Banking StandardsWritten evidence from CFA UK

1. Recent events have demonstrated that banks have often placed their own interests ahead of those of their customers and ahead of their responsibilities to the market.

2. The factors that have enabled banks to engage in inappropriate practices and run regulatory risks can be attributed to a number of systemic governance failures:

Ineffective governance within banks

Insufficient discipline from the market

Ineffective regulation

Moral hazard

3. The banking sector’s problems cannot be solved by measures aimed at the symptoms of those problems.

4. A radical approach is required and we propose the following solutions –

(a)Regulation must be made more effective.

(i)Regulators must supervise more effectively and ensure that financial institutions adhere to their regulatory obligations. Buyer beware has to be balanced with seller beware.

(ii)Regulators should enforce more effectively by making sure that the financial and non-financial costs of inappropriate behaviour materially outweigh any benefits that have accrued from such conduct.

(iii)The regulator should remove regulatory approval for firms to operate if a firm is unable to demonstrate its ability and willingness to adhere to the regulatory requirements.

(b)All bank staff should be aware of their regulatory responsibilities and adhere to them. They should understand the need to place client interests first and to uphold the integrity of the financial system. All staff should be required to abide by and adhere to a code of ethics and standards of professional conduct (such as CFA Institute’s Code of Ethics and Professional Standards) and firms should be required to demonstrate their ability to implement such codes and to monitor employee behaviour against them.

(c)Bank governance systems need to be more robust to increase the likelihood that profitable, but inappropriate activities are challenged earlier in future.

(d)Mechanisms for providing information to the market about bank governance should be improved. In addition, the regulator and policymakers should continue to act on the systemic risk of individual bank failure so that banks that take inappropriate risks or act inappropriately can be allowed to fail. The risk of permanent loss is required if internal governance is to be improved and if market discipline is to operate effectively.

5. In support of our submission we include the following material that we refer to in our response:

(1)Overview of CFA UK

(2)Summary of the Code of Ethics and Standards of Professional Standards

(3)CFA UK position papers on ‘Financial Amnesia, Effective Regulation and Stewardship

(4)Letter to the Joint Parliamentary Committee on the Financial Service Bill

(5)Letter to the Treasury Select Committee on the proposed Financial Services Bill.

Responses to the questions posed by the Parliamentary Commission on Banking Standards

1. To what extent are professional standards in UK banking absent or defective? How does this compare to:

(a) other leading markets

6. CFA UK is not well placed to assess the relative level of professional standards globally. However, it is worth noting that irrespective of standards elsewhere, a minimum level of professional behaviour should be required in the UK market. It is also notable that the recent examples of poor professional behaviour in the UK have occurred under a light-touch regime and have sometimes come to light as a consequence of regulatory activity in other regimes.

(b) other professions

7. Investment is a profession and its participants understand their responsibility to protect the public from incompetence and unethical behaviour by maintaining professional and ethical standards. The investment sector (or buy-side) has had its own share of embarrassing cases of poor practice, but a large number of those that work in the sector are members of a professional body and are conscious of their duty to maintain appropriate standards. The same should be true of finance more generally and banking in particular. Some have argued that professional and ethical standards should not apply in wholesale markets—such as the money markets—because all participants can operate on a ‘buyer beware’ basis. However, that assumption fails to take account of participants’ responsibility to maintain a fair market so as to promote trust and, ultimately, to provide a public benefit in effective price formation.

8. What the recent banking scandals reveal is the routine placing of personal or firm interest ahead of that of the market and clients. The banking sector, unlike the investment sector, appears to be far from operating as a profession. It is possible to point to any number of failures. With reference to the specific standards expected of CFA UK members, standard I(a) of our code requires members to understand and comply with all rules, laws and regulations governing their professional activities, standard I(c) requires members not to knowingly make any misrepresentations, while standard 1(d) demands that members should not engage in any professional conduct involving dishonesty, fraud, or deceit. In addition, standard II(b) states categorically that members must not engage in practices that distort prices.

9. It appears that some banks have paid lip service to professional ideals and ethical business culture within their marketing communications, but have not embedded those ideals and behaviours within their firms. If they had, their names might not be making headlines for the wrong reasons. That would also have been less likely if the UK had enjoyed a regulatory approach that focused on symptoms rather than on causes. Individuals in the banks concerned appear to have acted with little fear of penalty from a regulator, their firm or a professional body. This collective wilful blindness would be less likely to happen in the medical or legal profession, where professional codes of conduct are rigorously enforced and individual transgressions are penalised with appropriate severity.

10. CFA UK’s forthcoming paper on the stewardship of client assets—to be followed by papers on conflicts of interest and fee and compensation structures—is designed to provide practical guidance for investment professionals committed to maintaining appropriately high standards. The society is also working on mechanisms to enable investment professionals to seek informed guidance on ethical and professional issues.

and (c) the historic experience of the UK and its place in global markets?

11. The UK has a proud and long banking tradition. CFA UK advises that the Parliamentary Inquiry should respect this tradition by addressing shortcomings in professionalism and ethics whilst at the same time trying to avoid maligning the whole industry.

2. What have been the consequences of the above for

(a) consumers, both retail and wholesale, and

12. The consequences of different instances of unprofessional behaviour within the banking sector differ. Mis-selling resulted in direct loss to consumers, but the misreporting of Libor rates will have benefited some market participants and disadvantaged others. All market participants, however, suffer as a loss of trust in the financial sector. A reduction in consumers’ willingness to engage in financial transactions might lead to opportunity costs or direct costs in future.

(b) the economy as a whole?

13. The cost to the economy of the loss of trust in the banking sector has, to date, been limited. Such a loss of trust, as a consequence of poor professional practices, should have led to an increase in the cost of borrowing for banks and, in particular, for banks which are perceived to run greater governance risks than others. The central bank’s understandable desire to provide extremely low cost funding to banks in order to recapitalize bank balance sheets and reduce systemic financial risk means that there has been no discernible increase in banks’ effective funding costs.

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

14. As described above, public trust in the banking sector appears to be even lower than before. UK banks were once considered trusted providers of financial guidance, advice and services that placed the customer first. Revelations about inappropriate practices that have been taking place for close to a decade (in some cases longer) have demonstrated that these UK banks have placed their customers’ interests second was not a one-off isolated episode.

4. What caused any problems in banking standards identified in question 1? The Commission requests that respondents consider

(a) the following general themes:

the culture of banking, including the incentivisation of risk-taking;

the impact of globalisation on standards and culture;

global regulatory arbitrage;

the impact of financial innovation on standards and culture;

the impact of technological developments on standards and culture;

corporate structure, including the relationship between retail and investment banking;

the level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects;

taxation, including the differences in treatment of debt and equity; and

other themes not included above;

15. Various asymmetries appear to have influenced banking behaviour adversely. First, large global banks appear to have understood that they had become too big to fail. As a consequence, they could take on more risk than they should on the suspicion that they would be bailed out. We are all aware of the systemic consequences of this understanding. Secondly, compensation structures within the banking sector rewarded risk-taking. There was an asymmetry in the impact of gains and losses on compensation.

16. A more competitive banking sector might have meant that banks could not become too big to fail. Similarly, the shift in investment banks’ corporate structure from partnerships to publicly-listed companies meant that the incentive for bank boards to monitor credit growth and to control risk closely was reduced as their risk of personal loss became limited.

17. It is important to recall that there were almost no groups within society that noted the dangers of credit growth within banks and the growth of the banks themselves. Society appeared to benefit from the banks’ success. All of us chose to believe that asset prices were justifiable and too few noted the danger of bank leverage or the impact of risk asymmetries on behaviour. The regulatory framework failed in its primary responsibility to ‘take away the punchbowl’, but we all enjoyed the party while it lasted and none of us (consumers, the media, parliament or the professional bodies) should now comfort ourselves by pinning the blame for the banking sector’s failings solely on the banks.

18. CFA UK described the reasons why societies fail to identify credit bubbles and proposed some mechanisms for accelerating their observation in its position paper ‘Financial Amnesia’.

and (b) weaknesses in the following somewhat more specific areas:

the role of shareholders, and particularly institutional shareholders;

creditor discipline and incentives;

corporate governance, including

the role of non-executive directors

the compliance function

internal audit and controls

remuneration incentives at all levels;

recruitment and retention;

arrangements for whistle-blowing;

external audit and accounting standards;

the regulatory and supervisory approach, culture and accountability;

the corporate legal framework and general criminal law; and

other areas not included above.

19. The following interdependent governance failures all contributed to banks being able to undertake inappropriate activities and engage in unacceptable practices—

the role of shareholders, and particularly institutional shareholders;

creditor discipline and incentives;

corporate governance, including

the role of non-executive directors

the compliance function

internal audit and controls

remuneration incentives at all levels;

the regulatory and supervisory approach, culture and accountability;

the corporate legal framework and general criminal law;

Other—moral hazard and senior management .

20. In our position paper ‘Financial Amnesia’, CFA UK set out how regulatory failure contributed to the crisis. Essentially, the regulatory failure was attributed to the following factors:

(a)Organisational constraints—insufficient resources, bureaucratic weaknesses and/or an ineffective mandate.

(b)Poor management and policy-maker focus—regulators and policy-makers appear to respond to market failure by issuing new rules (which would suggest a structural failure in regulatory activity) rather than by reviewing the regulator’s failure to supervise and enforce within the existing structure (which would require acknowledging management or operational failure).

(c)Capture—Regulatory bodies are vulnerable to lobbying and capture by those they should be supervising. The relationship between the market and its regulator is close. The regulator can come to depend on the market for resources and information and regulators may become reluctant to rock the boat—a fear that is heightened if individuals working for the regulator consider that they may be employed in future within the market.

(d)Behavioural factors—halo effect (overawed by those that are being regulated) regulatory myopia, groupthink, status quo bias.

(e)Light touch plus caveat emptor results in a flawed regulatory philosophy—this philosophy was based on a “market knows best” paradigm which underpinned the “light touch” mandate. In addition, the buyer beware principle meant all the regulatory focus was on the supply-side of the market. Relatively few resources were invested in ensuring the demand side of the market for financial services was a potent source of discipline on financial firms.

21. Regulators are the last line of defence and need to ensure that they can act in the manner that maintains trust and confidence while having the courage to hold failing financial market participants to account. Regulators must also not fall into the trap of choosing approaches based purely on paternalism or libertarianism as has been the case since the Great Crash. For regulators to be more effective they need to learn from their own mistakes and become more courageous in their actions by supervising and enforcing the rules that already exist.

22. In our paper “Effective Regulation” we propose the following measures to address the failings we identified above and these are as follows—

1.Enhancing financial capability—so that consumers become a more robust source of market discipline on firms. Caveat emptor (buyer beware) has to be balanced with caveat venditor (seller beware).

2.Change the regulatory philosophy—Establishing a regulatory philosophy and approach which acknowledges that we live in a world that can act irrationally and inefficiently for protracted periods. Rather than facing a binary choice between the market mechanism and command and control, the regulatory philosophy should embrace libertarian paternalism (nudge theory).

3.Practical policy-making—

(a)Being evidence-based, so as to ensure that the design of laws, policies and regulations are accountable, consistent, proportionate, targeted and transparent.

(b)Consistency with, rather than conflicting with, existing laws and policies.

(c)Sensitivity to gaming. Practical regulation and effective monitoring would also minimize the consequences of gaming (for example regulatory and tax arbitrage or even evasion) on society. These efforts would ensure that costs of gaming would outweigh the benefits for those considering undertaking the activity.

(d)Dynamism. Governance is a complex system that requires evolution and learning for the policy levers to remain effective in the present and the future.

(e)An appropriate emphasis on the monitoring of the policy, combined with a credible threat of enforcement.

4.Supervision and enforcement- Regulation alone is not sufficient. Even the best designed regulation will be ineffective if it is not credibly supervised and enforced. The regulatory failure that contributed to the financial crisis was less about the regulations and more about an absence of effective supervision and a credible threat of enforcement.

5.Accountability—Just as market participants need to be held to account by their shareholders and the regulator, so the regulator should also be held to account. CFA UK believes effective regulation will strengthen UK’s position as a leading global financial centre. By fulfilling the essential role they play in enhancing the quality of market integrity, regulators will be able to further strengthen the UK’s position as a leading global financial centre.

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?

23. As we have cited in our position papers and responses related to financial regulation the key remedial action is making the interdependent sets of checks and balances more robust. Boards need to be more effective; investors need to be able to convey their concerns effectively and without fear of retribution.

24. In the wake of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom we note the enactment of The Sarbanes–Oxley Act of 2002 as a means of ensuring investor protection through Public Company Accounting Reform. SOX-type laws have been subsequently enacted in Japan, Germany, France, Italy, Australia, India, South Africa, and Turkey and have done much for improving the confidence of fund managers and other investors with regard to the veracity of corporate financial statements1. Given the current lack of confidence in the culture and control environment of banks’, we call attention to “SOX” measures in respect of Corporate Responsibility2 mandating senior executives’ individual responsibility for the accuracy and completeness of corporate financial reports and propose investigation into a similar framework for the role of Chief Compliance Officers/Chief Operating Officers in respect of the health of the bank’s Governance, Risk and Compliance capability.

25. Finally, the regulator needs to more effective in supervising and enforcing the relevant regulations. The quality of regulation in the UK financial services sector has fallen short and been a contributor to systemic governance failure. Regulators are the last line of defence, as we have seen; when they fail the consequences for the rest of us are significant. No new laws or regulations are required just the desire, willingness and ability to supervise and enforce existing ones. Quality of regulation is the priority.

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.

26. In our previous submissions about the Government remedies we have expressed concern that they are unlikely to achieve the progressive change hoped for.

“The strategy for reform is not to create an ideal set of rules and then see how well they can be enforced, but rather to enact the rules that can be enforced within the existing structure.” (La Porta et al3)

27. Effective regulation involves the design of policies, rules and laws that are successfully monitored and supported by the credible threat of enforcement. The new framework is focused on new architecture rather than making the existing one work more effectively. The tripartite system failed because insufficient emphasis was placed on supervision and enforcement. In our opinion, the risks of regulatory failure have not been reduced.

28. We welcome initiatives undertaken by the Financial Reporting Council in respect of the Stewardship Code, Code for Corporate Governance and Guidance on Audit Committees. Particularly we feel that proposals in respect of assurance reporting4 alongside a suitably expanded remit of internal audit committees could, and should, be investigated for implementation by banks as a means of providing markets with the necessary information regarding internal controls so as to enable market discipline to be enforced.

29. CFA UK believes that effective regulation is essential for the laws of demand and supply to function appropriately. History has demonstrated that market discipline cannot be reliably imposed by all regulated financial firms. The high risk of market failure makes the regulator the last line of defence for maintaining market integrity and, thereby, trust and confidence. Sadly, the evidence demonstrates that the regulator is also prone to failure. CFA UK calls upon regulators to learn from financial and corporate history and to make material changes in their regulatory approach to deliver the following outcomes:

(i)Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.

(ii)Enhance financial capability so that consumers become a more robust source of market discipline on firms. It is essential for the demand side to be a source of market discipline. Caveat emptor has to be balanced with caveat venditor.

(iii)Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets. Rather than facing a binary choice of market mechanism or command and control, the philosophy should embrace asymmetric paternalism. This would create an environment of market command with robust control mechanisms and make it possible for firms to fail without endangering the system or imposing major costs on the rest of society.

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

30. The Commission should seek evidence from the UK Government that the new Financial Services Bill will necessarily deliver a better outcome.


31. The crisis in the banking sector was the result of a systemic governance failure that was characterized by banks willing to place their interests above their customers; ineffective corporate governance; insufficient market discipline and ineffective regulation. Banks like other providers of financial services have regulatory obligations. From the late actions taken by the FSA in recent years it appears that some banks have been engaging in activities for a considerable length of time that placed their customers’ interests behind their own. In some cases regulatory inertia exacerbated consumer detriment, while fines levied on these banks may have been considered no more than the cost of doing business.

32. The introduction of a Code of Ethics and Standards of Professional Conduct for bankers would be welcome as part of the solution. The greater requirement is for more robust checks and balances within the financial system.

33. We look forward to collaborating with the inquiry.

24 August 2012

1 Article quoting fund managers at Eaton Vance and T. Rowe Price.

2 Title III consists of eight sections and mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports. It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance. For example, Section 302 requires that the company's "principal officers" (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly.

3 La Porta, Rafael, Lopez de Silanes, Florencio, Shleifer, Andrei and Vishny, Robert W., "Investor Protection and Corporate Governance" (June 1999). Available at SSRN: or DOI: 10.2139/ssrn.183908

4 Assurance Reporting: In March 2011 the Institute of Chartered Accountants in England and Wales (ICAEW) published a Stewardship Supplement to its Technical Release AAF 01/06 - Assurance Reports on the Internal Controls of Service Organisations. It covers assurance reports on internal controls of service organisations made available to third parties, and is referred to in the guidance notes in the Stewardship Code.

Prepared 19th June 2013