CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 706-ii

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

(SUB-COMMITTEE D)

PANEL ON CORPORATE GOVERNANCE: BELOW BOARD LEVEL

WEDNESDAY 14 NOVEMBER 2012

DR ANDREW HILTON and ROGER MARSHALL

JORIS LUYENDIJK

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards

Sub-Committee D-Panel on Corporate Governance: Below Board Level

on Wednesday 14 November 2012

Members present:

Mark Garnier (Chair)

Baroness Kramer

Examination of Witnesses

Witnesses: Dr Andrew Hilton, Director, Centre for the Study of Financial Innovation, and Roger Marshall, Chair, Institute of Internal Audit Committee on Internal Audit Guidance for Financial Services, gave evidence.

Q20 Chair: Good morning, and thank you very much indeed for coming along to this session of the Parliamentary Commission on Banking Standards, Panel D, which is looking specifically at the importance of bottom-up corporate governance. You have been asked to come along and help us with our inquiry.

Andrew Hilton, in your view, what went wrong with risk management in banking throughout the crisis? Do you think that it was the failure of regulation, regulators, banks or auditors?

Dr Hilton: That is an awfully big question, but the answer to it probably is that we got too cocky. There was a feeling that we understood risk; that was an illusion, but it was an illusion created by the introduction into the industry of an awful lot of people with a rather different skillset. We were recruiting people out of maths departments and physics departments-highly quantitative backgrounds-and introducing them to the financial services sector. They fell on the data like a pack of dogs on a dead cow and gorged themselves on it, and they thought that they understood risk. They applied procedures and techniques that were appropriate in the physical sciences to finance and accounting issues, and started to break up risk. They figured, "We understand market risk. Prices go up and down, and we can model that."

We introduced things like VAR-value at risk modelling. We understood credit risk because, after all, we had been doing that for a long time. Then there was a kind of residual risk that we called operational risk. It was rather like an onion: you would peel one slice off and think that you understood it. You built databases and you started to understand how that kind of risk worked.

I remember talking to a friend of mine who is now a very senior regulator in the United States. He had a congratulatory first in maths at Cambridge earlier in his career, and he was explaining to me how there were developments and statistics that enabled one to make comfortable decisions about risk on the basis of much less evidence than in the past. It was hubris. A lot of these models that we thought were robust turned out not to be robust. They turned out to be based on very simplistic notions of risk distributions and they tended to be susceptible to exogenous shocks-somebody riding in from the far right of your picture with a charge of cavalry, and the result is that everyone is dead on the battlefield and our risk models no longer prevail. It was largely hubris.

Q21 Chair: Do you think that those people who were employed to assess risk were up to the job?

Dr Hilton: They were certainly very, very clever.

Q22 Chair: That is not the same thing, is it?

Dr Hilton: No. They looked at risk in a quantitative way and they certainly bowled over people like myself, who did not have a strongly quantitative background. We could not stand up and argue the toss: we could not talk about fat tails or about whether this kind or that kind of distribution is right. They effectively steamrolled the qualitative people in the organisations. The general feeling was that there was a widening gap between the top levels of management in financial firms and the people at the bottom, who were actually doing these things.

One thing that is worth pointing out is that this was not a new phenomenon: it had been going on for a while. I am sure that you are aware of the option pricing model-the Black-Scholes model. The people who developed that model for the financial field got a Nobel prize for doing it, but if you are a physics graduate student, you know that it is exactly the reverse of a heat diffusion model, and the heat diffusion model is a thing you learn about at MA level. So in physics you get an MA, and in finance you get a Nobel prize, for doing something that looks pretty clever. When these guys from a physics background came into the financial sector, they said, "Wow! We understand this so much better than you do. We can all get Nobel prizes."

Q23 Chair: Of course, I can never remember which one it was, but either Mr Black or Mr Scholes blew up Long Term Capital Management and something else. That was a good use of the Nobel prize.

Roger Marshall, what are your initial thoughts on the state of internal audit in financial services? What areas would your committee be focusing on?

Roger Marshall: Perhaps I should explain briefly why the committee was set up and then link that in with the answer to your question. The internal audit community in the UK probably feels that there is almost a reverse expectation gap. With the external auditors, there is a worry that they have expectations put on them that they say they cannot deliver, and internal audit almost say, "Well, you should be putting more expectations on us than you are," i.e., there is no surprise that internal audit did not deliver during the credit crunch, and perhaps there should be more. That, coupled with the regulators’ demands for particular standards for financial services’ internal audit, has let to the committee being set up.

I have two initial observations out of that. The internal audit departments in major financial institutions are all in slightly different places at the moment-they have almost grown bottom up rather than top down-but when you actually talk to people in internal audit departments, there is a striking similarity in where they would like to go. I can perhaps expand on that a bit later.

Q24 Chair: Do you think the IT systems within organisations are up to the job of helping those internal audit departments analyse what is going on within the institution?

Roger Marshall: You have to divide between retail and investment banking. In the retail space, in some institutions there are quite old, quite complex systems, which would take forever to change, whereas more has been invested in investment banking systems. The question is perhaps more whether internal audit has the expertise to understand those systems, and you are now into how you resource internal audit. Do you try to grow that expertise within internal audit, or do they buy those skills in for particular jobs when they actually need that real specialism? Increasingly, they are moving to buying that skill in because it is a very specialist skill which they do not need very often, but when they do need it, they really need it.

Q25 Chair: We will definitely return to this later in the session. Andrew Hilton, what risks do you think the banks are most worried about today?

Dr Hilton: We run a series of what we called banana skin surveys for banking, insurance and, bizarrely enough, microfinance. Banking Banana Skins 2012, which we published earlier this year, was the 12th in a series that we have been running now for almost-well, 12 years, I guess. I can therefore tell you what people were thinking at the beginning of this year. This is a survey of 712 relatively senior bankers, who can reply anonymously or they can attach their names, and say what they think. It is not wildly good at predicting, I have to say. We give them a checklist of 30 risks, which vary slightly from year to year, and we ask them to rank them according to what they think is most likely to trip their institution up.

Sometimes I think the best predictor is to turn the list entirely on its head and to look at the ones that are least considered risky, but this year the top one was macro-economic risk-in other words we were at the beginning of this year, and we are now, concerned primarily about whether there will be a double-dip recession. We are worried about the eurozone crisis; we are worried about the European economy in particular tanking. The second is credit risk-it always is high up there. To paraphrase an old American advertisement, we lose money the old-fashioned way: we lend it.

The third is interesting. The third, which has risen quite sharply, is liquidity risk. This is something that was not considered a risk before the financial crisis. It was largely assumed, in all the models that I was talking about, that liquidity would be available under any circumstances. You could always offload the rubbish that you had to somebody-a greater fool will buy it.

The fourth risk was capital availability. The banks are under tremendous pressure, I think perhaps wrongly, to increase their capital. The regulators feel that capital is the solution to all problems. Capital availability and the price of capital is a big issue. Political interference-well, yes, they deserve it, I guess-was the fifth. Regulation was the sixth: it has actually fallen, as banks finally begin to understand that the regulator is a fact of life, but there has been a feeling in recent years that over-regulation is itself a threat and that over-regulation is killing the goose that laid the golden eggs for the City.

The one that comes bottom-30th-in our list is payment systems. I and many other people think that that is also one of the major risks. Because of the restructuring of the payment and settlement systems-the post-trade architecture-in Europe, so that more and more contracts go through central clearing and central exchanges, we are concentrating risk in a very few nodes. We will know a lot more about the next crisis, but when it comes it may be a lot bigger.

Q26 Chair: There is one interesting area which you have not spoken about but which is what I am particularly looking at in the context of this hearing: where do conduct, operational and reputational risks feature in that list of 30? They are certainly not in the top six, are they?

Dr Hilton: Right, running down after regulation, we have profitability, derivatives and then corporate governance, which rose from 12 to nine and includes many of those issues. I have to confess that reputation risk is not perceived to be itself a separate risk in our study. We do have rogue trader, which obviously greatly affects reputation risk, and we have criminality, but they are very low on the risk matrix.

Q27 Chair: That’s quite interesting. How low are they?

Dr Hilton: Rogue trader has fallen from 20 to 23. Criminality has gone up from 27 to 24. Fraud has fallen from 15 to 27.

Q28 Chair: Presumably that is fraud against them, as opposed to them committing fraud?

Dr Hilton: Fraud against the institution, yes. Let’s be blunt: sticks and stones may break my bones but names will never me hurt me. Take a bank-I will say this because it is not a sponsor of CSFI-such as Goldman Sachs. It has had terribly bad press over the last 10 years. Is there any evidence whatsoever that that has affected their reputation when it comes to putting their imprimatur on a deal? You still go, out of preference, to Goldman Sachs, and you know that no one is going to criticise you for it. They are the smart guys on the block.

Q29 Chair: Does that not strike you as slightly worrying-that rogue trading, criminality and fraud are in the 20s?

Dr Hilton: Yes.

Q30 Chair: They are not looking at themselves, are they?

Dr Hilton: No. This was, I think, before the Adoboli scandal. Every couple of years, you find that somebody has been beavering away on your trading desk and stuffing the tickets into a drawer. It is very interesting that many of these cases have been people who had prior experience in the middle office, so they actually understood the systems of the bank as a whole and they were able to work around them. That has certainly been true in at least two or three of the recent scandals. I think that management get complacent and very quickly forget. At any time, I would argue, someone in London is defrauding some institution. Whether he or she gets caught-

Q31 Chair: This is a rogue trader internally?

Dr Hilton: A rogue trader, yes. Whether he or she gets caught is a different matter. I would love to know more, presumably from the FSA, and it would be qualitative rather than quantitative data, about its feelings about the number of frauds that, shall we say, do not get caught, but get corrected. Perhaps some institutions connive at covering up, just because there is a perception of reputational damage.

Q32 Chair: How do you think banks manage risks that are difficult to quantify-for example, conduct and operational risks-or do they not?

Dr Hilton: I think it is very difficult. What makes banking special is the enormous amount of money that is sloshing through the system. One of the few genuine insights I feel I have ever had in my professional career is that a very, very small percentage of a very, very large number is still a very large number. There is a feeling, "Who will miss 0.01% of a deal?" but if that deal is quite substantial, you can live for a long time on it.

What differentiates banking from manufacturing or the service sector is the quantity of money. Banking deals in money rather like a cement plant deals in cement; they shovel it through the system. If a little bit falls off the side of the truck, who is going to notice? That is terribly dangerous and terribly difficult for management to keep control of. Just as there is pilferage in the retail industry, there is pilferage in the banking industry, but pilferage in the banking industry can mean £1 million or £2 million down the drain. It is very hard to control.

Q33 Chair: Do they get enough information coming back to them to work out what is going on?

Dr Hilton: There are issues of privacy. My little think-tank had a round table yesterday on whistleblowing. Whistleblowing is very interesting-it is a kind of parallel system of internal audit. If people are aware of problems that are going on in institutions but are not comfortable with the internal procedures or their line management, whistleblowing provides an alternative. The question is: how do you protect the whistleblower? How do you sort out the genuine whistleblower from the malicious whistleblower? How do you sort out the misunderstood whistleblower from the person who really knows what is going on and understands that fraud is being corrected? We need to spend quite a lot more time on whistleblowing. Before the round table, I was a bit sceptical-I thought that whistleblowing was probably done by a lot of people with grudges. It is not: quite clearly, the overwhelming number of episodes of whistleblowing are quite legitimate. I think there has to be a better procedure for handling, collating and putting back to the management the results of the whistleblowing. There are things we can do, but all the time, management has to be on the ball. There is too much money going through the system.

Q34 Chair: On the one hand, you have the quantitative side of things, where you use your internal computer systems to work out exactly what is going on-I question whether those are up to scratch-but there is also the qualitative side of risk management. Do you think that that will ultimately come down to whistleblowers, or do you think there should be a more formal way of doing this qualitative, reputational side?

Dr Hilton: For a long time, we, or the industry in general, thought that what is qualitative can eventually become quantitative-in other words, we can put numbers on some of the more qualitative aspects of operational risk. For instance, until 2009, there were huge databases being built up on operational risk events, and different consulting companies had different proprietary databases. The assumption was that slowly we would be able to put numbers on reputational risk; numbers on many of the things that we felt were exogenous. There was a tendency to think in the end that we will reduce it to numbers, and when we have reduced it to numbers, we can understand it, predict it and price it. There is a great deal more humility in the market at the present time. How long that will last, I don’t know.

Certainly, at the moment, those of us who are not real good at numbers feel that our day has come. There is much greater emphasis on behavioural aspects of trading, for instance. There is really interesting academic work going on on biases and how traders think as they operate. This is inherently qualitative. At some stage, I imagine, hubris will take over again-we will recruit a whole bunch of engineering and physics PhDs and we will go back down the route of trying to quantify that. It will probably be a mistake when it happens.

Q35 Chair: You made a very good point earlier about your rankings of this type of stuff. Reputational risk does not even feature as its own section within your rankings, and even when you have something that is related to reputational risk, it is still in the bottom 20s. There is no shadow of a doubt that banks are currently suffering the worst reputation that they have ever had-I am guessing; I am not a great historian, but I assume that is the case-yet they do not seem to be focusing on it.

Dr Hilton: Maybe in the 2013 banana skins survey we will focus much more heavily on reputational risk. There are aspects in this, as I say, that relate to reputational risk, but we have not looked at reputational risk qua reputational risk. Maybe we should.

Q36 Chair: The reason I am pressing on this particular one is that a lot of what we have talked about is culture of a bank, and of course you cannot necessarily quantify culture. The argument then goes: what can you use in order to try to drive a better culture? If you were talking about the reputation of the institution you were working for, you could say, "This is the most important thing. The reputation of our institution is the most important thing and that should drive our culture." Yet everything you have said to us so far this morning suggests that there is no interest whatsoever in reputational risk, because it is exactly as you said: Goldman Sachs may have a lot of questions over its tax affairs and various other trades it has done, yet at the end of the day people will still go to Goldman Sachs. Does reputation matter?

Dr Hilton: The problem is that reputational is multidimensional. Goldman Sachs’s reputation is as a ruthless, money-driven, enormously competent, extremely effective institution that does not give a damn about anybody other than itself and perhaps its client. If you are the client, that is not a bad reputation. That is a reputation that means they are going to fight for you-they will also fight for their share of the pie, but they will fight for you as well. Do you want to go to an institution that has a reputation, for instance, that says, "We’re really good. We give lots of money to the CSFI think-tank. We give it to the Church of England and lots of other people. We are really soft and fuzzy."? That is not necessarily the bank you want fighting your corner if you find yourself in a tough deal. If you are in an M and A deal, it scares your opponent more if you have Goldman Sachs on your side than if you have the Co-op Bank on your bank.

Q37 Chair: When these institutions are recruiting staff, either in internal audit or just on the front line, do you think that they are doing enough to assess the culture of those individuals?

Dr Hilton: I think there is certainly a problem. When I did my MBA a thousand years ago at Wharton, the top companies you went to work for were people like Procter and Gamble. For the past 15 or 20 years, though, the top places you went to work for were Goldman Sachs, Morgan Stanley-places where you could make a buck yourself and you could get very rich by the time you were 35. Now, that has changed again. This is an issue with reputation. I think the top students out of the business schools do not necessarily want to go into investment banking quite as much as they used to before, but it is still a place to go if you want to make a fortune by the time you are 35. That is always going to attract a particular kind of person.

Q38 Baroness Kramer: Andrew, could we just talk a bit more about the banana skins index? I was quite interested about your discussion of clearing houses, because we had Andy Haldane in front of us and he made a very brief comment about the new clearing house regime. I think that he described it as "too big to fail squared". That was interesting. Looking at the graph of the risks that are identified-the leading risks-I almost began to wonder if this is a lagging indicator, because if you look at something like 2006, too much regulation is the problem. The graph is very much backward-looking, isn’t it? I think that your discussion with Mark Garnier suggested that it tends not to look internally very much either.

How do we deal with this issue-that banks seem to be so unaware of the risk parameters that they are likely to be facing today and tomorrow, and constantly seem to take a backward-looking, somebody else’s problem-type approach? Are there any mechanisms for dealing with that?

Dr Hilton: I don’t think there are any mechanisms, but I think you have absolutely put it in a nutshell. I am sometimes driven to distraction by our banking banana skins survey for precisely that reason. I look back on the previous nine years that I have got in front of me and I know that in any one of those years it was indeed backward-looking. These are very senior people. I should add that my colleague, David Lascelles, who is primarily responsible for putting this together, is immensely well connected in the upper echelons of the UK financial services sector and when it says, "A senior banker says…", that is a really senior banker.

Yes, there is a tendency to fight the last war. How do you get them to fight the next war? Well, one of the problems is that the future is inherently unknowable. The only other contribution that I ever make to financial services is to say that if there are 10 variables that affect the future, there are factorial 10 futures, which is just over 1 million, so it’s a mug’s game to try and guess. All you can really do is produce an institution that is resilient to a much wider range of risk, because you cannot spot what risks are going to come. Of course, that kind of resilience has redundancy built into it and redundancy means costs that, if there is a downturn, you are going to try to prune away, so there is always a temptation to kind of cut out the redundancy, and if you are cutting out the redundancy in risk management, that is a real problem going forward.

Q39 Baroness Kramer: A lot of people say that the shareholders should be there, riding the company to make sure that it is focusing on the risk, because it impacts the shareholder in the long run. Do you see any signs of shareholders becoming much more aware and willing to take on the costs of the redundancy that you just described?

Dr Hilton: There have been shareholder associations since the beginning of time trying to get companies to operate in the longer term, but we remain driven by quarterly earnings reports and short-term targets. People who want to reform the financial services sector now look either to tighter regulation or to structural change. I am in the structural change category: I am inclined to think that you cannot eliminate risk from the system; it is endemic to the financial services sector; therefore let us set up a financial services sector that is less susceptible to and less damaged by the inevitable tsunami of problems that is going to overwhelm individual institutions. If we could have a financial services sector where no institution was too big to fail and where it did not matter whether one institution or several institutions failed because the system as a whole was resilient, I would be a lot more comfortable. That is the position endorsed by Professor John Kay and a number of other academics, for instance Paul Volcker in the US.

Q40 Baroness Kramer: Looking internally, we know that banks set up a sort of risk appetite-essentially at board level I would assume-to try to define the risk profile of their company. From your view, how effective is that kind of approach? Is it something that just satisfies the board, or is it possible to implement it down through the system?

Dr Hilton: I am deeply sceptical about measuring ex ante an institution’s risk appetite. "Oh yes, I would like more risk," people say, but in fact they want more risk until the risk turns round and bites them, and then they say, "No, no, no, I didn’t." The quantification of an institution’s risk appetite, or indeed an individual’s risk appetite when it comes to personal financial planning, is a completely bogus exercise, I think. We all want higher returns, and we understand that higher returns may come with higher risk, but when the higher risk actually occurs, we say, "No, no, no, we didn’t mean that," and we look around for our lawyer, Not, I think, a good system.

Q41 Baroness Kramer: It is quite interesting because, in a sense, it almost looks as though the quantjocks are now less designing product and starting to work on risk decision making and risk profiles. We were looking at work on Nesta and the far more quantifiable risk profile that banks seem to be turning to as a mechanism for managing risk going forward. In effect, are you saying that this could be as false as the mechanisms that we have had in the past, which were essentially designed to disperse risk?

Dr Hilton: Maybe what is happening is that the quants are, as it were, coming in through the back door. Before the crisis, quants were operating at an institutional level. We were all up to our ears in VAR; we all assumed that risks were normally distributed; we did not really know much about fat tails; but that was at the institution level. At the level of enterprise risk management, which was the buzzword of the time, we thought we understood risk as a commodity; we effectively priced it and, wherever we could, we traded it. Now, it may well be that the quants are coming in and saying, "We understand risk at the individual level, rather than at the institutional level." I feel Roger is indicating that he knows more about that than I do.

Q42 Baroness Kramer: And I would be very interested to hear Roger’s view.

Roger Marshall: I suppose I might have a slightly different position. My recent experience has been much more in insurance than in banking, but it has the same sort of thought processes. Banks, for a long time, have looked at quantifying their risk appetite-asking, "How much credit risk do we want to take? How much market risk?" They have not necessarily been very good at measuring what they have, particularly as financial instruments have changed. In the old days, when you just had quite simple loans, it was quite easy to say, "We’re not giving a loan of more than £100 million," or, "We’re not going to have more than this exposure to the building industry." That was quite simple, and it has been a staple of banking. The problem with quite complicated financial instruments is that not everybody fully understood, for example, their exposure to sub-prime, because it would pop up in a number of different places, and they did not really have the management information to add it all up and say, "My God, we’ve got all this exposure." I know one or two banks got into quite a lot of difficulties as a result.

I would not be quite as cynical about risk appetite. The board setting risk appetite-I am on the board of two insurance companies-and that being driven down deep into the organisation so that people get a bit of that, is quite a powerful tool. Then, if they go over that little bit, and provided you have the right measurement processes, you can go back to them and say, "Why did you go over that risk appetite we set you?" That is quite an effective tool. Of course, that is only for the quantifiable risk appetite. It might be quite a good way of measuring your credit appetite and monitoring against it, but it does not tell you about those less quantifiable risks-the sort of things that are just over the horizon. A lot of risk management is focused very much on the now and where we are against our risk appetite, and not on what is out there in the future-the black swans or whatever. The board risk committee can be an important vehicle for having those less structured discussions about what is out there that might bite us next year, not about where we are at the moment.

Q43 Baroness Kramer: Is there a muddle coming between risk appetite and the business strategy, which presumably does have that forward-looking part to it?

Roger Marshall: Yes, I think the business strategy defines the current risk appetite, and it probably defines where the company thinks it is going. This is more about what the possible, perhaps quite small probability, risks are which can really derail the strategy out in the future. Going back to your banana skin thing, where people seem to be focusing on the now, I understand that: these people are living their day jobs, and that is all about fighting today’s problems-but you have to have some method of looking forward and saying "What could go wrong in a couple of years’ time?" and that is quite difficult. Stress testing is quite important, as well. Stress testing to destruction tells you what would bankrupt the organisation. That is interesting, because it tells you the sort of thing that you should perhaps be focusing on more.

Q44 Baroness Kramer: The unknown unknowns, as it were.

Roger Marshall: Yes.

Q45 Baroness Kramer: Can I ask you about the effectiveness of the three lines of defence model, which I understand is the approach used now by much of the banking system? Looking through it as an outsider, it looks as though all the content is at the first line of defence, and the second and third lines are all very procedure-focused. Is that a correct analysis, and does it indicate some serious flaws in the system?

Roger Marshall: I think it is variable. The first line, obviously, is the people responsible for the controls. Many organisations also have processes to test that those controls are being adhered to-particularly, for example, the SoX (Sarbanes Oxley) type of organisation, which have to certify that they have controls. The second and first line sometimes blur a bit. Sometimes the second line gets involved in validating first-line decisions.

When you get to the third line, you are looking at internal audit. It is more a question of what the potential is for internal audit to be very effective. In some cases, at the moment, internal audit is quite procedural, but I think they have the ability to do a lot more than that, which is what my committee is looking at at the moment.

Q46 Baroness Kramer: I would like to explore that last point in a moment, but I want to ask you about the relationship between the first and second lines. You just talked about a blurring of that line, which sounds like a description that we get of quite a number of banking institutions. Is there a real risk that the first line basically reckons that something is the responsibility of the second line, so that in effect no one is looking clearly at whatever transaction they are doing and saying, "Actually, there is a serious potential risk here?" Instead, they are saying, "I’ve got clearance on that, so that’s fine. I won’t look at that particular issue." Do we have that kind of confusion?

Roger Marshall: That is the risk I was talking about. In a well run organisation, the first line has to say, "We are responsible for all our decisions." The second line, particularly risk management, are there to make sure that the first line are keeping to their limits, basically. The blurring comes when the first line wants to do something which is outside their normal limits and the second line gets involved in agreeing that; then, suddenly, the second line are part of the decision-making process, not outside it. That is why it is particularly important that internal audit looks at those sorts of thing, completely independently.

Q47 Baroness Kramer: Can I ask you about the culture that that can lead to? With the LIBOR case, we had numerous discussions of traders just shouting across the floor to someone, "Anyone need the rate set at this particular level?" It was a perfectly open environment in which behaviour that you think would have been questioned was taking place, and everybody at every upper level was acting as though they could not possibly have a clue that any of it was going on. Is there a problem with the first line getting stuck at very low responsibility levels and not feeding up through the hierarchy within its own structure?

Roger Marshall: I am not an expert in the LIBOR case. I am just an interested reader, rather than having gone into it. Obviously, the first thing there is the culture, which is a top-down thing; the second is compliance. The culture comes up with detailed rules about what is allowed and what is not, and compliance are there to enforce that. Compliance are also a second line of defence, if you like. They should be making sure, by doing audits, that the compliance rules are being complied with. Obviously, the first line have to stay within the rules set for them, and if they go outside that, clearly that is a disciplinary issue, but it is up to the people on top, first of all, to set the culture, and then to make sure the rules are being complied with.

48 Baroness Kramer: Before I move on-I want to see whether Andrew has some thoughts on this-may I ask one question? The other scandal that leaps to mind is the PPI one. We had some testimony yesterday that someone who resigned from one of the organisations thought that PPI had spun out of control. They thought that it was inappropriate to continue to sell it, but senior management said, "Yes, but we can’t be the first to break ranks in our highly competitive industry." Have the three lines failed in their operation in a situation like that? Where does one catch that kind of problem?

Roger Marshall: I think the third line could be argued to have failed. If you look at PPI, there is clearly a systemic failure going all the way down. Did the board understand what they were selling and, even if they were comfortable with that, what the conduct risks were? That is a board-level issue. When you get down to the second line, risk management should clearly have been saying, "These are the risks," and they should have been shouting them out to the board. I think that internal audit has a role, because if it is not working-if risk management is not saying that, or is not being listened to-internal audit also has a role in saying, "Big risks are being run here, and you need to be aware of that if you continue." It seems to me that there are issues all over the organisation that could be improved.

Q49 Baroness Kramer: Your thoughts, Dr Hilton?

Dr Hilton: I would like to say one thing on the three lines of defence. I worry slightly that-this is an example of Goodhart’s law-as soon as you put a name to something and you identify it as a clear procedure, it becomes less useful, because it becomes, essentially, a box-ticking exercise. You ask, "Have we done what ‘three lines of defence’ says?", and so long as you have ticked the boxes, you have met your obligations, whether you are in the first, second or third line. I worry about it, and I worry about the ubiquity of the term.

In doing a little bit of background reading for this, one saw pieces by at least two of the major consultancies that were based around "three lines of defence", as though it were a proprietary idea that they had come up with. It reminded me all too much of enterprise risk management from before the crisis. I remember going to a presentation by one of the major consultancies where "enterprise risk management" had a trade mark by it-it was being peddled as a solution from that particular company. "Three lines of defence" is being peddled, I am afraid, in rather the same way-as a solution, when it is really just a box-ticking exercise. In a way, you should forget it. You have got to embed this in the culture of the organisation, whether it is three lines of defence, four lines, or however many-it does not matter.

Q50 Baroness Kramer: So it can be gamed, as always?

Dr Hilton: It becomes gameable, yes.

Q51 Baroness Kramer: Roger, on internal audit, again, we have heard comments from various people involved in internal audit saying, "Yes, but they never come and tell us what is happening." In a sense, they felt that they were the outsiders, and perhaps they did not have the testosterone of the people out on the front line doing the deals and whatever else. Do we have the expertise and the resource for internal audit? Is there, if you like, the leadership attitude to internal audit that gives them the status that they need? And do you have any other thoughts on what might make internal audit more effective?

Roger Marshall: It varies between organisations. If you start at the top and ask whether internal auditors have enough respect, and whether they are always situated at the right level in an organisation, the answer is clearly no. There are some organisations where internal audit is at the group executive level-where they are either on the executive or attend or the meetings, at least. They are accorded a lot of respect by those organisations. In other organisations, they are not; they do not attend the group executive meetings-they might be called in occasionally to discuss their findings, but they are not accorded that level of respect.

The issue comes from the history of the internal organisations. Where they grew from, perhaps, quite small beginnings, external auditors tend to regard them as second-class citizens to some extent and, of course, a lot of audit committee chairs-including me-are former external auditors. There are a number of things that have to be changed to make sure that internal auditors have the right amount of kudos in the organisation and that they are at the right level. It is easy to impose that, but you also have to have the right people acting in those roles, so you need the right people as leaders of internal audit and the right people working for them. It is not just that we wave a magic wand and it is all solved; you also have to have the right people in place.

Q52 Baroness Kramer: I know that Mark Garnier will follow up with more questions around internal audits. I really appreciate that. Can I ask one last question, Dr Hilton, on whistleblowing? There was a meeting you had earlier that week. As you said, it is the informal mechanism for internal audit, in a way. Were there any suggestions that you could share with us on how we might create that more secure environment for whistleblowing to take place? I know in the United States there is a very different regime for whistleblowers, which recognises that they might never work again-that kind of thing. That is not something that we do here.

Dr Hilton: We do actually do that here. If it goes to court and a claim for compensation is made, that is not capped-it is rather like discrimination cases-and it takes into account the possibility that the individual may not work again, but there is not, in the UK, the same system that there is in the US, which is a bounty system. In the US, a whistleblower can get anywhere between 15% and 30% of the penalties assessed as a result of his or her whistleblowing. I think the bounty route is probably not the right route to go down, but you certainly want to provide better protection for people.

I was very taken by the discussion we had. There were two approaches to whistleblowing. One was through a charity, Public Concern at Work, which provides a secure phone line and legal protection for a whistleblower who wants to blow the whistle and does not feel that the internal procedures within the corporation are adequate. The other one was through a commercial operation, which outsources the whistleblowing function, but it is an outsourcing function that works on behalf of the company. I am not sure which of these models will prevail in the end. Either could, but I do feel that, at the moment, if I was a whistleblower, I might want to talk to somebody who had legal protection behind them and would be able to give me legal advice, rather than simply record what I was saying and guarantee that it would go to the right person within the company.

Whistleblowing is something that we need to work on. We need to acknowledge that whistleblowing is many things. At one end, it is a grudge; somewhere in the middle, it is a misunderstanding; but at this end of the scale, it can actually operate rather like an internal audit function and can be genuinely, extraordinarily useful to the companies, because it enables the top management to circumvent all sorts of problems in the middle management and get down to what is really happening at the rock face. I am more encouraged that here is, as it were, a growth industry, which could genuinely help make companies-particularly ones in the financial services sector-run better and increase the flow of relevant information to the top management.

Q53 Chair: Roger Marshall, I would like to dig down into the whole issue of the function of internal audit. You started to raise quite a number of points, and I would be grateful if you could develop those. To start off with, can you define the role and reach of an internal audit function, so that we get a broad picture of what it is supposed to be doing?

Roger Marshall: I can define it as it is at the moment, and then perhaps say where we would like it to move to. At the moment, it varies between internal audit departments, even within banks. It is largely focused on giving assurance to the board and to senior management that controls over processes are working. Where we would like to move it to, I think, is that we would like it also to be actively looking to make sure that all risks are reported to the right level, so if they come across a risk, they make sure that, if necessary, the board are aware of it, but certainly the right level of management are aware of that risk, and also whether it is actually being controlled properly or not.

Q54 Chair: Can you give us an idea of what it actually looks at? Is it just verifying systems and controls, or is it looking far wider?

Roger Marshall: Internal audit should-and, by and large does, in UK banking-have an unrestricted remit. It should look at governance, it should look at culture, it should look at the way that the risk management departments manage risk, and it should look at compliance and how they are doing things. It should actually have a very wide remit. Some internal audits, more than others, do cover that wide area. Some are more narrowly focused on controls within systems.

Q55 Chair: You said you were an external auditor.

Roger Marshall: At one stage.

Chair: If you were to come across an internal audit department that had a relatively limited remit, would that raise concerns for you, as an external auditor? As an external auditor, are you auditing the internal audit?

Roger Marshall: We do, to the extent that-well, we did, because I am not an external auditor any more-we relied on the work. We would review their work ourselves, on a test basis. For example, if they were going to branches of a bank, we would not review the work that they did on all the branches, but we would look at some branches to make sure that we thought that the work was reasonable and that we agreed with the conclusions.

Q56 Chair: But an external auditor would have a broad-reaching view of how an organisation’s internal audit function compares with those of others; you get an industry thing.

Roger Marshall: Yes.

Q57 Chair: So you would be able to comment or advise a bank on whether you think their internal audit is just not up to the job.

Roger Marshall: Yes, although of course we would be much more worried about what was being done on those controls, because we would be having our own view on culture, governance and that sort of thing, so although it would be an interesting discussion, our main concern would be to make sure that there was enough work being done on the detailed controls of an organisation.

Q58 Chair: Do you feel that internal audit departments are properly resourced, in terms of their ability to go and recruit the best staff they can, with cash, and then being supported properly?

Roger Marshall: That goes back to the status of internal audit within an organisation, and I think it varies with the organisation. People always talk about GE-General Electric-for example. The GE internal audit department was a very high-status organisation, and people felt it was a privilege, if you like, to be invited to go in there. They would go in there for three years, and different divisions within GE would then clamour for them when they came out, so it was an instant promotion to go into internal audit. In some other internal audit departments, you go in there, you stay in there, there is not a great desire for people from the various divisions to recruit out of there. You see the varying status levels you can have. One of the things that we-this committee I am on-would like to do is elevate the position of internal audit, and think of ways of making it more of a high-status organisation that people want to go into. There are differences; I am not damning all banks, but there are some banks with perhaps lower-status internal audit departments than others.

Q59 Chair: How do you raise that in the other banks? If you take GE as a model that you want everyone to aspire to, what would you be doing to make those banks achieve that?

Roger Marshall: As I said, the first thing to do is ensure that they have the right status-that the head of internal audit is at group executive committee level. I think that increasingly, the model will perhaps be to have less internal resources and more bought-in resources, because internal audit in a bank has a very wide remit. In a manufacturing company, you do not expect an internal audit to be looking to the same extent at the research programme to ensure that it is delivering quality, or the manufacturing process, but when you talk about money, almost everything is within internal audit’s ambit, and there are some very specialist risks in there, for which I think it is sometimes easier to get an external person in-perhaps from within the bank, perhaps from a consultant-because it is a really specialist resource that you need to bring in to look at that particular thing. Even if you wanted to have the resource internally, you could not actually keep them all year, and there would be no promotion path for them, because it would be a one-man specialist department. Also, there would be no easy way of monitoring quality, because no one else understands that particular skill.

Q60 Chair: Does internal audit have more of an over-the-shoulder, rear-view looking function, or do you think that internal audit is doing enough to assess the future risks?

Roger Marshall: For every unit that internal audit goes into, it should be trying to understand, "What are the risks in this unit? Do we think that those risks are being properly reported up the chain? Are those risks being properly controlled?", and not just, "What controls are there, and are they working properly?", so I think the answer to your question is that you cannot give a black and white answer. A good internal audit department should be focusing on all those risks, and that hopefully will stop future problems happening.

Q61 Chair: I should know the answer, but is there a professional standards body for internal audit?

Roger Marshall: Yes, it is a global organisation, the Institute of Internal Auditors, and there is a UK and Ireland institute that conducts exams, for example, so it is a professional body.

One issue has been raised by the FSA. I have brought with me a copy of the internal auditing standards. They are very high-level, and they are not focused on financial institutions; they are more about ethics, independence and reporting lines. It is impossible to disagree with them, but they are at a very high level. One of the things that the FSA has asked-this is really why my committee came into being-is whether we should be having more focused standards, perhaps at a fairly high level, for financial institutions’ internal audit. The FSA would like that, not only because it thinks it is a good idea, but because it finds it impossible at the moment to judge a bank’s internal audit department-there are very broad criteria in this thing that are not even specific to financial services-so it is very hard to say whether or not it is complying.

Q62 Chair: On a wider point, do you think that there should be a new professional standards body for bankers? I know that there is one, but there does not seem to be any requirement for people who work at banks to take and pass the exams and become a member of that organisation, rather than merely leaving it to the minimum requirement that the FSA asks for. Do you think that more should be done, in terms of moving towards an internal professional standards body for all bankers?

Roger Marshall: I am not an expert on this. I have mixed feelings. Sometimes, coming in from another industry can actually be quite helpful, because you tend to look at it from a different perspective. I am not sure that I would necessarily want completely to restrict it to people who have these qualifications, because you tend to end up with groupthink. As I say, do not take any notice of what I am saying, because I am not an expert. The groupthink is accentuated by the closed profession, if you like, so I am not sure I would necessarily go there.

Q63 Chair: That is a very helpful comment. Thank you.

The other thing that we are looking at is the evaluation of front-line staff. Clearly, there is a big debate going on about incentivising staff, and the vast majority of that incentive comes as financial incentives, or financial carrots for strong performance. I know a number of the banks are trying to move away from this, and we certainly recognise their efforts to do that. Do you think that there should be a system whereby front-line staff are evaluated? You are looking at their qualitative work, in terms of how good they are at delivering advice and expertise, and at maintaining reputation. Do you think that there is a lot to be said for translating that qualitative assessment into a numeric and quantitative grading, if you like, of staff, in order to help assess them for promotion and reward?

Roger Marshall: Earlier, when we were talking about PPI, I said that it starts with the culture. Clearly, when you enforce culture through the organisation, you enforce it by the reward structure. If you have a culture that says, "We are caring people-we only worry about our customers", but the reward structure does not go that way, people are more likely to listen to the reward structure.

I think what you are talking about is the sort of score-card approach to remuneration, which certainly senior management tend to have, where you are giving people a percentage of their remuneration depending on various different scores, which might include compliance with controls-the rating on risk management-and not just financial performance. I agree with that in principle; as to whether you can push that all the way down to every staff member, that might be quite complicated.

Q64 Chair: Do you not think that it is a worthwhile ambition?

Roger Marshall: I think it is a worthwhile ambition; it is a matter of practicality how far you can push it down. You can certainly push it down to the manager in charge of the individual little group. Whether you can push it all the way down, I do not know; I am not an expert.

Q65 Chair: The other question to ask is, again, a slightly more qualitative one about banking standards as a whole, and the role of internal audits in looking at the standards of an institution. To what extent do internal auditors look at the general standards?

Roger Marshall: Do you mean the general policies?

Chair: Not just the general policies, but their implementation. Do they assess whether they think that the bank is getting it right, in terms of how it is driven down to front-line staff, and how the standards are set at the top?

Roger Marshall: I think that they should be looking at both of those.

Q66 Chair: But are they looking at them?

Roger Marshall: Not necessarily. There is one other issue, which I will come back to. Banks will have compliance staff, who should be doing that in detail. They should be regularly checking compliance with policies. That does not mean to say that they are asking, "Are the policies right?", although perhaps the senior people in compliance will be thinking about that. I think internal audit should have that within their coverage. The amount of work they do will depend, I suppose, on their perception of how well that compliance function is operating. They will not completely reinvent the wheel if they think they are doing a good job, but they should be doing some work in that space.

Q67 Chair: But if they think the compliance department is doing a bad job, in terms of setting the wrong policies, can they-

Roger Marshall: They should be raising that with the audit committee, or whoever the right people are-the risk committee. They should be raising that issue.

Q68 Chair: Do you think there should be a clear mandate for the audit committee to report back to the board on a regular basis on the standards and culture of the bank?

Roger Marshall: That is interesting. Somewhere between the audit committee and the risk committee-I would have to think more about that.

Q69 Chair: Could you do so, and then drop us a note? That would be very helpful.

Roger Marshall: Sure, yes.

Q70 Chair: I have one final question for both of you. Why don’t we start with you, Dr Hilton? What would you recommend to this Panel to improve the standard of risk management and control assurance? Do you think the internal audit should have more teeth?

Dr Hilton: Internal audit is obviously crucially important. I would warn against building up yet another function within the institutions. One of the big problems that we have, in my opinion, in the banking sector in this country is the size of the banks. When you load on new obligations in the internal audit area, even though everything that the internal audit area is responsible for is good, that is yet another cost burden that the banks have to take on. It does two things. First, it increases the cost of bank products to the real economy. Secondly, it discriminates against smaller institutions. These are fixed costs; they can be spread over a larger client base more easily. I know one small bank that outsources its internal audit function. That sounds oxymoronic, but it is not. It is the only way for a small institution actually to have an internal audit function that is useful. In a way, that is potentially a growth industry, but I think one has to be careful not to say "This is good and therefore we should have more of it" to the extent that you actually discriminate against new entrants and smaller players in the industry and, indeed, reinforce the privileged position of the big institutions, which can amortise this cost over a larger client base. I have forgotten the second part of the question; I apologise.

Q71 Chair: Should they have more teeth?

Dr Hilton: No, I do not think they should have more teeth, but they should have better access. It is rather like the whistleblowing function. Internal audit is a way for top management, whatever it is-the risk committee or the audit committee-effectively to circumvent several layers of middle management and find out what is happening on the shop floor. You have a big difference in the skill set of the top and board-level managers-there is a different age structure and skill set; these are people who probably still have difficulty with their mobile phone-and the people down at the very bottom, who are actually taking the decisions that these guys are ultimately responsible for. The internal audit function is a way of circumventing and translating what is going on here into language that the people can understand, rather like, I think, whistleblowing.

Roger Marshall: On the "more teeth" point, I do not think internal audit per se have teeth. The issue is really what happens to the results of their work. Internal audit should be empowered to look into anything, and then, if they have concerns, they have to be robust and deliver them to the board, to the audit committee or to senior management, depending on what the issue is. You then get into the philosophy of what happens if they come up with a problem.

In one organisation that I used to audit, internal audit would go into a division and come up with one of two conclusions. Either it was satisfactory-that was fine-or it was unsatisfactory; then, nobody in that division had a bonus at all that year. That is a lot of teeth; that delivers results. The problem is that a lot of time is then spent arguing about the conclusion, rather than implementing the recommendations. The other thing is that no one actually owns up to internal audit; no one says, "Look, we’ve got this problem. Could you give us your advice?" So you can go all the way from that end, which sounds, on the face of it, a nice place to be, to the other end, where internal audit are almost there to help the organisation to improve itself. Most organisations are somewhere in the middle. Provided that a division owns up to problems and fixes them, it does not get dinged too hard by internal audit coming up with control issues or problems. As I say, it is not up to internal audit to have teeth; it is really what the organisation does with its findings.

Q72 Baroness Kramer: I have one small question, which comes from Andrew’s last set of comments. You described the problem in banks where you have two completely different generations, cultures and skill bases at the bottom and at the top. There is a really wide gulf. In a way, the strength of those who are the most skilled at the bottom is exactly the weakness of those who are the most skilled at the top. Is the internal audit function, in a sense, a communication tool between the two? We tend to think of audit as something that is there to catch mistakes-a policing system-but is there also a role for it as a communication system between those two? Is that part of what you were describing, or am I trying to put too much into the audit role?

Roger Marshall: I think you might be trying to put too much into the audit role. There was another thing that I did not get on to when we were talking about the mission of internal audit: I think internal audit is effectively preventive. If you give it too many roles, it will not necessarily be able to do any of them very well. It is there to minimise risk to the organisation, so its role is not mainly to add value or to improve the organisation or whatever; it is to stop bad things happening, and it does that by telling the board or senior management, "You have an issue here. You are running too big a risk. You do not have controls over it. We don’t like your standards." It is all about preventing problems for, or risk to, the organisation. We should keep it at that, rather than trying to expand it too much.

Chair: Thank you both for coming. I will draw this session to a close. If you have any further thoughts on any of the subjects raised this morning, please feel free to drop us a line, or to get in touch with the Clerks. We will now go into private session for half an hour and meet again for the next witness at 11 o’clock.

Examination of Witness

Witness: Joris Luyendijk, writer and journalist, The Guardian, gave evidence.

Q73 Chair: Thank you, Mr Luyendijk, for coming before us this morning. As I think you probably heard earlier, this is Panel D of the Parliamentary Commission on Banking Standards. We are here today to look specifically at bottom-up governance of organisations. We are very grateful to you for coming before us with your particularly unique and different angle. As an anthropologist who has had exposure to the banking sector, can you describe how we should go about assessing a bank’s culture?

Joris Luyendijk: I suppose the hardest thing with regard to this question is something that I am battling with too, which is that I cannot actually observe the bankers-I have to rely on their reporting-so I would almost say, "Install microphones on banking desks", because there is just such a vast gap between what people say they do, what they think they do, what they will tell you they do, and what actually seems to happen. I would like to preface everything that I say with these two methodological points: I am relying on what people tell me, and I am relying on volunteers. I have a blog, and people can sign up for an interview. I meet them and we anonymise the interview. I send a transcript of the interview to them, and they check it for accuracy, balance and identifiable detail. Then it goes online, and often they come into the comment thread and engage with the readers.

Q74 Chair: It is quite interesting, because to start off with, to a certain extent you have a bit of a self-selecting group of interviewees. Do you think that the blog brings out the less self-selecting part of it? Does it widen it sufficiently to give a good analysis of culture?

Joris Luyendijk: I think it can never be a full analysis, because there is always a self-selection towards people with a grudge or an axe to grind, or some sort of reason to step out of the culture, which is very much organised around silence I am struck by some of the interviews with volunteers, because I always ask them, "Why would you risk your job by talking to someone from The Guardian? We are the enemy!" Many of them are Guardian readers, and I think that they are worried about two things. First, they are worried about the wrong sort of regulation based on a misunderstanding of the sector. Secondly, they feel that they get a raw deal in public opinion. In my experience, almost every profession feels that if others knew more about them, they would realise how valuable they are.

There is this idea of taking ownership of the conversation-of reading two interviews online, both with M and A bankers, and then saying, "Look, I have a completely different experience, and I would like to see that experience on the web." I thought that that was very encouraging, and it really belies the idea that they are all the same, and are all working together-that they know what they are doing, and they are all working against the rest of us. I get e-mails saying, "I like your blog because I finally understand a little bit about what they are doing on the seventh floor."

One of the things that emerges from the blog is how huge, and hugely diverse, the sector is. The idea of one silver bullet that will address all those different activities on all those different levels is something we need to do away with. You may be in structured finance or project finance, on the trading floor or in corporate finance, and those activities are so different.

Q75 Chair: You may not be able to answer my next question, but based on observations that you have made, how would you describe the overall banking culture at the wholesale banks? Presumably that is an extraordinarily open-ended question, depending on which part of the bank you are talking about.

Joris Luyendijk: Yes.

Q76 Chair: Would you like to have a crack at it anyway?

Joris Luyendijk: Yes, of course. We journalists like these generalisations. There are these hugely different activities, but if there is one big divide, it would be between back office, middle office and front office. There is an overriding sense of identity that people have when they are in one of those three places. Some of the anecdotes are just so telling. I spoke to a gay banker who wanted to organise a networking event for gay bankers in his bank. He finally got a lot of people whom he knew and who were out to come to the thing, but then those bankers realised there would be gay bankers from the back office, middle office and front office. The front-office gay bankers said, "No, I’m not going to an event with back-office bankers." That really tells you something about how deep these things go.

I have spoken to quite a few compliance people, and they talked about how they would go for a football match, say, every second Wednesday of the month with the traders. That was interesting in itself, because the traders would be one team and the compliance people would be another team. One day, they were late, so they had to take taxis. The traders claimed it through expenses, which was no problem; the compliance people tried to claim the same taxi fare through expenses, but it was refused. They took it all the way, and it took weeks, because the compliance people took it very seriously: "Why should the traders be allowed to claim it, and not us?" Again, there is that idea of double standards in the treatment of similar costs for front office and middle office, with middle office taking such offence. This was essentially a £10 taxi fare.

Q77 Chair: That is very interesting. One of our later questions is on the class divide, but you have raised it now, and it is good to explore it. What is driving that class divide? I suspect it is due to who is a profit generator and who is perceived not to be a profit generator, but can you expand on that?

Joris Luyendijk: I think it is exactly what you said. Ultimately, it is the strikers versus the defenders. If a defender does really well, in the end it is 0-0, so you are where you began.

Q78 Chair: How does that manifest itself? Do the traders look down on the middle and back-office staff? Do the back-office staff look back up at them resentfully?

Joris Luyendijk: Yes. It is expressed in clothes: back and middle-office people tell me, "I know, even walking through Canary Wharf, whether someone is front office or back office." If your pay is four times as high, you will buy more expensive watches-it is watch communication. If I ever do a PhD, it will be about watches in the financial sector. I know about hedge fund sales managers who have 20 watches, and when they go to a pension fund, they wear a cheaper watch than when they go to a wealthy family, because they want to communicate different things by signalling wealth. So it is pay. Back-office people say they know when a colleague has to call a front-office person, because usually the colleague reaches a number of times for the phone before he picks it up.

Q79 Chair: Do you think this is a very unhealthy situation, from a practical point of view? As you obviously understand, we are trying to resolve the perceived or real problem with banks. Do you think it is a fundamental issue that you have this breakdown in relations between one side and the other?

Joris Luyendijk: Yes, although I am not sure it is a breakdown; it emerges from the very basis on which banking is organised. In football, you always pay the striker more than the goalkeeper, and this is similar. The more compliance you have, the more money the front office people have to make. It is very difficult to put a number on a loss you avert by intervening on a risk, but it is very simple to put a number on a trade you make, so there is this asymmetry. What would happen if you started paying the people in the back and middle office the same as the front office? I do not think it has been tried so far.

Q80 Chair: Here’s a very important question. Do you think that this class divide results in the middle and back office not pushing back hard enough against the front office when they perceive that they are doing something wrong?

Joris Luyendijk: Yes.

Q81 Chair: A sort of oppression of the back office. If a trader wants to do a trade of dubious compliance quality, do you think that the trader will have an arrogance about him that will allow him, in his own judgment, to get on and do the trade, irrespective of what he thinks the back office will tell him, even to the point where he would have a stand-up row with the compliance officer on his floor in order to force the trade through against the compliance officer’s better judgment? Do you think that happens?

Joris Luyendijk: I think it does happen. I am not sure how prevalent it is. We are talking about traders; again, commodity trading, derivatives trading and flow trading are very different sorts of activities. Front office, especially trading, seems to select testosterone-infested alpha males. That is not the kind of temperament you find among back and middle-office people. To survive on the trading floor, you need that. There is very little time, and you are acting on incomplete information in a highly dynamic environment that is deeply time-sensitive, so nice guys finish last on the trading floor. Traders tell me how difficult it is to shut this off when you are switching to another area in your life, be it dealing with the coffee lady who takes so long in getting you your change, your wife, your friends or the back office. There are deep psychological and cultural factors at work.

This is changing now, but there is the glorification of the trader. Even Goldman Sachs is glorified. It is not so much about the nicest guy in the room; it is about the most impressive guy in the room. In the back office, you make maybe a tenth of what a trader makes, nobody knows who you are, and you have to come to the trader. That is another thing: I was speaking to a compliance person yesterday, and he explained that he is a director in the middle office. The managing director never comes to his office; he has to go to the office of the managing director. If the managing director has to go to a front office managing director, he goes to the front. The front never comes to the middle office. Again, there is this sort of spatial hierarchy.

Q82 Chair: Have you done any observations in other industries to compare this with? Is this a very unique type of approach, with this highly testosterone-fuelled alpha male on the dealing desk basically throwing his weight around, or is this pretty predominant?

Joris Luyendijk: I am a journalist, so you know us.

Q83 Chair: How is it at The Guardian?

Joris Luyendijk: I have only been at The Guardian for 18 months. My background is religious anthropology in Egypt in the slums, so that is quite different. I have asked most of my interviewees this question about whether there was a qualitative difference. Most would say that at some point quantity shifts or evolves into quality. The money available seems to allow the banks to treat their staff in a way that in the end produces this culture.

People in the software industry have told me, "We read your blog and it’s very similar: sales-driven; exploiting information asymmetries; crazy hours-those sorts of things." However, ultimately, there was less money to go round there-less money for severance pay that paid for silence, and less money for PR, public affairs, and all these sorts of things that banks now have, because they make these huge margins, thanks to their oligopoly. That also helps to create this atmosphere in the workplace where you treat people very badly, but then pay them really well. I have not come across another industry where that is similar. Then again, I have not been around much.

Q84 Chair: Obviously, they are treating people badly. I am interested in the role of the line managers-the heads of desks and heads of departments. Presumably, in many cases, those line managers started as clerks on the desk and moved up through the ranks as they trained up. Do you think they are reinforcing this culture, or do you think they have a role to play in trying to negate that culture?

Joris Luyendijk: I have spoken mostly to people who are junior, and a handful of managing directors, but mostly to people below that level, if only because it becomes increasingly difficult to hide people’s identity. There are many fewer MDs than vice-presidents. As for the way that people talk about their managing director, or their line manager, I am struck by how diverse it is. They will tell you, "I have had five managers so far. Three were absolutely fantastic. Two were complete psychopaths." Is banking populated by bad people? Most of my interviewees would say, "No, the problem is not that they are all bad. The problem is that the ones who are bad are tolerated and, if they make a lot of money, even glorified."

You are just really out of luck if you have a mildly psychopathic manager, because this person controls your life, especially in the most competitive banks, where they have these regular cullings of the herd. You know that every year, your line manager sits down with human resources and crosses out one name on the team. That is a level of dependency and helplessness that to me seems incredible.

Q85 Chair: This is the theory that the slowest animal in the herd dictates the speed of the herd, so chop off the last one, and the herd will speed up again. Is that what is behind that?

Joris Luyendijk: That is what they say in the brochure. In real life, on the office floor, of course, the slowest animal is a measurable criterion, but in, say, mergers and acquisitions, on the European and Middle East desk, where people are constantly pitching deals over longer periods to a client base, it is quite difficult to identify the slowest animal in the herd. You can identify the most troublesome animal in the herd, and that is often what happens. I am beginning to get a sense of the incentive structure of whistleblowers.

Q86 Chair: We will come to that in a minute; my colleague, Susan Kramer, will elaborate on that, but I just want to stick with this management thing, particularly as you have talked about these people who say, "I had five managers; two were psychopaths and three were okay." What defines an okay manager? Is it somebody who is being nice to them, or somebody who is inspirational, in terms of supporting them in doing their job well? What are they looking for in a manager?

Joris Luyendijk: I think "fair" would be the term. I am constantly looking for analogies, because they help me to explain to my readership, which is completely illiterate as regards finance. If you talk long enough to people, they all seem to be in a sort of a team, and in that team they are trying to harvest information-it is time-sensitive, often-and feed that information either back into financial markets, where clients or traders act on it, or into a longer drawn-out purchase, for example with mergers and acquisitions. The team either wins or loses; when it wins, it takes all; when it loses, there is no deal. It is not like, on the way there, there are moments when you can choose between a moral decision or step and an immoral decision; it is a race, and you win or you don’t win. Within the team, there is a similar race, because everyone knows that within two years, this or that position is going to open up. I think what my interviewees-but there may be a bias there-would always talk about was just fairness.

If you are a flow trader and your client wants you to trade something that you think is just not a good idea, and you end up losing money for the bank, but you did it in order to safeguard your relationship with the client, then you want your manager to notice that; you do not want them simply to look at your P and L and say "Ah, you lost money"; you want them to say, "Ah, you kept our client!" That is where a psychopathic manager could destroy you; "You lost money again?" and if you did not do the deal, "You lost a client again?" I am struck by apparently how free those managers are; if people can have managers of such differing temperaments, then apparently there is a lot of leeway for different personalities to come up through the ranks.

Q87 Chair: I am very interested in this team concept, because certainly in the post "big bang" City, as the newly forming universal banks were trying to grab market share, they were doing it by grabbing teams. There was certainly a case then that if you were part of a team that had moved to another institution, you were not working "for" that institution; you were working "at" that institution, as part of a franchise team that was merely using the brand name. Do you think that culture still predominates in the City now?

Joris Luyendijk: That would be a difficult one to answer. Of course, I would speak to two or three people a week, or maybe four, so it is hard to generalise about an admittedly shrinking City.

Q88 Chair: Even as individuals, do you get the sense that they do not see themselves as part of the greater whole, because they see themselves as franchise holders doing the best they can for themselves or, at the very best, their team?

Joris Luyendijk: For themselves, ultimately.

Q89 Chair: Absolutely for themselves?

Joris Luyendijk: Yes. It was striking. I have interviewed a few people in banks who were recently laid off, and I asked, "What was the biggest mistake you made?" They said, "Loyalty. For a long time I thought that my bank had loyalty to me and that we were in a reciprocal relation, and we weren’t. I am a resource that happened to be human and not a computer, and I can be discarded at any point."

Q90 Chair: To what extent do you think that the culture is being driven from the board? Given that directors have a fiduciary duty to their shareholders, do you think that they are taking this approach in order to-sorry, I am assuming that they are taking that approach. Do you think that the board takes the approach that you describe-the view that a trader, either as part of a team or as an individual, is a resource? You worry about them, because they get on their bus or into their Ferrari and go home every night, and may not come back again, but at the end of the day, you are there to maximise and sweat the asset, thereby looking for short-term gain. Do you think that directors have a problem, in that they are not trying to drive long-term cultural growth and standards, but are simply looking at this as sweating assets?

Joris Luyendijk: It really depends on the banks. From what recruiters and individual banks say, there is such a difference in banking culture. Standard Chartered and maybe some smaller European banks would be on one side, claiming, at least, to hire people for careers rather than jobs. A place like Deutsche Bank is generally known as this snake pit, where you have to be completely political and constantly protect yourself by striking up short-term alliances. If you were to design an environment for short-termism-say you set up a colony on Mars and said, "We want it to be as short-termist as we can"-I would say, "Take the blueprint of a bank", because on every level you are encouraged to think of yourself, and of yourself only.

You can be fired within five minutes. People come back from lunch and their colleague is gone. That is the good scenario, because at least your colleague was sitting in front of you and now you know that they have gone, but people are not told about lay-offs. I am told that you have these meetings where they say, "Why doesn’t John answer his e-mail?" and there is a painful silence among those who know what happened to John. There is the way that people were fired at UBS. I can see why you do not want people in again, because they may take sensitive information, but the callousness with which people are laid off, and the code of silence that immediately surrounds this person, means that if, say, you have noticed wrongdoing or a risk and you want to take that up, you know that there is the regular culling of the herd. You know that there are alliances that you may have struck up with colleagues who have promised to stand with you, but they may be gone the next day, for a completely unrelated reason.

Then there is the hiring culture, which is now not very prevalent, but until recently it meant that people could also be poached within five minutes, because you have all these recruiters hanging over the market, constantly phoning people. Often, when I interview bankers, I ask, "Aren’t you worried about being seen?" and they tell me, "I am actually more worried about you being seen as a recruiter," because they are still very junior. I am sitting there writing, usually not dressed like this, and they think, "Oh, that’s a typical recruiter."

Q91 Chair: This is an important question about recruitment in banks. They are, of course, doing two types of recruiting. Some are doing graduate trainee courses, looking for people who will potentially have a long-term career in banks-Goldman Sachs, for example, will do more of that-and there is the other type of recruiting that you just described, where head-hunters hang around the City, waiting to poach teams. Either way, are the banks guilty of recruiting fundamentally difficult people to manage? If you are looking for an alpha male who will go out and win deals for you, be they short-term trades or corporate finance deals, is that inherently a person who has bad cultural standards? Are long-term good standards and culture in a bank simply incompatible with the type of people you have to hire to win the deals?

Joris Luyendijk: No. It is striking how few masters of the universe sign up to meet with a Guardian journalist from the Netherlands, so I have to rely on how people talk about the masters of the universe. It usually involves a team harvesting information. There are indeed maybe a few functions on the trading floor where it is really about alpha maleness, but so many other activities have to do with co-operation and nurturing long-term relations, not between your bank and the other bank, but between you as a person-a branded franchise-and the other person, and beginning quid pro quos in relation to bits of information. That is how you build up a career. Most of the people I have spoken to have very high emotional intelligence.

I think that you could very well do without the alpha males, except maybe in a few of those trading things. For those trading functions, many people ask, "What’s the skill?" There is all this research about monkeys throwing darts at boards and outperforming the traders. Many people in the support functions just wonder, "What’s the skill? I can see the P and L and the money, but what is the actual skill?" They talk to me about going to a trader and saying, "So how do you know what the market is going to do?" And they say, "I just know." That works until it no longer works.

In many other functions, you have to be a very skilled politician. Incidentally, that is one reason why the quants often do not make it high up in a bank; with many of the quants, if you have a lot of maths skills, you usually have fewer social skills. They rise to director level, then they all fall off.

Q92 Chair: I want to explore the concept of promotion, because clearly, a rock-star trader who performs very well may get promoted. The problem is that he will get promoted to a job that he is not necessarily very good at-a line manager or higher than that. There is a joke-not a very funny joke, but a sort of amusing story-that goes round; the idea is that you always get promoted to the bottom level of your incompetence, because that is the point at which nobody wants to promote you any more. All the management functions of an organisation are full of people at the bottom level of their own incompetence, because that is where they stick. Do you think there is a fair amount of truth behind that? Do you think that the people coming through at the bottom in these banks will, generally speaking, never make good managers, and that the banks are not doing enough to bring on managers who are good managers, but not necessarily good traders?

Joris Luyendijk: What I hear is that the skills you need to be a good trader are almost opposite to the skills you need to be a good manager. It is similar to the media; as a journalist, you are on your own and constantly have short-term relationships with the people from whom you harvest information. That is completely different from a manager. As a journalist, you try to score. As a manger, you try to get others to score. That may be a more important factor. The beta principle suggests that you keep on doing what you have been doing all along, and you just get a few extra tasks and at some point you collapse, but managing or trading are just completely different things.

Q93 Chair: Have you seen any evidence that banks are recruiting managers to manage on the wholesale side?

Joris Luyendijk: I am sure they are, because otherwise my informants would not be talking about the three really good managers and the two slightly psychopathic ones.

Q94 Chair: It is an important point. Do you think that it is a conscious decision of the banks to get the good managers, and that the psychopathic managers are the ones who slip through the net? Or did they just get lucky with the three good ones?

Joris Luyendijk: Generally, if you ask a CEO of a bank after a few beers, they really want to get rid of the psychopaths, because ultimately they will bring down the ship. Almost everyone says that the Gordon Gekko and City boy stereotype is the one thing that they try to weed out, because yes, they will bring in very good P and L for a few years, but then they will make a huge loss, compared with nice profits for the first few years.

Q95 Chair: From that, I suppose you are getting a sense that there is a will to try to improve this, even if it is very difficult to do.

Joris Luyendijk: Yes, generally. Although again, we are talking about such a huge sector. It is difficult. The kind of discipline that the banks impose on the rest of society with quarterly earnings and analyst statements and what CEOs of other corporations complain about-short-termism driven by a financial sector that overreacts to quarterly earnings, and those sort of things-the banks themselves are subject to the same dynamics. When a new management team comes in, it promises to turn things around on a short term basis, so they are also caught.

Then there is the whole grey area, which is a point that I often miss in public discussions. On the one hand, you want to stop rogue trading, but there is also the Greg Smith "muppet" question-you are not breaking any laws, but you are taking unethical advantage of your information asymmetry. Yes, there are rogue traders and people who break the rules, but it seems that there is a far deeper problem in the sense that the rules themselves are deficient. Otherwise, after the crisis of 2008, a lot of people would have gone to jail. The fact that nobody went to jail after such a breakdown means that there is something wrong with the rules themselves. So there are these grey areas.

A compliance manager gave a good example two weeks ago. The Italian Government wanted to encourage foreigners to buy Italian stocks, so they created a tax credit so that foreigners who owned Italian stocks would get 150% of the dividend, whereas Italians would only get 80%. A trader looked at this and said, "Ah! I can arbitrage this." He built a derivatives instrument, so that Italians could now buy the derivative instrument and claim 140% tax credit. The compliance manager said that after a few years the Italian Government caught on and created a huge backlog in processing the tax claims. Over time, inflation ate into the gains. In the end, everybody lost because people did not get the gains and the Italian Government have this headache. But not everybody lost-the trader who built the instrument did not lose. Now, what the trader built was perfectly legal. It would have made money for the bank-or it seemed to make money for the bank. It stayed within all the rules. He probably went to all his compliance people and ticked all the boxes. Most traders talk about compliance as box ticking, or hurdles. They have externalised ethics: once you have got past the priest, you are fine.

Q96 Baroness Kramer: This is absolutely fascinating. I have a question to follow on. We live in a high testosterone world as well.

Joris Luyendijk: Yes-Prime Minister’s questions.

Q97 Baroness Kramer: In politics, I think you could say there is a natural check, whether it is the media, constituents, publicity, PR. Are you essentially saying that, in the world of banking, when this sort of risk taking spins out of control, there is no natural check? If anything, the shareholders are a buy-in to the same system; senior management is a buy-in to the same system. There is no natural check in the way that it works.

Joris Luyendijk: Yes, on many levels. On the meta level, in the sense that the market does not correct. My favourite example is this: if a bakery had sold bread of the quality of a CDO that Lehman Brothers sold in 2007, what would have happened to the bakery? What would have happened to the hygiene agency that was supposed to check on the quality of that bread? If you look at the financial sector, the ratings agencies and the banks are still there. It is the people who ate the bread who suffer and have to pay the medical bills. On the meta level, the fundamental principles of the free market do not apply. The free market does not self correct.

On a lower level, there is simply the opacity of the sector. It takes a very long time to figure out what was actually created, built, sold, traded and ended up on all sorts of books. My favourite quote is from an FSA person, before the FSA sent round an e-mail warning everyone at the FSA not to talk to me, which I thought was quite telling.

Q98 Chair: Very telling.

Joris Luyendijk: Very telling.

Q99 Chair: Would you like to submit that e-mail to us as evidence?

Joris Luyendijk: I wish someone had forwarded it to me, but they didn’t dare. Somebody else told me. My favourite quote from an FSA senior who used to work at a bank is, "I’m not so much worried about a banker lying to me; I’m worried about a banker lying to himself that he oversees the risks taken." In these huge operations, where there are a lot of quants who use terms like "standard deviation" that most others do not understand, it is very tempting to tell yourself that it is all safe. Also, you know that if it blows up, it may blow up years after you have left.

What makes the free market superior to a planned economy is that it is supposed to be self-policing and self-correcting. If I look as a complete outsider at the financial sector, I see four big accountancy firms, three rating agencies, a handful of financial law firms and a handful of bulge bracket banks. That is a cartel-maybe not in the sense that they huddle together and agree on prices, but effectively a cartel.

With the Facebook IPO, it is clear that all the banks had a piece of the action. I asked mergers and acquisitions bankers why, and they said, "If there’s one bank missing, that analyst may write some dissenting stuff about Facebook, but if you have all the banks on board, it’s going to be very difficult for the equity analysts to say, ‘Actually, this whole Facebook thing probably stinks.’"

Another issue that is rarely discussed is those Chinese walls. I find it extremely difficult to believe that they actually function. I also have not come across a justification for why you would have brokerage and advisory under one roof. People talk about these dynamics: monitoring media companies as an equity analyst, building up long-term relations with investor clients and then being leaned on by the advisory section to talk up a certain company that is having an IPO, for example.

Q100 Baroness Kramer: We may have to park that, though it is absolutely fascinating, particularly as we look at the structure of non-ring-fenced entities. It is very interesting. Before I forget, I also want to say that we will have an opportunity to question the FSA. It would be interesting to know about whistleblowing within the FSA. Let us park that question and make sure we ask it at the appropriate time.

Before I get to whistleblowing, I wanted to ask you something. The answer that everybody gives is "Change the compensation structure, and you will change the behaviour. That’s how you can manage risk taking at the granular level within the organisation." What is your view of that?

Joris Luyendijk: I think it would certainly help. It would be a condition, not a guarantee, on many levels. If people were simply paid less-if the gap between pay in other sectors of the business world and in banks were smaller-it would be easier for people to switch. It is not only rewarding people for risks, it is also giving people the sense that finance is not the only game in town for them.

Q101 Baroness Kramer: So you are talking about the absolute level of pay, not just the division between your basic standard pay and the variable pay or bonus? You are saying in absolute terms that that will happen if you bring it down.

Joris Luyendijk: Again, if a baker in my neighbourhood made the kind of money that a banker makes, other bakeries would open up in the neighbourhood. We have tens of thousands of students who have done nothing else since they were 14 but try to get into the right school, the right university and the right internship to become an investment banker. There are hordes of people trying to become a baker. Why aren’t there more bakeries in my neighbourhood? It is a market failure. Many of the salaries are simply market failure by an oligopoly that functions as a cartel. Because of their margins and because they have so much money, they can poach the best people in the FSA. The huge margins feed into all sorts of sub-areas and pervert them.

Q102 Baroness Kramer: Many of these institutions would then say to you, "But if we pay less-maybe we can vary between base pay and variable or whatever else-we have to pay the going market rate, or we won’t get the good people." Is that an argument that you buy? Is it valid, from the perspective of what you have seen, or are there other things that would encourage people? We are talking about human beings. Are there issues around job satisfaction and "us" status, or other kinds of reward that banks do not deliver to this sector of their employees?

Joris Luyendijk: To answer the last part of your question first, when I ask people why they do this, especially people in their late 20s-I am 40, I have children and my life is very deeply regimented-who have spent all their lives in a glass building fighting over a number on a screen with someone else in another glass building, job satisfaction is one of the things they mention. It is just so stimulating to be surrounded by all these superbly educated people in such a competitive environment. Many have done internships in NGOs, politics, and they come back with the sense that, "Wow, banks are so much more driven. There is such a drive there." That is very appealing if you are in your late 20s and you don’t have kids and you’ve also almost forgotten what it is like to have a life because you work so much. So the job satisfaction for many of them is there. Some of the people who have made good there still come back because they enjoy it so much.

Q103 Baroness Kramer: What gets you ahead? You talked about the fact that even senior management have decided that they probably don’t want the psychopath in there. So is there something in your career progression that reinforces those behaviours that could be changed and would change, if you like, the balance?

Joris Luyendijk: That would be really hard to say. I am thinking of corporate finance in the oil sector versus a derivatives slow trader.

Q104 Baroness Kramer: We all know that the Church of England is the follow-on to that.

Joris Luyendijk: Yes, I will suggest that to my interviewees later. Is this an option? Maybe this question is too big for me to answer, also because I rely on self-reporting.

Q105 Baroness Kramer: I appreciate that. If we look at something like whistleblowing, again, you would have thought that by temperament these were people who would have the courage to do whistleblowing, the sort of risk takers. But it does not seem to be very common. In the United States there is a bounty available, effectively, if you are a whistleblower. Do you think it has to have a real monetary incentive for it to become something that is part of the banking system? Is it a world in which it is money that talks?

Joris Luyendijk: It is certainly the case that if you blow the whistle, it is not only about risk taking or rogue trading and that sort of thing, but sexual harassment. I have spoken to a lot of women who have been through incidents of sexual harassment who did not report it. All of them would say, "My career in finance in general would be over." Even though it is so large-250,000 people-there are all these little niches. Usually your competence stretches to that niche plus a few adjacent niches. If you step out of the family and you report somebody and you blow the whistle, basically you step out of the code of the entire sector. That has stopped these women reporting things that were truly shocking.

Insurance it seems has a real problem. There is a lot of alcohol, a lot of client entertainment. They hire a lot of attractive young women for "investor management", as they call it. They are usually older men who need to be managed, apparently, by women looking beautiful. They don’t report it. Would they do so if they were given a lot of money? That is quite possible because the women concerned are often in their early 30s, thinking about kids. The ones who do report it are usually the ones who have made their peace with leaving the sector, having kids and pursuing something entirely different.

One of the best interviews I had was with an MD who was in the IPO business. He compared investment banking to a game, a trap and an addiction. The game is the race element, with an outcome that can be seen as winning or losing. The trap is the fact that you are paid so well; and then in London, usually, you send your children to very expensive schools. So quitting your job also means uprooting their lives. Then the addiction is the sense that you are part of a whole social milieu. If you step out of that milieu, also because you work so much, your life becomes this huge void. If you’re used to 100 hours a week-it may be a bit like politics. I think politics can also be very addictive; I know about politicians who work a lot. If you would do something that means that, from one day to the next, you would never, ever basically be allowed in, that would be such a change. That is far more than, say, as a journalist going to work in PR; you know, you are still part of the same world. Again, money may help, but the social thing is very important.

Q106 Baroness Kramer: Let’s look at something quite prosaic like a performance appraisal system, which presumably plays a role in progression, and those kinds of things. From what you can gather, do those things play any role in upholding standards, or are they merely the process of instilling the fear against rebellion that you discussed earlier?

Joris Luyendijk: Yes, and it seems to be one of those chores. This is going to be my second December doing these interviews. Everyone seems to have to hand in these things by 1 January, so mid-December, people have two things on their mind: "Ah, I still have to do these appraisals," and the Christmas party.

Q107 Baroness Kramer: These are appraisals of their colleagues?

Joris Luyendijk: Yes. On the one hand, it’s good work, but on the other hand, it means you put a number on everyone, so you become extremely vulnerable once you are a one-in some banks, apparently, if you are a five you are promotable; if you are a three, you are sort of tolerated; and if you are a one, you are on your way out. I shiver to think what would happen in The Guardian if we all had these numbers behind our names, because it would also eliminate a lot of ambiguity where information may travel. This is one example of how the appraisals work. I would have to base myself on how people tell me they work, and that is a lot of steps.

Q108 Baroness Kramer: It sounds quite frightening. I am just trying to understand how one can change or affect value systems. Do you have any sense that, if you like, a board-level strategy based on clear values and high integrity-the kind of thing that we see on the websites, heading up the annual report, or elsewhere-gets down through the organisation? Do you have a sense of how many levels it gets down before it dissipates? Does it make it to the bottom in any way?

Joris Luyendijk: I haven’t really asked people about that. When we talk about senior management, the thing that always comes back is that they have no idea what’s going on.

Q109 Baroness Kramer: Out of curiosity, is that said with pride or out of frustration?

Joris Luyendijk: I think exasperation. When you look at how big these banks are, it makes sense. I was struck when Bob Diamond came before the Select Committee, and at some point somebody asked him, "So what have you undertaken to make sure that something like LIBOR isn’t happening anywhere else in your bank?" There was this shudder of panic, I think, on his face-maybe it was projection-because I think that is the No. 1 question to ask a CEO: "Will you guarantee your bonus on the promise that during the next year there won’t be a nasty surprise?" I think that if you run a 40,000-people bank full of quants with all these products that are so-it’s not like you’re a shoe factory and everything is ultimately a shoe. Some structured CDO, or a long-term relationship with Shell as a mergers and acquisition bank, and loan portfolios and these things -it’s so different. Some interviewees describe the CEO as essentially a PR person, keeping in place the illusion that there is control.

Q110 Baroness Kramer: So where is the influence? I mean, at what level are the influencers in the organisation? If you are there, on the trading floor or one or two levels up from the trading floor, who is it who is creating the influence that determines your behaviour? I suppose the question is: what strand of management should we be looking at in that sense?

Joris Luyendijk: The way that people look back on their careers and then compare managers and the teams that they were in seems to indicate that these teams are just very different. People use terms like "lucky" and "really unlucky". Maybe in secondary school you have one teacher and the next year you have another teacher, and they sit under the same culture but they have just such different temperaments and are in different phases of their careers. I like the cliché of the current banking system being Catholicism without a hell. Ultimately, what will drive risk-averse behaviour is if the individuals undertaking the risk feel that if it goes wrong, they will be the ones to suffer. Imagine an army: if it kills enemy soldiers, it is hugely rewarded; if it kills civilians, it is fine because someone else takes care of it. What kind of army will that be? It will carpet-bomb enemy territory. I know that banks try to control risk, especially after 2008, but we have all these outsiders worrying their heads off about how we can govern behaviour inside banks, whereas in the free market system it should be people themselves.

Q111 Baroness Kramer: Are you saying that basically they are individualists, and that they need to feel individually at risk, and that that is the way you will work thi system?

Joris Luyendijk: They need to be at risk.

Q112 Baroness Kramer: It will not be through leadership, team loyalty or whatever else, but very much through the individual feeling that they are at risk if their behaviour is inappropriate?

Joris Luyendijk: I think so, yes. It is as if the Catholic Church tells people, "If you sin someone else goes to hell, so don’t sin."

Q113 Baroness Kramer: As you think this through, and if you were going to try to achieve a change in banking standards, which is the rather shattering remit that we have as a Commission, are there some things you would do? Can you see from your information and conversations something that would make a real difference? Are there a number of things you could pinpoint?

Joris Luyendijk: A previous speaker mentioned internal audit, and I was struck when two internal audit people told me about the difference in the way they are received in Germany, France, the UK and America. They said there was a direct correlation between the degree of job security and the degree of co-operation with control functions. When people are completely insecure, as in the US, there is pushback from the first second they arrive, whereas in Germany, people just hand over the boxes because they feel completely safe in their job. I spent some time in Frankfurt interviewing bankers there, and the auditors said the same thing: they have no problems there. British bankers in Frankfurt were frustrated that underperforming people were not made redundant. That is the downside of job security-you get freeloaders.

So few risks were taken in the German banking sector, and when they bought the toxic stuff, it was because they did not realise it was toxic. That may have something to do with the fact that the German banking system seems to be built more on long-term relations: apparently people could not fathom the possibility that they would be sold something so bad. If you assume that people are building relationships with you, you assume that they will not sell you something so toxic and so bad.

Job security would be hard to regulate, I think, Hours are another thing. It has been interesting to interview partners of young bankers. They meet at university and one goes into banking, and that person not only changes, but disappears, because if you work every day for a number of years in your formative 20s from 9 in the morning to 12 at night and most weekends, at some point the only friends you have left are people like you. There is social atrophy. One question to all my interviewees is, "How can you live with yourself?" Many come back with the answer, "Actually, it has been a long time since I asked myself that question." They are in the mode of just working and then, for many of the younger ones, intoxication. They go from adrenalin to alcohol-perhaps not excessive alcohol, but they need alcohol-and then go to bed. When they get up, they check their BlackBerry and log their brains back on to the sector.

Hours seem to play an important role, as does compensation. Ultimately, we as outsiders can never govern behaviour inside organisations. That is what the free market tells us. If it were possible for us outsiders to govern it, a planned economy could make it a comeback.

Q114 Chair: There are a couple of points I want to pick up on. You talked about Frankfurt and the different culture there-I have a copy of your article here about this. You pick up on something in particular, which is that the financial transaction tax is a vote loser in the UK, but a winner in Germany. You also say that finance in Germany "is less of an end in itself" and that "Finance in Frankfurt is more knitted into the wider fabric of the economy". You talk about the big cultural differences, but do you think it is far deeper than just the type of people who work there? Clearly, if you have something as pure, if you like, as the financial transaction tax, here, from No. 10 Downing Street to the lowliest trader, we see it absolutely as a block to one of our greatest assets to this country, which is the financial market, whereas in Germany they seem to embrace it almost because the financial sector has more to give back. Do you want to enlarge on that?

Joris Luyendijk: I have not been there long enough to really drill into this but, yes, if you have a car industry, you are against strict CO2 emissions. The Germans have tried to make life easier for the car industry in the same way as Britain will do for the financial industry.

Q115 Chair: So it is a matter of protecting your biggest asset. They will protect their car industry at all costs, we will protect our financial industry at all costs.

Joris Luyendijk: Yes, but just as the car industry is now seen to create climate change, I really wonder if the financial sector is truly an asset. The UK is in the same position as my country, the Netherlands, with a banking sector that is several times the size of the economy-and then there is leverage. I wonder how many members of the general public understand leverage and that if the value of the assets goes down by 5% to 10%, the bank is technically bust, and you have four of those banks, each of which is decisive. I know that the balance sheet is calculated differently from GDP but, still, these banks are huge. So, yes, they might look like an asset but, from another perspective, they are four huge hydrogen balloons hanging over the head of this society, just like they are hanging over Dutch society, with ING and, until recently, ABN Amro-until a greater fool relieved us of that. Sorry about that. Is that truly an asset?

I get a lot of comments on The Guardian site. People are very angry, but what struck me is how few people are aware of the risk of leverage. Look at Greece or China. What could possibly go wrong when your assets go down 5% to 10% and you are technically bust but your Government have already borrowed so much money? Step 1 should, on a general level, be that the UK and Holland should own the risk of having these huge banks, so that when one goes bust it will not discredit the entire political and media establishment. Genuinely, if one went bust, all of us would look very stupid, because people would ask, "Why didn’t you warn us?"

Chair: That is a problem we are wrestling with today.

Q116 Baroness Kramer: I wondered if, when you were looking at somewhere such as Frankfurt, you had actually seen some mechanisms that would make the trading side of banking work within that environment. My sense is that what the Germans have done is to export their trading piece to London-you described Deutsche in terms that certainly would not fit in Frankfurt-and basically one could say the same of nearly every other European country, in effect. Are we looking at an industry that will only fit in a place that is able to live with a great deal of this high octane?

Joris Luyendijk: I take your point entirely. It filters out the deeply driven, enormously ambitious, high-octane people from the whole of Europe. The few traders to whom I spoke in Frankfurt would all say, "Well, I am going for quality of life," and then they would run down this exhausting list of advantages of living in Frankfurt over living in London. It was very clear that they had a different approach. You might argue, if you really hate the high-octane traders, that Frankfurt benefits from London absorbing those people.

Would Frankfurt change again? The fact that Germany still has a real manufacturing industry means that it is high status to work for BMW, Volkswagen or many of those other things. There is not much left here, and I suppose what there is is in consultancy or law, which is very related to this sector.

Q117 Chair: Another thing that you were talking about is the marrying of risk and reward for traders. You said that you have a lot of people who sit on a desk: their upside is potentially unlimited-they can get millions of pounds in bonuses-and the downside, at the very worst, is that they lose their job. I appreciate of course that clawback is being brought about, but the downside is just what you have been paid. Have you done any analysis on the pre-big bang City-the pre-1986 City of London-where the unlimited liability partnership model meant that if you took a foolish or foolhardy risk on your business, not only were you going to lose everything, but your partners would also lose everything. When I say everything, I mean genuinely that little Jack would be thrown out of Eton for unpaid school fees and Sophie would have her pony repossessed at the gymkhana that weekend. As a measure of risk appetite, that is quite a big thing. Have you done any work on that?

Joris Luyendijk: Yes, the veterans that I have spoken to all talk about this. Before the Americans came in and bought all the brokerage firms, there would be all these parties with people celebrating 10 or 15 years with the firm. There are never any parties like that anymore: people just move on, move on, move on. The City has really imported the American idea of resources that happen to be human.

On the other hand-this was a very interesting point-a lot of women and people from ethnic minorities, who are over-represented in my sample of Guardian readers, would say that if you look at the photos from back in those days, they all look like me: white, straight and male. These partnerships were all "my word is my bond," but it all came out of the same sorts of mouths. It has become far more open and diverse in that sense. Then again, others are complaining that, beneath the diversity in sexual orientation, skin colour and ethnic background, people are actually more homogenous than ever, because the City used to hire very different sorts of people and people might have had different careers. Also, the salaries were not as high, so you could move in and out much more easily. You were not trapped.

Right now, they are saying that you get people who, from 15 years old or younger, have been scheming to get into the right internships in order to make it to a bank. At 22, with no life experience outside business school and all these internships, they enter a bank and they are brilliant when it comes to technical skills, but when it comes to life experience-for example, considering the possibility that you are being lied to in your face for months-that just has not happened to them.

Q118 Chair: That is very interesting.

Joris Luyendijk: If you are going to read any of the interviews on the blog, the best one I think is the banking analyst who engages with the readers about whether he deserves his £1 million bonus. He talks about how it is that smart people like us could for years give a buy recommendation for banks that had those balance sheets. He says that basically what you do as a banking equity analyst is call up investors, almost every day, and tell them what you think. If you are going to be the only one who says, "Dump those Irish banks," for years, it means you are basically telling the person on the other end of the line, "Everyone else is wrong but me." That requires a certain kind of personality. According to that banking analyst, the old City allowed for more people with that kind of personality, but right now, I suppose, standardised recruiting has maybe weeded out many of those people.

Q119 Chair: So it has gone from being one type of club to another type of club.

Joris Luyendijk: In a sense. This is another point. As you say, it is hard to break up the banks or force the banks into certain measures, but banks are hostages to this post-national class of business school-educated, global professionals. Many of them are often from mixed marriages, from different countries; they speak several languages and they are married to someone from yet another country; their kids speak a few languages; they have lived all over the planet and they use social media to be in touch. Essentially, they have no solidarity to a particular nation. For them, it is a jurisdiction or a tax environment. If you are going to appeal to a kind of solidarity and say, "Look, we bailed you out," this half-Indian, half-Lebanese banker married to a Française, with children who speak Russian because that is where they used to live, is going to think, "What do I have in common with a nurse in Leeds?" If this person is half-Indian, he is going to think, "Actually, this nurse in Leeds, even if her benefits are cut, still has a vastly superior life to many of the people in India." Their whole mindset is different.

This is one of the mismatches we currently have: we have global banks, but national Governments, national electorates and national conversations. Can you even have global banks, especially when they operate as an oligopoly, when you do not have global regulation? If Holland chops up its banks, the best, juiciest bits will just be picked up by other banks, which will become even more too big to fail, and all that would have happened is that we would have lost our financial sector. It is the same for Britain.

Q120 Chair: That is very interesting. We are running out of time. I have one last question, which you may not, in fact, be able to answer. Obviously, the remit of this Panel is to look at not only the wholesale banks, but the retail banks. I appreciate that you have not necessarily done any work on the retail banks, but do you get any sense that there has been a cross-contamination of cultures, from the wholesale banks to the retail banks?

Joris Luyendijk: That is really difficult to say, because the people I would speak to in the investment banks or financial firms are typically under 35, so I do not think they are privy to the kind of deliberations at that senior level, where that contamination could have happened. Retail is down there with the back office.

Q121 Chair: I must say, I am not surprised.

Thank you so much for coming in. I want to draw the session to a close. It really has been very interesting, and we are very grateful. If you have any more thoughts, please do send us a note. In the meantime, I suspect we will all be reading your blog from now on.

Joris Luyendijk: May I make one suggestion? I am a social scientist, and I am struck by how little social science there is about the financial sector. It is incredible: if you want to know about gender in Gaza, you get 10 research papers; if you want to know how traders actually operate, there is maybe one anthropological survey. Right now, tens of thousands of bankers are being laid off, and many of them are thinking about a new career path. If there was almost a GI Bill for people coming out of finance wanting to do an ethnography about their 10 years in banking-qualitative stuff, not something buying into this economics idea of how the free market works, with rational actors and transactions, but something showing how it really works-just £10 million to £20 million in scholarships for PhDs could have an incredible impact on our understanding of the sector.

Q122 Baroness Kramer: Not the omerta that you described earlier?

Joris Luyendijk: It would allow them to get out. They would then have a career in academics, which is the dream of everyone.

Chair: Thank you very much.

Baroness Kramer: Thank you so much.