Andrew Cornell says 'conduct risk' is now a permanent risk element in banking alongside credit and market risk

By Andrew Cornell*

Since the crisis there have been 10 inquiries into financial services, including a once-in-a-generation major system inquiry. 

Now, in a year of a general election, the Australian Federal Opposition is calling for a Royal Commission into the industry, the most comprehensive investigation available in the Australian political and legal system. The focus would be on “culture”.

As historically has been the case in Australia, banks are a regular populist target. A series of significant and serious, albeit systemically peripheral, scandals and lawsuits have put them in the firing line again. 

However, while this development is local, it would be wrong to see the investigation of cultural issues in banking as a parochial Australia one. Indeed Australia is actually catching up with the rest of the world.  

Conduct risk

What the global focus on banking culture demonstrates is 'conduct risk', as it is known, is now a permanent risk element in banking along with credit and market risk and one investors and the community must be aware of. Nor is culture, as indeterminate as it is by nature, something which can’t be measured. 

Indeed, a dedicated social enterprise, the CCP Research Foundation, has been established to monitor and measure conduct risk. (CCP standing for 'conduct, culture and people'.) The foundation had its genesis in work by the London School of Economics and has a running total of conduct costs in banking – fines - of more than $US300 billion. 

As CCP notes in a fascinating video presentation by its managing director Roger McCormick and research director Chris Stears “seven years after the collapse of Lehman and the onset of the worst financial crisis of the post-war era, there is still an ongoing crisis of public trust in relation to how our banks are run”. 

Culture is increasingly at the centre of such valuations as conduct risk. In the first edition of the Lafferty Bank Quality Ratings, “Monitoring the World’s Best Banks”, considerable emphasis is placed on culture. 

In the report, Lafferty analysed the failure of HBOS in the UK – at considerable cost to the taxpayer – in terms of five cultural problems. 

The Korn Ferry Institute’s report “The Tone from the top: Takings responsibility for corporate culture” found 72 per cent of 500 business leaders surveyed said culture was extremely important to organisational performance yet just 32 per cent said their organisational culture aligned to a great extent with their business strategy. 

“The gap between these contradictory findings should concern business leaders, board directors, and executive teams,” Korn Ferry said. 

Ironically, Australia’s banking “culture” was actually a key element of the strong performance during the financial crisis. As was clear from this analysis I did for The Australian Financial Review, the “culture” which supported the Australian banks was actually one of fear and mortification. 

The banks still had sufficient corporate memory to be traumatised by the near failure of two of the Four Pillars in the recession of the early 90s while Australia’s principal regulator, the Australian Prudential Supervision Authority, was still recovering from its failure to prevent the collapse of a major insurance company in the early 00s. 

"I think one of the main reasons things went so right in Australia for the major banks is that they went so wrong in the 1980s and early 1990s," Bob Joss, the American executive brought in to save Westpac after the catastrophe of 1992, told me. 

Cannot be translated

That risk sensitivity is part of culture but culture is not easily defined. One is reminded of a particularly astute definition of poetry as “that which cannot be translated” – that which resonates beyond the literal. In the same way, culture cannot be proscribed by rules and regulations. 

Commonwealth Bank director, veteran regulator, novelist and BlueNotes contributor Harrison Young delivered a speech at a banking conference two weeks ago which is as good an essay on the meaning of culture as I have seen. 

“Culture cares more about tradition than logic. It shows us a path, an approach that has worked in the past” is one of his many insights. 

Another was this: “Operational snafus have traditionally been seen as a cost of doing business. They are becoming significant threats. Bank executives will need to acquire an instinctive understanding of the non-linear hazards of our digital future, just as commercial lending officers have an instinctive understanding of the dangers of rapid credit growth and unfamiliar markets. Instinctive understanding is cultural.” 

What he means is the costs are rising. “Alongside bad and doubtful debt charges there will be conduct costs. Stakeholders will look at prospective conduct. That is, culture.” 

The credit ratings agency Fitch put out a specific note on this for the Australian banking sector last week.

“Recent revelations about alleged conduct issues at a number of Australian banks highlight increased regulatory scrutiny of conduct and culture in the financial system,” Fitch said. “Fines, class-action law suits, increased regulatory oversight and remedial action are all possible outcomes from this push.” 

Fitch might have added a Royal Commission which along with taxpayer costs roughly estimated at $A50 million will cost the banks tens of millions the banks to participate. And that’s just the conduct cost of the commission before any eventualisties. 

Given the number of inquiries over the last eight years, there is an active debate about what another could achieve. The Australian Financial Review’s Chanticleer columnist Tony Boyd delivered one of the most reasonable views here. 

But conduct costs are now an established part of the banking environment and hence their measurement becomes a vital discipline. In briefings this week, Fitch has suggested it doesn’t expect conduct costs in Australia to approach those offshore and its ratings are stable. 

“Penalties, fines and the cost of remedial action are unlikely to be meaningful relative to the size of the banks involved, and it is unclear as to what class-action lawsuits may emerge, the prospects for their success, and the ultimate cost to the banks,” Fitch said. “Nevertheless, these actions are likely to evolve over many years.”

Nevertheless, the challenge is they are open ended. CCP has argued that has implications not just for earnings but for regulatory costs and capital bases. The foundation pointed to a statement regarding the Swiss bank UBS flagging prudential implications because of “known or unknown litigation, compliance and other operation risk matters”. 

CCP’s McCormick perhaps summed up the challenge for the banking industry – globally – when he said “it never occurred to me that ethical behaviour would be an issue in its own right. Post the GFC we knew (banks) had been reckless and negligent but we didn’t know they had been lying”. 

Trust once again is at the centre of banking.

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*Andrew Cornell is managing editor of ANZ's BlueNotes. This article first appeared on the BlueNotes website here, and is used with permission.