s next?

While positive steps are certainly being made, WMBA’s Clarkwarned: “An unintended consequence of over-exuberant regulation is the hit onliquidity. I expect to see this during 2015.”

McDermott told FOW: “There has already been significantregulatory change, the most obvious example being the establishment of aregulator focused on conduct. But, ultimately, a cultural change cannot bebrought about by regulation alone.”

“Looking ahead, scrutiny will only continue and increase. Itremains to be seen what effect this will have on trader behaviour,” warned aformer head of FX prime brokerage.

“We have come some way,” concedes the FCA’s McDermott.“Certainly when I speak with senior figures in the industry I know conduct isat the top of their agenda.”

When considering whether an industry-wide shift in focus forregulation – from rules to principles-based – market participants suggest thatboth can work: “It is the lack of understanding that creates regulatoryuncertainty – this is the enemy and is very damaging to the market,” said theWMBA’s Clark.

EBS’s Hooker said, “The difference is rules are definitiveand principles are open to interpretation. This therefore causes a struggle;running both in tandem, not contradictorily.”

McDermott warns the battle is not yet over and that changesto the culture of an industry is no mean feat.

Thus the future challenge is change: “Ultimately unless thischange in culture becomes part of the DNA of firms, unless the front line ownsthis change and buys into it, it won’t happen, no matter how many fine wordsthere are from those at the top and no matter how many thousands of compliancestaff firms employ.”

Conduct and culture at financialinstitutions will be discussed indepth at FOW’s Regulation 2015 event on 8September. For more information and to register, visit www.fow.com/events.