Banking Standards

Submission from HSBC (S019)

HSBC welcomes the opportunity to respond to the call for evidence with regard to the Commission’s consideration of:-

a. professional standards and culture of the UK banking sector, taking account of regulatory and competition investigations into the LIBOR rate-setting process;

b. lessons to be learned about corporate governance, transparency and conflicts of interest, and their implications for regulation and for Government policy.

The comments below respond to the initial questions posed in the Commission’s call for evidence.

1. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets?

1.1. Absence of or deficiency in professional standards in UK banking has to be judged ultimately from the perspective of those who use or comment upon the use of banking services; their judgement today would not be flattering. However, it would be inconsistent with the evidence to conclude that the pattern of improper behaviour and practices, albeit recurring, means that there is a systematic absence of professional standards in UK banking. On the retail side [1] , customer satisfaction and recommendation scores point to a fairly consistent and high level of service. Indeed within this, First Direct has consistently topped independent customer service surveys across all sectors, not only banking. Customer behaviour, in terms of complaints about core banking services and incidence of switching providers, again does not point to an industry bereft of professional standards. On the wholesale side, London has until the LIBOR scandal enjoyed a relatively untainted position in terms of conduct: the major issues have been around conflicts of interest in the structuring and distribution of securitised and structured products which were largely an issue for the major investment banks operating in the US. The 2010 report of the US Senate Permanent Subcommittee on Investigations: ‘The Anatomy of a Financial Crisis’ provides examples of some of these conflicts and behaviours.

Regulatory Developments

1.2. Neither can it be said that staff and management in banks are unaware of society’s expectations of them and how these are evolving. On the retail side, the FSA’s ‘Treating Customers Fairly’ initiative which was completed in 2008 was embraced enthusiastically by banks as a framework for building customer satisfaction. The FSA’s interim report in November 2008 noted ‘TCF remains central to our retail strategy – it has gained enormous buy-in from firms and their senior management, and is a hugely important part of our retail agenda for consumer protection’.

1.3. From January 2009 the FSA’s Advanced Risk Recognition Operating Framework (ARROW) assessments of firms with retail activities included a TCF component with:

o a review of TCF outcomes: direct testing of the customer outcomes with reference to a firm’s own management information (where (the FSA) believes it is robust), other relevant intelligence about the firm’s conduct; and

o an assessment of the firm’s culture to understand potential reasons where there is poor performance or identify where good performance might not be maintained. [2]

1.4. Thus culture and behaviour have been an area of growing regulatory importance and management attention over the last five years. At HSBC, the TCF framework was embedded into the UK bank’s ‘Best Place to Bank’ and ‘Best Place to Work’ programmes. These were customer and staff focussed initiatives driven by a simple view that highly engaged staff and satisfied customers would drive required financial performance in a sustainable way.

1.5. On the Commercial Banking side of the business, the Business Finance Taskforce set up following publication of the Government’s green paper ‘Financing a Private Sector Recovery’ in July 2010, committed to 17 actions aimed at improving banks’ relationships with customers, ensuring better access to finance and promoting understanding of the needs of business customers. Customer reaction and tracked metrics all point to the success of this initiative.

1.6. The last three to five years have therefore seen major co-operation between the industry, regulators and government around improving banks’ service propositions to core retail and commercial customers. From our experience as a global bank, we believe that these programmes establish standards of conduct as good as any elsewhere in the world. Indeed these are now more developed than in many countries given the UK’s more integrated and sophisticated markets and as a consequence of the problems that have had to be addressed. Furthermore, in all areas of regulated activity, sanctions for non-compliance have been significantly toughened and more extensively applied with increased ‘naming and shaming’. There can be no doubt that the UK’s regulatory regime is now tough and demanding. The issue therefore is not with the design or promulgation of the standards under which the UK industry is designed to operate, or any absence of adequate regulatory sanctions for their non-observance; rather the issue is with ensuring the consistent application and enforcement of these standards within regulated institutions.

1.7. So how can it be with all this management focus on the TCF and ‘Better Business Finance’ initiatives, accompanied by extensive industry training and governance, both internally and externally through the FSA’s ARROW reviews, that there have been recurring failures in the application of the required standards in retail and commercial banking? On the wholesale side, the key question is what factors might have contributed to a belief among albeit a small number of traders that attempted manipulation of a key reference rate, whether for personal gain or otherwise, was anything other than totally unacceptable behaviour?

Environmental Developments

1.8. It is worth reflecting on how an industry once known and trusted within the community for its high standards of propriety has fallen to such low public esteem. Without attempting to justify poor behaviour and practices, there are a number of environmental factors which can be identified objectively, and which need to be understood if we are to draw a line under the past and begin to rebuild confidence in the financial industry which is also an essential precursor to economic growth.

1.9. Firstly, the aftermath of the dotcom and tech bust saw the financial markets flooded with liquidity, and yields on government debt fell to historically low levels. This drove an urgent search for yield amongst investors and intermediaries to find products to match embedded liabilities and meet expected returns. Market expectations for returns continued to stay higher than was justified by the prevailing risk free interest rates. This led to a tolerance and then implicit acceptance of higher risk and more structured products (essentially through leverage) to deliver the required higher yields.

1.10. One further consequence of this extension in product range was a growing and mutually rewarding relationship between the retail and commercial side of banking and the markets side. What had historically been a relatively passive risk transfer relationship added progressively a product provider/distributor relationship, more marked in some firms than in others. There is absolutely nothing wrong with this – indeed it is a characteristic of a sophisticated and efficient financial market enabling customers to better manage their financial risks such as interest rates, foreign exchange rates and commodities prices so that they can concentrate on their commercial activities. There are however clearly tensions and conflicts that have to be managed to appropriately govern the extent to which product flow is demand led or supply driven, and to ensure adequacy of product information and sales training on more complex products. Recent history has clearly evidenced that this was not always done adequately.

1.11. A second observation on environmental factors is that product ranges in retail and commercial banking expanded over the last decade. This was largely driven by customer demand for outcomes that required the acceptance of greater risk and more structuring of product features. It is possible that customers’ enthusiasm for the desired outcome was also taken, to an extent more than was justified, to incorporate a full acceptance and understanding of the underlying risks and structuring features.

1.12. A third observation would be that in the mid 2000’s there was significant investor pressure to increase equity returns through either financial or business leverage. In financial terms, this was focused on reducing capital ratios. HSBC resisted what was quite intense pressure during this period – at one point there were external broker reports calling for up to $20 billion to be returned through share buyback. In business terms, the focus was on the development of originate-to-distribute models, with assets being packaged and sold on to investors (who did not have a direct relationship with the customer) thereby removing the capital requirement from the bank. It is possible that this very strong public call for leverage and structuring from many institutional shareholders, combined with a very strong focus on shareholder value creation which was at the time dominated by a Total Shareholder Return (‘TSR’) metric, contributed to an overweighting of short term shareholder perspectives rather than a longer term customer relationship focus. The fact that management’s long term remuneration at that time was also typically heavily weighted to TSR would also have been a factor, but we will deal with remuneration issues in more detail below.

1.13. Fourthly, also driven by the co-ordinated flood of liquidity to the financial markets post the dotcom/tech bust and more recently by very low official interest rates in the wake of the financial crisis, the value of banks’ deposit bases declined as the spread between the average deposit rate which banks needed to pay to attract deposits and the yield on high quality liquid assets fell to historic lows and in some cases turned negative. This revenue reduction was critical as, historically, deposit spread revenue was the most important part of a retail and commercial bank’s revenue model given that it required the acceptance of very little risk (and therefore capital) on the deployment of excess deposits into liquid assets.

1.14. Fifthly, as regards retail and commercial banking, the revenue model that had underpinned banking for most of recent history was being dramatically transformed. As noted above, deposit spread revenue declined notably during the last decade both from lower yield on high quality liquid assets and from higher deposit costs in banks that were being forced to lower their dependence on wholesale funding. There has been increasing public and regulatory focus on the structure of bank charges within the UK and, particularly, the existence of cross-subsidies inherent in a ‘free if in credit’ model. Over the last few years, there have been successive regulatory-driven adjustments to the fees, margins and charges which were a consequence of ‘free banking’ for most customers, but no longer fitted with the ‘cost plus’ model that the industry was moving towards. On top of this, post 2008, under the ‘Treating Customers Fairly’ initiative described above and also as a consequence of the FSA’s Retail Distribution Review, there is a continuing focus on unbundling fees and charges so far as possible, making the intermediation costs embedded within financial products much more transparent. We object to none of this – it represents an overdue modernisation of the revenue model of banking. The point is simply that all the cross subsidy elimination and unbundling has taken place while the causal driver of that revenue model – ‘free’ banking – remains intact.

1.15. In addition to the impact of market forces, banking has therefore adjusted its revenue model over the last decade in response to regulatory intervention, to accommodate significantly lower overdraft fees and charges, lower credit card over limit and late payment fees and charges, and lower credit and debit card interchange fees. It has also begun paying interest on business current accounts. The commission-based revenue model for wealth management products will be eliminated as a consequence of the Retail Distribution Review and many in the industry including HSBC have significantly withdrawn from this market, unable to match the cost of meeting revised expectations with the market’s acceptance of a fee basis of charging.

1.16. Addressing the cost challenge of an industry in transition has clearly also contributed to the declining reputation of the industry. This has arisen as certain services of value to some customers but not economic to deliver are withdrawn, as physical infrastructure, namely branches, are rationalised to match growing customer online and direct banking preferences, as certain activities are consolidated into centres of excellence to gain economies of scale but causing regional job losses, and as some work was moved to centralised Group service centres outside the UK. The public sees these cost adjustments alongside the high remuneration of senior bankers, at the top of the bank and in the wholesale side of the business which have a different remuneration and employment model, but this adds to public anger. It is, however, possible that this disconnect will be clarified as we implement the ring fencing proposals from the Independent Commission on Banking when it will be clear that the higher remuneration in the wholesale bank is not subsidised or in any way supported by the retail and commercial banking activities.

1.17. At the same time, as costs in the retail and commercial bank were being contained throughout the last decade for the reasons noted above, there were growing offsetting pressures on the cost base from regulatory interventions and reforms. These arose from the Business Finance Taskforce undertakings, the greater customer screening and due diligence requirements under the ‘Treating Customers Fairly’ programme, as well as the enormous commitment of resource to the regulatory reform agenda. This simply illustrates that the important and shared goal of a more transparent and potentially safer financial system, with greater customer protection, cannot be achieved without greater cost

1.18. So the background environment in retail and commercial banking in recent years has been one of revenues constrained because of economic slowdown, exacerbated by a significant reduction in deposit spread income as a consequence of low interest rates and further pressured due to the progressive elimination of or reduction in so-called ‘cross subsidy’ revenues as the banking model is modernised to be more transparent and fair to all consumers.

International Comparisons

1.19. In terms of international comparisons in retail banking, Great Britain is marked out by its ‘free’ banking model. This was only extended to Northern Ireland relatively recently, and in response to action by the Competition Commission. In many European countries, the provision of core banking services is delivered through public sector or mutual banks who do not seek to make the same return on capital as a private sector bank. While this could be seen as a form of economic subsidy, as a competitive alternative this model has also exhibited flaws, most recently with the Spanish Cajas.

1.20. Asian retail and commercial banking is distinguished by a focus on ensuring that the industry as a whole self-capitalises, generating the returns necessary to satisfy capital providers, absorb unexpected losses and fund growth. There is no less focus on treating customers fairly but there is perhaps more recognition that a long term commercial balance is required for any banking model to be sustained. The result can be a more interventionist approach to the viability of the industry, for example, when unrealistic loss-leader propositions emerge that could damage the market as a whole, and promotion of a closer industry dialogue than has been the case in recent years in the UK. Part of the difference in approach is also reflected in product approval philosophies: in Asia most markets offer product approval safeguards so that once approved, banks can be reasonably sure that, subject to following agreed procedures, product sales will be regarded as compliant. Competition is still strong but the collaborative approach to create a broad vision of a sustainable industry may give a better impetus towards delivering the desired retail market outcomes than has been seen hitherto in the UK.


1.21. The above is offered by way of background and context. It does not seek to justify or condone poor practices. The aim is to capture some of the forces which can shape the development of an industry, and which need to be considered if we are to create an environment conducive to high professional standards and focused on the interests of customers in both the short and long term, underpinning a sustainable banking sector making a sound contribution to the economy. Significant actions have already been taken to address inadequate standards with the Business Finance Taskforce and Treating Customers Fairly initiatives being particularly positive to ingraining the right values and setting clear expectations from society on ‘fair dealing’.

1.22. Comparison with other professions is a very relevant benchmark. We would submit that the banking industry has progressively seen its historic professional standing diluted largely as a consequence of its failings. On top of this, as the industry grew more sophisticated, detailed regulation increasingly replaced a traditional reliance on judgement, reflecting the increased range and complexity of banking activities. The historic sense of public duty and a relationship banking model, much admired in the past, has been juxtapositioned increasingly against a more transactional business mentality and a more mechanistic regulatory approach.

1.23. In thinking about this response we were reminded of the testimony of J P Morgan back in 1933 which still stands today in our view as what the aspiration should be.

First-class business in a first-class way

"I have ventured to frame a brief statement of my views on the subject of duties and uses of bankers.

The banker is a member of a profession practiced since the middle ages. There has grown up a code of professional ethics and customs, on the observance of which depend his reputation, his fortune, and his usefulness to the community in which he works.

Some bankers are not as observant of this code as they should be; but if, in the exercise of his profession, the banker disregards this code – which could never be expressed in legislation, but has a force far greater than any law – he will sacrifice his credit. This credit is his most valuable possession; it is the result of years of fair and honorable dealing and, while it may be quickly lost, once lost cannot be restored for a long time, if ever. The banker must at all times conduct himself so as to justify the confidence of his clients in him and thus preserve it for his successors.

If I may be permitted to speak of the firm of which I have the honour to be senior partner, I should state that at all times the idea of doing only first-class business, and that in a first-class way, has been before our minds. We have never been satisfied with simply keeping within the law, but have constantly sought so to act that we might fully observe the professional code, and so maintain the credit and reputation which has been handed down to us from our predecessors in the firm. Since we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgement and not of principle.

The banker must be ready and willing at all times to give advice to his clients to the best of his ability. If he feels unable to give this advice without reference to his own interest he must frankly say so. The belief in the integrity of his advice is a great part of the credit of which I have spoken above, as being the best possession of any firm.

Another very important use of the banker is to serve as a channel whereby industry may be provided with capital to meet its needs for expansion and development. To this end the banker can serve well, since, as he has at stake not only his client's interests but his own reputation, he is likely to be specially careful. If he makes a public sale and puts his own name at the foot of the prospectus he has a continuing obligation of the strongest kind to see, so far as he can, that nothing is done which will interfere with the full carrying out by the obligor of the contract with the holder of the security."

J.P. Morgan, Jr., May 23, 1933, Excerpt from statement made before the Sub-Committee of the Committee on Banking and Currency of the U.S. Senate.

1.24. It is not the case that this sense of public duty and responsibility has been lost irreparably or in all cases. There still exists clearly this sense of public responsibility and accountability where bankers are proximate to the communities they serve and where they are relevant to those communities. We see this most notably in Hong Kong where the Hongkong and Shanghai Banking Corporation is identified closely with the success and prosperity of Hong Kong and is, notwithstanding its scale, seen also as a community bank. This shared identity is also seen in regional and local markets where the bank, local authorities and communities work closely together to build economic activity. First Direct is a clear example of a brand and level of customer service which its customers appreciate, trust and recommend to others.

1.25. One of the tragedies of the current public anger over banking reputation is that the very substantial majority of our employees do not, and should not, in any way identify with the criticisms being levied as their own activities are performed diligently, valued by their customers and aligned with society’s expectations of the industry.

1.26. The current reputation of the UK’s banking industry also sits very uncomfortably with the strong reputation of the UK’s leading professions – legal, medical and accounting inter alia – which is particularly problematic as, at least as regards the legal and accounting professions, a great deal of their business, expertise and reputation derives from London’s position as a leading international financial centre. It is therefore critical, beyond the banking industry itself, that the UK’s banking industry reputation is restored to its historic high level of international respect.

2. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?

2.1. Other than the growth of a general lack of trust, with its long term consequences for customer relationships, lapses in the application of standards have created the need for customer redress programmes in respect of certain retail and commercial offerings on a scale not seen before. On the wholesale side, there is a growing burden of regulatory enquiries and litigation to establish if losses have arisen which should not have occurred both from those who are generally aggrieved or have fiduciary responsibilities on behalf of end investors.

2.2. As a further consequence of the expanded regulation and more intrusive and extensive supervision necessitated by and attributable to recurring behavioural lapses, the industry’s operational and compliance cost base has risen as has its litigation and regulatory sanction cost exposure; ultimately such costs are borne by society through higher intermediation costs to consumers or through lower returns to pensions and savings systems.

2.3. For the economy as a whole the consequences are both current and prospective.

o Currently the consequences include:

· Loss of activity occasioned by lack of confidence in the banking industry;

· Diversion of a portion of industry management’s attention from economic activities to management of redress and litigation exposures;

· Higher intermediation costs and lower shareholder returns;

· Investor concern over the sustainable business model given recurring redress and remediation impacts; sectoral capital allocation to the UK is at risk of being diverted to other banking markets if current issues are not expeditiously addressed.

o Prospectively the consequences may incrementally include:

· Risk of greater financial exclusion given redress experience in certain customer segments;

· A narrower product range from major banking providers;

· More focus on execution only, non-advisory services;

· Loss of wholesale activities to competing international centres if London’s reputation is not restored, with consequential impacts to related services sectors; there is also a risk of some UK headquartered companies following the move progressively to those competing centres.

3. What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?

3.1. Trust in the banking sector is clearly at an all-time low driven by the combination of:

(i) recurring mis-selling findings requiring significant customer redress;

(ii) industry-wide downward revisions to fees and charges to eliminate non-transparent cross subsidies;

(iii) scandals over LIBOR rate fixing and money laundering allegations;

(iv) anger over remuneration levels in a sector judged to have caused much of the financial crisis and to have required taxpayer support;

(v) perceptions of a lack of support for the real economy through lack of meaningful growth in lending to the ‘real economy’ such as SMEs;

(vi) a decline in the availability of low deposit mortgage credit which, wrongly as it turned out, had come to be seen as the norm; and

(vi) declining levels of physical infrastructure and advisory services as the industry manages down its cost base and responds to changing regulatory requirements.

All of these are seen in the public’s eye as evidence of declining or absence of standards in banking in the UK and are in aggregate mutually reinforcing.

3.2. Expectations of the banking sector can be seen through three prisms:

o The public has low expectations of a change in behaviour given recent experience, continuing media outrage, a clamour for further redress and a very public change in regulatory focus towards more severe sanctions including exploring the need to seek criminal sanctions;

o Regulators and government expect visible actions from within the industry in the short term to restore confidence in a sector essential to the UK economy;

o Investors continue to have little confidence in their ability to forecast the sustainable business model, structure and financial returns of the industry. This is evidenced inter alia by the substantial discount to book value that most banks trade at, as well as the discount evidenced on the recent divestment of Lloyds Banking Group branches. Essentially most investors don’t know what to expect.

4. What caused any problems in banking standards identified in question 1?

4.1. In the final analysis, problems around the application of banking standards lie with management either through failing to ensure standards were applied as intended or in failing to recognise that society’s expectations of the conduct expected of the industry had evolved and not keeping pace with that change.

4.2. Paragraphs 1.8-1.18 above set out in some detail background and contextual factors that contributed to a recurring negative perception of industry standards.

4.3. A critical analysis of these factors highlights two key issues which likely contributed to instances of inappropriate standards of behaviour, certainly when judged with hindsight.

4.4. Firstly, the very low interest rate environment and bullish market sentiment in the early part of the century respectively fuelled and rationalised the need to identify or create products that secured higher returns (for both customers and banks) than those available from more traditional investment products. This led to greater structuring and complexity of financial products which, in turn, needed to be supported by higher levels of sales training, monitoring of sales practices and more thoughtful sales incentivisation. History shows that governance over sales processes was not as good as it should have been.

4.5. Secondly, actions to eliminate cross subsidies and improve transparency, ultimately brought together under the TCF regime, which the industry fully supports, led to a steady stream of adjustments to the revenue model of retail banking over an extended period. This pattern of adjustment both contributed to the deterioration in public trust as each adjustment was seen as an individual failing within the industry rather than as part of a package. It also created pressure both to cut costs and to identify replacement revenues. Cross selling of insurance was one consequence that in principle was logical and potentially to the advantage of the consumer but was clearly poorly executed.

4.6. Looking at lessons learned in the retail and commercial banking businesses would point to a number of other contributory factors:

o During the last decade there has been a shift towards seeing banks more as retail businesses than was previously the case. There was focus on creating more of a ‘sales culture’ in response to market encouragement to monetise the depth and loyalty of the customer base, in part in response to greater and highly selective competition from established retailing and marketing brands. One illustration of this change in emphasis was that senior management was increasingly recruited from retail businesses; and there was greater use of sales targets and related incentivisation to deliver these targets. While there was and is nothing wrong with this approach, it is clear that lessons were learned over this period in terms of: (i) better targeting of sales incentives and better training around the sales process; (ii) better documentation of the sales process itself and of the customer’s understanding of inherent risks; (iii) reviewing sales outcomes more critically against expectations; (iv) assessing post sale product performance more often; and (v) segmenting target markets more finely so that product sales are more likely to be appropriate. All of these lessons and more are embedded in the TCF regime and in our own procedures but many of the current redress situations are legacy issues arising from earlier times.

o Customer patterns of interaction with their bank have moved progressively and rapidly towards greater use of direct channels, further encouraged by banks seeking to manage their cost structures. But this has reduced face-to-face interactions outside the Premier segment, probably contributing to the loss of a community bank ‘feel’ amongst a growing number of customers and staff. This has been exacerbated by the role of service centres, sometimes located offshore, to improve efficiency and reduce service delivery costs at the expense of branch contact. For some customers, this reduced personal interaction has meant a loss of personal empathy recalled from prior times even though an overwhelming proportion favours the convenience and efficiency of ATM machines and internet banking. The challenge for banks is to satisfy both populations within the same structure.

4.7. With regard to the wholesale side of the business, the following observations may be relevant.

o Leading up to the financial crisis, there were clearly structural deficiencies in remuneration policies in many firms that allowed cash bonuses to be awarded and vest on the basis of short term financial performance that subsequently turned out to be overstated or false. Underpinned by new regulation at a UK and EU level, these deficiencies have now largely been addressed through deferral and clawback arrangements across all leading markets and participants.
At HSBC, we have gone further to require long term compensation awards to the most senior executives once vested to be retained until retirement.

o The prior arrangements also led some institutions and staff therein to focus on structuring products that front loaded accounting profits, and therefore bonuses, through aggressive mark-to-market and mark-to-model accounting. With hindsight, there were inadequate controls and governance over such arrangements and again this has been remediated both by better controls within banks and extensive regulatory changes to eradicate the arbitrage opportunities that led to this behaviour.

o Progressive sophistication, complexity and speed of trading, all increasingly fully automated, have probably also contributed to a remoteness in some parts of financial institutions between what happens within segments of trading rooms and the consequences of that activity on real world investors and businesses. Arbitrage activity is essentially  institutionalised where it serves as a mechanism to aid price transparency and liquidity. The role of some trading operations – for example high speed trading – seems increasingly designed to serve the efficiency of the market itself rather than be tied to any direct individual customer relationship and this de-personalises the activity. This may be where policy makers want to see markets activity develop but if so it becomes a much more technical activity in nature with society’s benefit coming from the enhanced efficiency created. It is difficult to ascribe culture and values to algorithmic or high speed trading once programmed, so the controls have to be in the design. That is not to say that the activities serve no useful purpose nor that those who design them do not have appropriate values or integrity but it does emphasise that the controls have to be evident in the design of the systems as once designed they will simply respond as programmed. The recent automated trading losses arising from software errors in a US trading platform highlight this point.

o There is also a need to reconsider the definition of a ‘sophisticated’ counterparty when considering the sale of high-risk complex financial instruments to ensure that these are only sold to truly sophisticated investors.

o In August 2008, The Counterparty Risk Management Policy Group (‘CRMPG’) issued a report ‘Containing Systemic Risk: The Road to Reform’ to Henry Paulson, Secretary to the US Treasury and Mario Draghi, Chairman of the Financial Stability Forum which recommended establishing fresh standards of sophistication for all market participants in high-risk complex financial instruments. In the financial crisis that followed the issue of the report its findings were subsumed into the plethora of regulatory reform initiatives but they remain relevant today.

o In recommending specific characteristics and practices for participants, CRMPG was guided by the overriding principle that all participants should be capable of assessing and managing the risk of their positions in a manner consistent with their needs and objectives. All participants in the market for high-risk complex financial instruments should therefore ensure that they possess the following characteristics and make reasonable efforts to determine that their counterparties possess them as well:

· the capability to understand the risk and return characteristics of the specific type of financial instrument under consideration;

· the capability, or access to the capability, to price and run stress tests on the instrument;

· the governance procedures, technology, and internal controls necessary for trading and managing the risk of the instrument;

· the financial resources sufficient to withstand potential losses associated with the instrument; and

· authorisation to invest in high-risk complex financial instruments from the highest level of management or, where relevant, from authorising bodies for the particular counterparty.

o CRMPG further recommended that large integrated financial intermediaries should adopt policies and procedures to identify when it would be appropriate to seek written confirmation that their counterparty possesses the aforementioned characteristics.

4.8. With regard to the role of governance in all its forms in relation to causation of inadequate or absent standards of behaviour we offer the following observations:

o Non-executive directors increasingly play a critical role in establishing risk appetite, monitoring ‘tone at the top’ and assuring that reward and succession planning are aligned with both required performance and standards of behaviour. The G30 report ‘Toward Effective Governance of Financial Institutions’ published in April 2012 established a best practice framework that has added greatly to clarifying the Board’s accountabilities in these areas. Hitherto there was less clarity as to the Board’s responsibilities as against those of executive management.

o Compliance and internal audit functions predominantly operated on an exception reporting model rather than an assurance model leaving responsibility with business management to address deficiencies; hindsight suggests this was less effective than it was designed to be. HSBC recognised this upon its management succession in 2011 and moved to an assurance model with compliance and audit functions given greater authority to enforce their recommendations. The audit process also was redesigned to be more holistic rather than concentrating on narrow adherence to Group standards.

o In terms of the themes identified by the Commission for consideration in the context of problems around banking standards we have no observations in the following areas:

· Taxation, including the differences in treatment of debt and equity;

· Creditor discipline and incentives;

· Arrangements for whistle blowing;

· External audit standards; and

· The corporate legal framework.

5. What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?

5.1. We risk deceiving ourselves if we believe that it is possible to engineer a regulatory system that eliminates failure and unintended consequences. However regulators and public policy makers on behalf of society clearly have a duty to respond to the failures highlighted in the crisis and beyond. They have the ability to modify and recalibrate the framework under which the industry operates but with this privilege goes the responsibility to do so only if the changes made are proportionate and in the long term interests of society.

5.2. There also has to be recognition that no framework of regulation and oversight can deal explicitly with every circumstance to which they need to apply. And if we train a future generation of bankers to follow an immensely detailed rulebook, not only will complexity ensure unintended breaches, but we risk intelligent minds identifying numerous unintended consequences and so rationalising non-compliance or structuring solutions which are form-over-substance or which arbitrage local variations. A consequence of rationalising arbitrage and structured solutions to mitigate unintended consequences is that this inevitably leads to more self-interested behaviour. A mindset is created around it being okay to get around rules if they don’t make sense.

5.3. So once again we come back to how public policy can address ‘behaviour’. It is worth noting that a simple word search in the Independent Commission on Banking Report mentions capital 463 times, liquidity 140 times and behaviour 7 times. In the FSA’s report into the failure of RBS, the numbers are 1,389 for capital, 733 for liquidity and 16 for behaviour respectively. Simplistic - but all the same instructive.

5.4. If we are to learn the lessons of the crisis, improve the sustainability of the financial system and demonstrate its overwhelming social value it will be not only because we have changed behaviour but because expectations of behaviour have changed as well.

5.5. Capital, liquidity and infrastructure enhancement will also play a role as will better governance and supervision but the greatest opportunity for improvement will come from defining, teaching, reinforcing, rewarding and enforcing values in terms of how the industry and those within it must operate to serve the societies that entrust to the industry their financial security, needs and aspirations.

5.6. If we are ever to rely on behavioural values it also has to be based on trusting organisations to deliver them and organisations trusting their people to deliver – and that trust has to be built over time and evidenced by experience. And we need to find a way to build assurance into the system that trust has been earned. At HSBC we have instituted a programme of training around values establishing a code of conduct that defines what is acceptable based on what we call ‘courageous integrity’ which requires staff to do what is right even if difficult or unpopular. Progression and reward depend upon exhibiting the values; failure to do so results in retraining or departure. As the recent G30 report also concluded, there is value in firms designing and enforcing such codes of conduct.

5.7. The industry together with the relevant regulatory and public policy bodies need to work together and think more deeply about how they can get to understand, and as necessary shape, the character and culture of organisations critical to the financial system. It is only the aggregate of behaviour evidenced within the system and in particular how it has changed that will change society’s perception of banks rather than thousands of pages of worthy new regulations designed to work in theory.

5.8. So rather than supervisors obsessing about whether an organisation can break down exposures by the hour, by product, by customer, by industry classification, by business line, by country, by region – there has to be more attention given to tone from the top, how individuals are screened for behavioural characteristics when recruited or promoted, how ethics and values are taught and reinforced, how values are enforced and rewarded and how an organisation looks for and adapts to changing expectations within the communities it serves.

5.9. On top of this, consideration might usefully be given to developing a behavioural monitoring ‘audit’ requirement, independent of the supervisory process and perhaps akin to the social responsibility or sustainability reviews currently conducted, with public reporting thereon periodically. Without minimising the challenge inherent in designing such a programme, there is a need to find a way to attest to the essence of what banking as a profession has to embody in serving society – independence of thought, character, judgment, accountability, responsibility, a duty that goes beyond each individual’s self-interest or the narrow interest of the employer to personal undertakings of fair dealing, trust and integrity.

5.10. A further aid to improving public trust in the industry would be to find a way that the industry can get more certainty up front that product attributes and sales processes are acceptable if delivered as agreed. The current application of regulatory principles to go back up to ten years (e.g. re interest rate protection products) to characterise failings in industry behaviour engenders great uncertainty and is damaging to public trust of the industry and confidence in the protection provided by the regulatory process.

5.11. Finally, there is a need to distinguish unacceptable personal behaviour from unacceptable corporate behaviour in terms of sanctions. While institutions must continue to be accountable for the culture of the organisation and how their employees are incented to behave, there is a need to ensure that sanctions, including criminal sanctions, can be levied in appropriate circumstances against individuals whose behaviour falls well outside defined norms in order to reinforce personal responsibility and accountability. Inability to pursue individuals for behaviours deemed wholly unacceptable by society but for which there are no sanctions available has contributed to deterioration in public trust in the industry.

6. Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government's proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.

6.1. We have already given detailed comment on all of the above. The changes already in place and in contemplation are comprehensive and well designed to address many of the issues noted above. In particular the changes already effected on compensation structure around deferral and clawback, offer significant protection against the worst misalignments seen ahead of the crisis. The UK’s ‘ring-fencing’ proposals will give clarity and objectivity to the interrelationship between retail and commercial banking on the one hand and wholesale banking on the other.

6.2. There is one aspect of the changes to the UK’s regulatory architecture on which we have commented extensively elsewhere. This concerns the statutory objective of the Financial Policy Committee, which we believe should be adjusted to recognise the importance of regulating both the volume and price of bank credit. A properly risk-based system would help to instil credit discipline at all times in the economic cycle, greatly reducing the imbalances and distortions to which we referred in section 1 of this response.

6.3. The missing piece is that around culture and behaviour and our suggestion of an independent ‘integrity’ audit set out above may be worthy of consideration.

7. What other matters should the Commission take into account?

7.1. We have no further matters to raise.

24 August 2012

[1] For the purposes of this document, ‘ Retail ’ refers to the provision of financial services to individuals, within the Retail Banking and Wealth Management operations of HSBC; ‘ Commercial ’ refers to the provision of services to small and medium sized enterprises and middle market corporations with the Commercial Banking operations of HSBC; ‘ Wholesale ’ refers to the provision of services to international corporate and markets activities within the Global Banking and Markets operations of HSBC.

[2] FSA Annual Review 2008/9 page 39

Prepared 22nd September 2012