■ by Geoffrey Davies, Technical Head of Department, Prudential Policy Directorate, Bank of England

In June 2013, the UK’s Parliamentary Commission for Banking Standards (PCBS) published a detailed and wide-ranging report on standards in the U.K.’s banking industry.1 Coming in the wake of the financial crisis, the exposure of LIBOR manipulation and a series of other headline-grabbing conduct issues, the report’s conclusions were scathing. The British public’s trust in banking had been lost, not as a consequence of a few rogue individuals or dysfunctional banks but as the result of “common deficiencies of standards and culture.” Renewed trust would need to be earned and, in the words of the report, such trust “will only have been earned when the deficiencies in banking standards and culture, and the underlying causes of those deficiencies, have been addressed.”

The PCBS put forward a large number of recommendations to address these flaws. In keeping with the wide spectrum of underlying causes that it had identified, the recommendations covered a broad range of areas, from the failings and incentives of the banks’ management and shareholders, to the nature and competitiveness of their markets, to the role and approach of the regulators and the effectiveness of the framework they operated within. Since publication of the report, the majority of the parliamentary commission’s recommendations have been taken forward and are now in various stages of development and implementation whether through legislation, regulatory rules or changes to market practice.

Against that background of change, this article restricts itself to three recent responses to the PCBS recommendations, each of which has been the subject of published policy in the last six months.

The PRA’s Policy Statement on Existing Powers to Address Failings in the Culture of Firms

In June, the UK’s Prudential Regulation Authority2 (PRA) published an explanation of how it uses its formal powers to address serious failings in the culture of firms.3 As well as highlighting the importance of culture in the PRA’s approach to supervision, the publication also served to explain how the PRA’s existing powers met the PCBS recommendation that regulators should have the necessary tools to intervene proactively to address weaknesses in firm culture.

As set out in the statement, the PRA expects firms to have a culture that supports their prudent management. The PRA does not have any “right culture” in mind; rather, it focuses on whether boards and management clearly understand the circumstances in which the firm’s viability would be under question, whether accepted orthodoxies are challenged, and whether action is taken to address risks on a timely basis. As prudential regulator, the PRA must be satisfied in particular that risk management and control functions carry real weight within the firm.

Serious failings are to be identified through the PRA’s normal supervisory activity, which includes frequent contact with firm representatives as well as assessments of board effectiveness, valuation methods and remuneration policies.

The PRA will look to act proactively where serious failings are identified. This is likely to involve an increase in the intensity of supervision and may be combined with a requirement for specific remedial action. The PRA has a variety of statutory powers it can use, ranging from imposing direct requirements to varying a firm’s permissions and commissioning independent reports. Continuing shortcomings can, however, lead to enforcement investigation without the regulator needing to have exhausted all of its supervisory options.

The PRA’s statement of policy illustrates the range of supervisory tools that can be applied to tackle poor culture at a firm. Of course, the culture of a firm is formed by the behaviors of the individuals within it and therefore the supervisory tools that act on the incentives of those individuals are of considerable importance, too.

The PRA and FCA’s New Accountability Regime for Individuals

The UK has had regimes for regulatory pre-approval of key function-holders since the late 1980s. In reviewing the effectiveness of the current regime,4 the PCBS identified a number of weaknesses and recommended that it be replaced with a new regime focused more squarely on individual accountability. The statutory framework of this new regime was incorporated into UK legislation – the Banking Reform Act 2013 – that was passed into law at the end of last year.

Building upon this legislation, the PRA and the Financial Conduct Authority (FCA) in July published a joint consultation of their respective proposals for changes to the way that individuals in banking and the largest investment firms are assessed as “fit and proper” and are held accountable.5 The changes can be broadly split into three parts:

• A new “Senior Managers Regime” replaces the current regime for regulatory pre-approval of senior individuals. Responding to the criticisms of the PCBS report that the existing regime did little to set expectations or incentivize the raising of standards, the new regime clarifies the responsibilities of individuals holding key roles in banks and makes it easier for the regulators to hold them accountable. Firms will be required to document the allocation of responsibilities prescribed by the regulators (which includes embedding a firm’s culture and standards) to specific individuals and must vet each senior manager at least annually to certify that he or she is fit and proper. Significantly, new enforcement measures have been introduced by the legislation to enable the regulators to sanction senior managers where the manager cannot demonstrate that they took reasonable steps to avoid a breach of standards by the firm (the so-called “presumption of responsibility”). In addition to this civil sanction, senior managers who are aware that their actions could lead to failure of the firm and whose conduct falls significantly below what could be reasonable expected, can be subject to criminal prosecution if the firm fails.
• A new “Certification Regime”’ requires the firms to assess and certify the fitness and propriety of a wider set of their employees who, though not in the top level of management, nevertheless undertake functions deemed by the regulators to pose a risk of significant harm to the firm or its customers. Responsibility for effective running of the certification regime lies with the firm and must be allocated to an individual within senior management.
• A new set of “Conduct Rules” (see box) applies to a potentially much wider set of employees than just to the individuals pre-approved by the regulators. While the PRA will apply these conduct rules to senior managers and to employees within the scope of its Certification Regime, the FCA, as consumer conduct regulator, intends to apply the rules to essentially all employees except those who carry out tasks not specific to banking.

The three sets of proposed measures are designed to impact not just individual behavior but also the general culture within banks. One effect of the “presumption of responsibility” should be to incentivize senior management to ensure that the culture and governance within the areas they manage allow them to identify and reduce the risks of regulatory violations occurring. Specific Senior Managers (typically the chairman and CEO) will have particular responsibility for developing and embedding a firm’s culture and standards. As a further aid to achieving this, a cadre of bank staff below them will need to demonstrate they are fit and proper both in terms of their competences and standards of behavior. Where their actions or omissions fall below minimum standards of conduct, these employees will themselves be accountable to the firm and, as appropriate, to the regulators. Requirements to notify the regulator about conduct breaches and disciplinary action together with heightened requirements to obtain references from past employers should act as further deterrents to poor conduct and help to reduce the risk of bad apples reappearing in the industry.

Strengthening the Alignment of Risk and Reward

Coinciding with the launch of the consultation on accountability, the PRA and FCA published proposed changes to their Remuneration Code for banks and PRA-regulated investment firms. The changes have been designed to address the weaknesses in the alignment of risk and reward highlighted in the PCBS report. The proposals include:

• Increasing the alignment between risk and reward over the longer term by requiring firms to delay payment of variable remuneration (e.g., bonuses) for a minimum of five or seven years depending on seniority.
• Further enhancing the ability of firms to recover variable remuneration, even if paid out or vested, from senior management if risk management or conduct failings come to light at a later date.
• Developing options to address the problem that employees can sometimes evade the application of “malus” (i.e., reductions in unvested awards) by changing firms.
• Strengthening the existing presumption against discretionary payments when banks have been bailed out.

These proposed changes would sit alongside new rules coming into effect on January 1, 2015 that require firms to be able to ‘clawback’ variable remuneration for at least seven years from the date of award.

Together, the proposed measures on individual accountability and remuneration represent a substantial regulatory response, reflecting the importance placed by the regulators on incentivizing the right risk-taking culture in firms. However, as is generally acknowledged by both industry and regulators, the primary responsibility for improving the culture and standards in banks lies with the senior management of the banks themselves. Within that responsibility for each institution lies the opportunity for collective action; without it, banks face a far greater task in aspiring to raise standards beyond the minima set by regulation.

The Proposed Banking Standards Review Council

A recent example of collective action in the UK can be found in the proposals for a Banking Standards Review Council (BSRC) that were published in May 2014.6 These also owe their origin in part to the PCBS. Substantial evidence was taken during the commission’s hearings on the role of banking as an identifiable profession, the viability of formulating unified standards for bankers and the efficacy of establishing a professional body to set them. Though wary of the substantial risks of duplicating or substituting the responsibilities of the regulators in setting and enforcing standards, the evidence heard led the PCBS to support “preliminary work” to establish a professional body.

In response, Sir Richard Lambert was called upon by the chairmen of the seven largest banking firms7 to develop a plan demonstrating their commitment. The proposals, published in May 2014, establish the objective of the BSRC “to contribute to a continuous improvement in the behaviour and competence of all banks and building societies doing business in the U.K., in relation to both retail and wholesale activities.” In summary, Lambert recommended that the BSRC should do this by:

• Requiring participating firms to commit to a program of continuous improvement under the headings of culture, competence/training and customer outcomes, and to report back on their performance to the public every year.
• Setting standards of good practice by identifying activities where voluntary standards would serve the public interest, and – through working with practitioners and relevant stakeholder groups – coming up with agree upon procedures.
• Publishing an annual report setting out where progress is being made both by the sector and by individual banks and building societies, and where more needs to be done.
• Holding a yearly meeting with non-executive directors or, in their absence, risk or reputation committee chairs of the larger banks and building societies to discuss the institution’s progress relative to the previous year and to its peers.
• Working with the industry and its stakeholders to develop a single principles-based code of practice in alignment with the regulators’ own high-level principles.
• Identifying and encouraging good practice in learning, development and leadership, with a particular focus on behavior and ethics rather than on technical competencies.
• Helping the banks to meet the obligations being placed on them by new legislation by acting as a clearing house for good practices.
• Working with the professional bodies already active in the banking industry to increase the value placed on professional qualifications and reporting annually on progress.

Recognizing that its credibility lies in demonstrating its independence from its member banks, the BSRC has established a small independent panel (chaired by the Governor of the Bank of England) to appoint the BSRC’s chairman and to ratify the new chair’s appointment of the CEO. The BRSC’s governing council will comprise a minority of bankers together with members representing a range of stakeholders.

The BSRC’s proposals are ambitious and establishing its credibility will necessarily take time and require widespread and continuing commitment by industry. They do, however, offer a valuable opportunity for banks to coalesce collectively around voluntary standards that operate above the minimum regulatory levels expected by the regulators. Taking this initiative should provide more freedom to the industry in shaping what these higher standards of conduct and competence should look like.

Culture within banks is influenced by many factors and it is therefore not surprising that responses to address weaknesses in culture should take many forms. Robust supervisory tools, clear accountability within senior management, the proper alignment of risk and reward and the fostering of industry standards are all outcomes that, once in place, will drive up standards and promote positive cultural change within banking. The recent developments described above should help deliver that. ■