Profiting from trust

Where are the big risks for banks in 2016? ANZ Lending Services, which deals closely with the insolvency and risk management sector, last week rounded up a dozen or so specialists and asked them this question.

BlueNotes will run a series of articles based on their thoughts but one risk was a bit of a surprise. Alongside the credit cycle, China, the mining services slowdown, cyber security, these hard-nosed recovery people pointed to something often considered “soft”: trust.

"Shame may restrain what the law does not prohibit."
Lucius Annaeus Seneca, Philosopher

Since the global financial crisis there have been growing questions over trust in banks - whether its putting bank and personal interests above customers, shenanigans in markets, remuneration or, more pervasively, political and regulatory pressure - erodes a crucial source of competitive advantage for the traditional industry.

It's often said even if consumers don't particularly like banks, they trust them. That's worth a lot. In a world where disruption is the norm, where start-ups can offer clever alternatives to bank loans or payments or wealth management, what keeps customers from switching is a nagging fear of insecurity, that the new competitors or their technology can't be trusted like the old banks.

But every time a bank pays a massive fine for rigging a benchmark or inappropriate lending or advice, every time a new parliamentary inquiry digs up the corpses of scandals past, every time the regulators get out the strap, that competitive advantage shrinks.

Reserve Bank of Australia Assistant Governor (Financial Markets) Guy Debelle delivered a speech last week called The Global Code of Conduct for the Foreign Exchange Market to a room full of people whose conduct was being coded.

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“The reason, as many of you are painfully aware, is that the foreign exchange industry is suffering from a lack of trust in its functioning,” he said. “This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market.”

Debelle was unequivocal: “Trust is the lynchpin of all financial market transactions. Without trust, markets do not function well…. We clearly need the market to be functioning as effectively and efficiently as possible. But for that to happen, we need to restore the trust in the foreign exchange market.”

The song sheet has clearly been distributed globally.

Deutsche Bundesbank's Dr Andreas Dombret also gave a speech last week called “Why focus on culture?” in which he said “trust - this is one of the most important factors in the banking sector. Without it, banking as we know it would be difficult, if not impossible”.

His message was frank: “Now it is up to us to regain this trust, re-establish faith in the banking industry and restore the image of bankers as decent, trustworthy and upstanding businessmen. By 'us' I mean banks, other companies in the financial industry, and supervisors. Regulators can create a proper regulatory framework, set the right incentives and encourage good conduct.

Debelle was just as inclusive with the FX Code: “This is not a code of conduct for the sell side. It is there for the sell side, the buy side, non-bank participants, the platforms; its breadth is both across the globe and across the whole structure of the industry.”

The regulators though are not naïve enough to suggest trust can be regulated back into existence. Dombret quoted the insight of Seneca, the Stoic philosopher and adviser to Emperor Nero, into the nature of regulating ethics and morals: "Shame may restrain what the law does not prohibit".

One of the perceptions the financial services industry must battle, not just since the financial crisis but to this day, is too many financiers know no shame. This is particularly stark in the debate over remuneration.

Deutsche Bank co-chief executive John Cryan fanned this debate when he turned on his own profession and questioned why their bonuses were so high when shareholders did not receive the same returns. Deutsche is looking to slash the bonus pool by around a third.

That seemingly straightforward point – that any bonus should be commensurate with the value accrued to shareholders – sparked its own debate with some accusing Cryan of hypocrisy for not foregoing his own bonus.

The Financial Times ran a very entertaining FT debate on the theme.

The essence of the debate is clear. If bonuses are to be a proper incentive, they must be linked to shareholder returns and hence, prima facie, remain too high. Cutting them however may have the perverse result of driving activity into the less regulated “shadow” banking sector where no, or less, shame exists to limit that which is not regulated.

Debelle's speech made a similar point. “An overall aim of the code is for it to be principles-based rather than rules-based,” he said.

“From my point of view, an important reason is that the more prescriptive it becomes the easier it is to get around. Rules are easier to arbitrage than principles. If it's not expressly prohibited or explicitly discouraged, then it must be ok seems to be the historical experience.”

He argued “the more prescriptive and the more precise the code is, the less people will think about what they are doing”.

This gets to the essence of the trust challenge. It is about people thinking. It is about ethics (and individual morality). And at the institutional level it is about culture.

That's why it is right and proper for more organisations – not just banks – to be talking about culture. It is not just because all stakeholders expect it, it is because fit cultures deliver better and more sustainable results.

Robust cultures make it less likely improper behaviours will flourish which in turn make it less likely regulators will intervene.

Warren Buffett famously said "culture, more than rule books, determines how an organisation behaves”.

If ever there was iron in the velvet it was in this line from Debelle: “As it is in all our interests for trust to be restored to the FX market, I very much trust that you, as market participants, will work with us constructively in this important endeavour.”

Yet the threat of regulation shouldn't be the main imperative driving banks to improve their culture – even though the hundreds of billions of fines levied against (almost exclusively northern hemisphere) banks in recent years now effectively discount bank share prices.

The more important point is trust is a core business. And today, more than ever as front after front of potential disruptors, from tiny fintechs to giants like Alibaba and Apple, move across the landscape, that competitive advantage is ever more valuable.

As Dombret argued “sustainable profitability over the long term is not possible without ethical conduct”.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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