CULTURAL FAILURES AT BANKS: A REVIEW AND POSSIBLE SOLUTIONS

Alan Morrison University of Oxford

Joel Shapiro University of Oxford

I.

Introduction The years following the financial crisis were beset by an onslaught of banking

scandals: LIBOR, Forex, ISDAfix, mis-selling, money laundering, tax avoidance, and others. They involved dysfunctional bank cultures that prioritized short term payoffs over long term relationships. These problems had been going on for years out of sight (or at least out of mind) of both senior managers and regulators, and came as a dramatic surprise to outside observers. In this paper, we will analyse the root causes of the cultural failures at these banks and possible solutions. We begin by defining culture, so as to properly understand the source of dysfunctional culture. We draw on the sociology, management, legal, and economics literatures for this task. We then ask how cultures may change, with a particular focus on how banking culture has changed in the last century. Using this framework, we then explain two recent dysfunctional bank cultures: that of the derivatives and money market traders who manipulated LIBOR, and that of the foreign exchange traders who manipulated the foreign exchange fixes. Drawing upon these studies, we propose policy solutions meant to prevent and detect cultural failures.

II.

What is culture?

The way corporate culture is most commonly described is Marvin Bower’s (1966) characterization as “the way we do things around here.” Implicit in this statement are two key elements. First, it is difficult to describe the way things are done – including how they are done, when they are done, and what is done in response to certain events. This may arise because of a difficulty in contracting (writing the contract, enforcing it, unforeseen events) or articulating (at all or sufficiently) how to deal with contingencies. Second, it implies that things are done for a reason. Cultures can arise to solve a social (or economic) problem that can’t be handled through contracts or simple conversations. Kreps (1990) put this in

economic terms; culture arises to select among multiple equilibria in a way that could not be contracted on or discussed. 1 Culture thus depends on shared values (agents evaluate outcomes in the same way) and norms (agents place the same constraints on themselves as other members of the culture). While culture may be specific to a problem, it also depends on interactions. Therefore artifacts that spur interaction, such as the water cooler, determine the formation of a culture (Schein, 2004). Interactions also depend on language. Cultures may develop shared understandings and language to facilitate and economize on communication (Cremer (1993) and Lazear (1999)). There are two important implications from this description of culture that have been overlooked in the debate on dysfunctional bank cultures. The first is that cultures arise for a given network of employees, defined both by the work they do and the physical (and virtual) space in which they interact. This means that particularly in complex organizations such as banks, there is not one specific culture, but many cultures. Moreover, cultures may extend across banks. In the LIBOR and Forex cases, which we will discuss subsequently, cultures that spanned multiple banks arose either through trading relationships between banks and/or mobility of employees across banks. The second is that cultures are difficult to outsiders to understand. They have specific knowledge and languages that may be difficult to interpret. This will make it difficult for regulators to monitor. Moreover, it may also create a distance between senior management and rank and file employees. There are, of course, other reasons senior management may not be actively monitoring its employees. If profits are above average, the incentive to monitor is less, despite warnings of malfeasance. Also, we will see below that banks rely less on reputation, so again malfeasance may not be a priority of senior management.

III.

Why is bank culture an issue now?

The change in investment banking culture provides important insights here. Investment banking transactions used to be completely relationship based; for example, ensuring that a long term client gets a fair price. This type of relationship involved a commitment by the investment bank to its clients that could not be codified. Therefore it was important to tie its personnel’s wealth and human capital directly to the reputation and 1

Thakor (2015) discusses this and the economics literature on corporate culture in detail.

success of the investment bank, which it did through the partnership form (Morrison and Wilhelm, 2015). Over time, computerization and financial engineering codified most elements of transactions, and weakened the need to have such a culture (Morrison and Wilhelm 2007, 2008). The partnership thus vanished and the joint stock company emerged. In fact, almost all financial activities have become more codified and arm’s length. Nevertheless, the artifacts that arose with the culture in the first place – the networks, languages, knowledge, and routines remained, despite the fact that relationships, values, and norms had changed due to technology. This interaction between old artifacts and new values and norms may lead to a dysfunctional culture.

IV.

How do we explain recent cultural failures?

A. A brief overview of LIBOR and Forex manipulation

LIBOR was introduced in the early 80s as a way for banks to hedge funding costs. It is now used for swaps, forward rate agreements, mortgages, and many other products (market size over $300tn, see Wheatley (2012)). For a given LIBOR, a panel of multinational banks had to report their borrowing costs. There was no requirement that reports be based on transactions, and indeed sometimes there were no transactions. LIBOR manipulation generally occurred for two reasons. First, derivatives traders would ask the money market desk to manipulate the LIBOR submission to increase the payoff on their positions. These attempts were sometimes based on requests by former colleagues now at other banks. Second, management requested lower LIBOR submissions to hide credit risk from the market. For Forex manipulation, we focus on manipulation of the WM/Reuters 4pm fix. The WM/Reuters fix was created in the early 1990s for pension valuation.2 It began to be used for construction of indices, and many funds trade at the fix to reduce tracking error. Nonfinancial corporates also trade at the fix. The 4pm fix is based on actual trading using data over a one minute window. Traders had orders to buy and sell at the fix, creating a net exposure in one direction. Moving the rate increased profits (and cost clients). Traders used chatrooms to communicate with traders at other banks. They would do so to learn about

2

http://www.euromoney.com/Article/3276783/Foreign-exchange-Fix-scandal-might-heraldthe-end-of-voice.html

orders tied to the fix from other banks, agree on the direction they wanted to move the rate, and discuss how they would move the rate.

B. Analysis

The first question we address is what was the economic problem that the cultures surrounding the LIBOR and Forex rate setting arose to solve? LIBOR became problematic because of the easy communication between derivatives traders and the LIBOR submitters on the money market desk. However, the co-location of the derivatives desk and the money market desk made economic sense; derivatives traders needed continual updates about interest rates in order to trade effectively and the money market desk could provide this information flow. In addition, many derivatives traders had their instruments linked to LIBOR, so an understanding of how LIBOR would be set each day was useful. This illustrates that the network that formed between the derivatives trading desk and the money market desk was based both on economic motives and locational ones. The LIBOR scandal also involved many instances of collusion; i.e. contact between banks to manipulate the rate. This appears to be a result of labor market mobility – traders contacting former colleagues who moved to other banks. Foreign exchange traders received orders during the day to trade at the 4pm fix. As they guaranteed a trade for their clients at the fix, which was unknown at that point, the traders has substantial risk exposure to the fix. In order to mitigate that exposure, traders communicated with traders in other banks to learn about order flows. Therefore networks formed between banks based on a common goal. This, of course, subsequently facilitated collusion to manipulate the fix. The second question we address is whether these cultures were easy for outsiders to observe. The Financial Times reported that3 “Investigators are also being hampered by limited understanding of what one lawyer called the unusual ‘dialect’ used by forex traders. ‘Most of these messages are crushingly boring and pure garbage. [But] they are difficult to decipher,’ a senior banker involved in an investigation says.” Forex traders used terms like “loading the ammo” and “clearing the decks”. This made it difficult for regulators and management to understand what they were actually doing, both above board and below. Sir

3

http://www.ft.com/cms/s/0/a296da48-9579-11e3-8371-00144feab7de.html\#axzz2tfdCIcDV

Philip Hampton, Chairman of RBS, stated that4 “We had no controls, absolutely. Libor has been going since the mid 1980s, and we had no controls in place.” Therefore, whether senior management could observe the cultures or not, there was no mechanism in place to deal with them. As we pointed out above, senior management may not have had incentives to deal with manipulation as (i) it was profitable and (ii) there may have been a perceived minimal reputational damage to the firm from its discovery. The third question we address is how these cultures became dysfunctional. As we have seen, the networks needed to manipulate were already established to solve the economic problem. Chatrooms and co-location facilitated communication. The potential for rigging was obvious. The major cost was actually detection. However, several factors decreased the likelihood of detection. First, bank holding companies have become increasingly complex in recent years (Avraham, Selvaggi, and Vickery (2012)). Second, we have already pointed out that senior managers and directors may not have understood or observed the manipulation. Even if they did, they did not have strong incentives to look into it. Third, regulators also seem to have turned a blind eye to manipulation - some regulators were informed of LIBOR manipulation5 in 2008 and of Forex manipulation6 in 2006.

V.

Possible Solutions

In this section, we discuss ways to prevent cultures from becoming dysfunctional and what should be done if they do become dysfunctional. Policy discussions have operated around the presumption that banks have one culture. However, we have demonstrated that there are multiple cultures at work within a given bank, and that those cultures may span banks. The most basic suggestion is to map the cultural networks that exist within banks, potentially with the aid of a sociologist or anthropologist, so as to be able to direct policies effectively. One example of this is setting an appropriate “tone from the top”. If such a tone was directed at the whole firm, it would have a weak effect. Tailoring it to specific networks within the firm would resonate, as it would adopt the culture and cultural understandings of the particular network. To effectively accomplish such targeting, senior management should

4

http://www.theguardian.com/business/2013/feb/06/rbs-libor-rigging-in-quotes http://money.cnn.com/2012/07/13/investing/geithner-libor-barclays/index.htm 6 http://www.telegraph.co.uk/finance/bank-of-england/10685543/The-lunch-meetings-atthe-heart-of-the-Bank-of-England-forex-inquiry.html 5

be embedded in these networks; to listen, learn, and communicate back to the network appropriate behaviour. The president of the Federal Reserve Bank of New York, William Dudley, in 2014 suggested the use of performance bonds to correct cultural problems. Performance bonds deduct fines on the bank from the bank’s deferred compensation pool. This has the effect of punishing bad behaviour (rather than shareholders) and incentivizing monitoring in the firm.7 Once again, this proposal, while very well designed, would be more effective if targeted toward networks at fault. Just as firms use underperformance as a motivation to review employees and perhaps replace them, we suggest that outperformance should trigger formal reviews. Outperformance should be explainable, and not be a result of malfeasance. Repeated outperformance should draw management’s and regulators’ attention. Notice that it should not be sufficient to state that workers engaged in similar work in different firms also outperformed as a justification; collusion across banks also implies that this would be true. Lastly, forming a professional licensing body for bankers can help in many dimensions. It can formulate and promote codes of conduct throughout the industry. It could act as a central clearinghouse for information on individual conduct. Therefore direct evidence of malfeasance could leave permanent marks. If possible, the body should be able to exclude people from the industry for misconduct. Moreover, the body might also update the records of participants (even if not directly identified in wrongdoing) in an identified cultural failure (even if not directly identified in wrongdoing). Therefore the ability to hide one’s record and escape wrongdoing that may be fostered by the fluid labor market mobility of the banking sector (see a discussion in Acharya, Pagano, and Volpin (2013)) could be reduced with the presence of such a body.

VI.

Conclusions

The explosion of banking scandals following the financial crisis has impacted the regulatory agenda. Yet many discussions about the dysfunctional cultures that underlie these scandals do not address the fundamentals of how cultures arise and how they work. In this paper we build on the economics, sociology, law, and management literatures to further understand culture and provide potential solutions. We note that banks have multiple cultures 7

Facilitating whistleblowing also improves monitoring at the firm.

and cultures may span between banks. Cultures have their own languages and knowledge, and are thus difficult for outsiders to understand. Embedding management into cultural networks, increasing monitoring incentives, and promoting licensing bodies can all reduce the likelihood of cultural dysfunction.

BIBLIOGRAPHY

Acharya, Viral V., Marco Pagano, and Paolo Volpin, 2013, Seeking alpha: Excess risk taking and competition for managerial talent, Working Paper 18891, March, NBER, Cambridge, Mass.

Avraham, Dafna, Patricia Selvaggi, and James Vickery, 2012, A structural view of U.S. bank holding companies, FRBNY Economic Policy Review pp. 65–81.

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Cremer, Jacques, 1993, Corporate culture and shared knowledge, Industrial and Corporate Change 3, 351 – 386.

Dudley, William C., 2014, Enhancing financial stability by improving culture in the financial services industry, Speech at the workshop on “reforming culture and behavior in the financial services industry”, October 20, Federal Reserve Bank of New York, New York City.

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Morrison, Alan D., and William J. Wilhelm Jr., 2007, Investment Banking: Institutions, Politics and Law (Oxford University Press: Oxford, UK).

Morrison, Alan D., and William J. Wilhelm Jr., 2008, The demise of investment banking partnerships: Theory and evidence, Journal of Finance 63, 311–350. Morrison, Alan D., and William J. Wilhelm Jr., 2015, Trust, reputation and law: The evolution of commitment in investment banking, Journal of Legal Analysis Forthcoming.

Schein, Edgar H., 2004, Organizational culture and leadership (Jossey-Bass).

Thakor, Anjan V., 2015, Corporate culture in banking, Mimeo, July, Washington University in St. Louis, MO.

Wheatley, Martin, 2012, The Wheatley Review of LIBOR.