Banking StandardsWritten evidence from TheCityUK

Since the beginning of the financial crisis, many failings in the banking industry have come to light. Some involve the poor conduct or low standards of employees, institutions and the industry as a whole. These failings have had a particularly significant impact due to the importance of financial services to the UK economy.

The banking sector has recognised these failings in conduct and standards and has identified five main reasons why these occurred:

Accountabilities at Board level were unclear. This resulted in weak governance structures, lack of oversight and visibility at the “top of the house” and insufficient checks and balances for executive management. This was especially true with regard to risk appetite and risk, capital and liquidity management.

Risk and Control functions were not always sufficiently independent, powerful or resourced to appropriately influence strategic decision-making or day-to-day behaviour. This resulted in excessive risk-taking at some banks.

Remuneration structures for senior managers and risk-taking employees at some institutions allowed cash bonuses to be awarded and vest on the basis of short term financial performance, resulting in a misalignment of incentives between employees and external stakeholders.

Certain institutions and individuals lost their way in terms of acceptable ethical standards. At its height this was a fundamental cultural failing in the industry.

Punishments for breaches of conduct or standards—both internal (applied by the institution) as well as external (applied by the supervisors)—often lacked teeth, with very few penalties limited to the extremes of “job loss” and “individual legal action” for individuals; pre-crisis, the financial penalties for institutions were relatively low.

The banking industry is determined to address the failings and has therefore been making efforts to improve standards and conduct. Many of these efforts have been prompted or supported by the range of legislative and review findings and recommendations since the financial crisis, and are aligned with the direction of travel that the Commission has indicated that it wishes to see. We point to the following areas where progress has been made over the last five years:

Improved Board governance and oversight since the 2009 Walker Review of Corporate Governance, coupled with greater emphasis on the “stewardship” role of Boards and their shareholders.

More independent, larger, more influential and better equipped Control functions.

More appropriately structured executive and front-line remuneration.

Increased transparency for shareholders, bondholders, regulators and customers.

Tougher penalties for breaching standards.

Improved core business practices (training, whistleblowing, sales and product approvals).

Product simplification, particularly in wholesale markets.

It is reassuring to see that the steps taken are widely considered key to improving standards, as evidenced by them repeatedly being reflected in evidence put before the PCBS. However, it will take time before the full benefits of the above will be completely realised. There remains further progress to be made across several of the above dimensions (noting that some banks have more to do than others) and it will be key when looking at next steps to recognise this, while reinforcing the progress already made. In this regard we request that the Commission:

1.Provide a balanced review—recognise progress made thus far, as well as the many failings.

2.Consider how a “charter for bankers” may practically raise standards in institutions which have to operate at a global level.

3.Recognise that poor financial outcomes for customers do not always equate to poor standards; many banking products involve risk for both parties.

4.Differentiate between markets (particularly between retail and institutional clients) and recognise the diversity of banks (particularly differences between non-UK and UK domiciled banks) in the UK banking sector.

5.Augment and complement (rather than replace) the recommendations of the Walker review and consider the potential impact of UK regulatory super-equivalence on competitiveness.

6.Support the role of the FCA, keeping realistic expectations as to what can and cannot be achieved through regulation alone The issues outlined above focus on the banking industry, but the proposals and recommendations in this letter are informed from the experience and approaches of UK financial institutions more broadly.

All of the above should be considered in the context of the UK as a global financial centre. As noted in both The City of London Corporation and TheCityUK submissions to the Commission (23 and 24 August respectively), a strong financial and professional services sector, enjoying confidence and trust, are key to the UK’s future prosperity. This is further evidenced in TheCityUK review “UK competitiveness in financial services” (9 November). When conducting its deliberations, we encourage the Commission to be mindful of the international competitiveness of the sector and its position as the nation’s leading net export earner contributing £47 billion to the Exchequer last year, its role as a major employer employing 2 million people across the UK (two-thirds outside London), and the fact that it has many aspects that extend well beyond banking, such as insurance, asset management and investment.

We believe the Commission is timely, as it offers a chance to look to the future of financial services, clarifying the changes already made and underway, and highlighting the role the sector plays in helping our nation’s economy prosper. We consider it critical that the sector, its regulators, its customers and clients focus on the future. Our vision is for the sector to put the unhappy past behind it and move forward in doing all that it can to grow the economy and to help businesses and individuals to thrive.

Introduction

This letter is a submission to the Parliamentary Commission on Banking Standards on behalf of TheCityUK and The City of London Corporation addressing the topic of standards and conduct in the UK banking sector. It does not address issues relating to the draft Financial Services (Banking Reform) Bill:

TheCityUK is a national membership organisation representing the UK’s financial and related professional services sector. Our members are drawn from across the banking, insurance, asset management, legal, accountancy and other related areas of a sector which employs two million people. Our purpose is to promote and explain the role and value of the sector in society and the economy, and to promote the sector abroad.

The City of London Corporation is the elected governing body for the City of London that promotes and supports the UK-based financial services industry, as well as providing a wide range of services for the City, London and the nation as a whole.

This letter has been signed off by TheCityUK Advisory Board.

To inform the content of the letter, senior executives and non-executives from 11 financial institutions (comprising UK domiciled banks, the UK operations of non-UK domiciled banks and other UK-based non-bank financial institutions) have been interviewed on a non-attributable basis. The issues covered in this letter focus on the banking industry, but the proposals and recommendations are informed from the experience and approaches of UK financial institutions more broadly.

This letter seeks to highlight the progress that has been made in the three years since the Walker Review and how the sector continues to try to address the root causes of past failures. It recognises that much work is yet to be done, with some banks having made more progress than others, and outlines some of the challenges facing the industry in doing this. It recognises and welcomes the support and guidance that the Commission is anticipated to provide, and makes several overarching suggestions for the consideration of the Commission.

The letter is structured as follows:

Progress made since the Walker Review (2009).

Suggestions for the Commission.

Progress made since the Walker Review (2009)

Since the Walker Review of Corporate Governance was published in 2009, UK banks have made significant progress implementing its recommendations. In parallel, UK banks have recognised the need to go further than the Walker recommendations to address broader issues relating to business conduct and standards. While good progress has been made, the process of adaptation and learning is continuous and banks are making efforts in several areas to meet the expectations of their stakeholders, with some banks further along the journey than others.

In this section we outline some of this recent progress on conduct and standards, and identify areas for future attention. We divide the discussion across seven main themes:

1.Board governance and oversight.

2.Risk and Control function design and application.

3.Remuneration and performance management.

4.Information and transparency.

5.Tougher sanctions.

6.Core (conduct-and-standards-related) business practices.

7.Product simplification.

1. Board governance and oversight

The ability of the Board to monitor, assess and manage key risks is vital to the development and maintenance of high standards and appropriate conduct in banking institutions. The Walker Review made a number of recommendations regarding both Board size and composition and Board functioning and performance. The G30 report “Toward Effective Governance of Financial Institutions” published in April 2012 has brought further clarity to the role and operation of the Board.

Since the Walker Review, Boards of UK banking institutions have implemented considerable change. Notably, non-executives are now committing more time to their role and are in a better position to provide oversight and challenge given more experienced and knowledgeable backgrounds in financial services. Boards are supported by senior committees with clear roles and responsibilities and more timely and relevant information. Distinct Board-level Risk Committees (BRCs) are commonplace (all major UK banks now have distinct BRCs) and exert greater influence. They are supported by new executive-level committees, such as Reputational Risk Committees, with specific mandates to ensure appropriate business standards and ethics. In short, the structures and resources required for effective Board level governance have been reinforced and Boards are better able to oversee and challenge the executive.

It is recognised that Board governance and oversight could be improved further. First, better focused reporting (recognising the significant advancements already made) would facilitate greater levels of insightful challenge and scrutiny, supporting debate between executives and non-executives. Banks are continuously evolving Board-level reporting, especially with regard to risk. Second, new governance structures are still bedding in and the specifics of roles and accountabilities are being worked through to establish the most appropriate and effective governance frameworks.

Banks face challenges regarding Board governance and oversight. First, under current ring-fencing proposals (which are also under review by the Commission), UK banks will have separate Boards and governance frameworks for the two ring-fenced entities. Establishing separate governance processes with roles and responsibilities appropriately delineated will not be straightforward. Second, it is important but increasingly difficult to strike the right balance between ensuring adequate Board oversight and taking Board engagement so far that imperils the independence of the Board. It should also be recognised that non-executives remain to a large extent dependent on the executive directors, internal audit and external auditors, so need to pay particular attention to the calibre and culture of those groups. The increased expectations, accountability and scrutiny for a non-executive in financial services could make the role less attractive to quality candidates. Third, foreign banks with subsidiaries operating in the UK need to comply with UK governance requirements as well as regulations in their domiciled countries. Any legislation reinforcing UK governance structures should avoid making cross-geography governance too complex and burdensome for non-UK banks.

2. Risk and Control function design and application

Within many UK banks, significant change has been made to the size and importance of control functions such as Risk, Compliance and Audit. There has been heavy investment by banks in people, tools and infrastructure, with checks and controls in place for processes such as planning and product design.

For example, for 5 participating banks, the proportion of UK staff that are in control function roles has increased by over 25% since 2007.1

Aside from increased scale, the independence and the influence of the control functions has improved. For example, at the largest five UK banks, the CRO is part of the Executive Committee and has direct reporting lines into both the CEO and the Board Risk Committee. This is supported by clearer reporting lines and better articulated roles and responsibilities within the function.

The tools on which risk and control functions rely have been bolstered. In particular, better articulated Board-level risk appetite statements (the declaration of how much and what types of risk an organisation is willing to accept in the pursuit of returns) are now established at most banks. Banks are now working to cascade these risk limits throughout the organization, embedding risk appetite into core business practices and decisions. In addition, many banks have significantly upgraded the quality of risk reporting and systems, with focus on more holistic coverage of risks, more metric-based information and more timely data provision.

Risk management and governance can be further improved in the following ways:

Ensure that there is a clear articulation of responsibilities and accountabilities for operational risks (including conduct and reputational risks) across the three lines of defence (the business, the control functions, and internal audit).

Ensure that risk appetite “bites” in all aspects of front-line activity. Many institutions are attempting to better articulate their appetite for conduct and reputational risks.

Continuous improvement of the timeliness, accuracy, insightfulness and relevance of risk reporting. The better reflection of non-financial risks such as operational risks, conduct risk and reputational risk is a particular focus.

Banks are tackling the challenge of defining and establishing an appropriate “risk culture”. For example, several banks are conducting internal independent cultural reviews to better understand how their risk and control culture influences behaviour and outcomes. Their ambition is to articulate the desired risk culture and ensure that it is appropriately embedded into the organisation through incentives, training, recruitment, communications, and performance management, etc.

3. Remuneration and performance management

There has been a recognition that financial incentives and rewards must promote the right behaviour and culture, as promoted by regulations, including the Walker Review, the Capital Requirements Directive (CRD) and the FSA Remuneration Code.

Consequently, there has been significant change in the way employees are financially rewarded, particularly for senior managers and risk-taking employees.

The remuneration structure of senior managers is now broadly consistent across banking institutions. All have fixed and variable components. Variable pay has been reduced as a proportion of total compensation. The majority of variable compensation is paid in long-term incentives and deferred payments, with deferred payments typically vesting after periods of approximately three years. The majority of variable compensation is paid in stock and subject to risk-adjustment. Deferred portions are subject to “malus”; deferred but unpaid compensation can therefore be clawed back if performance targets or behavioural standards are not met.

Compensation for frontline Wholesale banking staff has changed dramatically. As with senior managers, fixed pay has increased as a proportion of total compensation and variable pay is deferred and subject to malus. Cash remains a key element of deferred compensation, but the use of equity continues to increase. Guaranteed bonuses for new hires are used very rarely, and only to attract key new hires who have large outstanding deferred payments due with existing employers. Such appointments require Remuneration Committee approval and are significantly reduced. Multi-year guaranteed bonuses have all but disappeared.

Pay structures of frontline retail banking branch and telephony staff have also been subject to scrutiny. Following the 2012 FSA review of frontline retail remuneration schemes, many major banks have changed frontline compensation structures, increasing focus on conduct risk gateways, higher weightings towards customer service metrics and removing incentives for sales volumes. Further refinements will be made as trade-offs between network performance and reward structures are better understood.

Remuneration structures are defined by committees and driven by performance management frameworks. The Board-level Remuneration Committee defines the organisation-wide principles for compensation, review and challenges significant compensation rewards, and sets and approves risk-adjustment mechanisms (with guidance from the Board Risk Committee). There is a greater emphasis on performance management as a means to influence behaviour. The trend is towards more frequent and more detailed appraisals and reviews with a strong focus on conduct and standards. Progress on this varies between banks and most do not yet employ the best practices.

It is broadly recognised that the changes made to remuneration structures and practices are good for the banking industry. However, work remains to be done:

There is still a large divergence in the methodology and robustness of risk-adjustments to compensation between banks. Most banks risk-adjust the total variable compensation pool. However, due to data and systems constraints, banks find it difficult to cascade risk-adjusted performance metrics beyond product lines, and metrics are not always consistent and robust. Improved systems and more granular metrics are needed to ensure risk is better aligned with remuneration.

Linking pay to individual performance remains a challenge. For example, malus is typically dependent upon group-wide—as opposed to individual—performance; the value of equity rewards are subject to external factors; and drives to increase fixed pay decrease the “bite” of variable or deferred rewards.

Increased fixed pay as a proportion of total compensation increases the fixed costs of banks, leaving less flexibility to manage costs in times of poor returns and, hence, increasing risk.

Large deferred pay components reduce staff mobility within and across firms and, hence, reduce the efficiency of the financial services labour market.

CRD IV proposals to cap variable pay as a proportion of fixed salaries are still being debated. Opposition to the proposal has arisen due to potential impacts on fixed costs, reduced cross-firm mobility, and restrictions on the ability to reward outperformance.

It should also be noted that questions still remain about absolute levels of compensation which are subject to much public and regulatory scrutiny and discussions continue about the appropriate sharing of rewards between shareholders and employees.

4. Information and transparency

Increased levels and frequency of disclosures, especially around the risks taken by institutions, have resulted in better information and greater transparency for external stakeholders, including customers, shareholders, bondholders, regulators and rating agencies. There is also some evidence of increased investor engagement (eg “The Shareholder Spring”), following upgrades to the FRC Stewardship Code and a greater willingness from bank executives and non-executives to engage with investors.

Increased information and transparency can be beneficial. It enables industry analysts—and, therefore shareholders and bondholders—to better understand institution-specific dynamics and risk profiles. Increased dialogue and information flows to regulators enable them to identify risks ex ante, and improved dialogue with investors can act as a check on management actions and behaviour.

However, there are challenges with increased disclosure:

Ensuring consistency across banks is difficult (often due to organisational structures and legacy data storage systems).

Not all users of information are able to interpret and use new information properly; there is a risk of information being misinterpreted by less sophisticated stakeholders, which could impact reputation or the stability of a bank.

Significant senior management time can be taken by investor interactions and regulatory liaison, diverting attention from day-to-day business matters.

Increased information does not always translate to improved transparency. In order to increase transparency, the Enhanced Disclosure Task Force (EDTF) have recently published recommendations for developing high-quality, transparent disclosures. These address a bank’s business model, the key risks that arise from this and how they are measured, a bank’s liquidity position, the calculation of RWAs, the relationship between market risk measures and the balance sheet; and the relationship between a bank’s market risk measures and its balance sheet.

5. Tougher sanctions

Personal responsibility for failures in standards is increasingly clear and severe for those working within the banking industry. This is true of sanctions applied by institutions as well as supervisors. This has been seen in some recent high profile cases involving senior managers and in many lower profile cases. Sanctions placed on banks for failures in standards (eg PPI redress and LIBOR) are also much more severe than pre-crisis, when financial penalties for institutions tended to be small.

This is supplemented by increased discipline underpinning the FSA approved persons register. This ensures that those performing a controlled function (ie roles with particular regulatory significance) have sufficient experience and expertise to perform the role and will do so in accordance with a set of standards.

There is open, positive discussion about the potential benefits and practical application of a “charter for bankers” for all banking employees. There are different ways in which such standards could be established which would influence the success of the initiative. Creating clear rules, guidance and/or training to avoid equivalent but opaque processes would be beneficial, but it will be important to avoid overlap or dilute existing approved persons frameworks.

6. Core (conduct- and standards- related) business practices

Standards and conduct considerations increasingly influence the way business is conducted within banks. For example:

Mandatory compliance and conduct training have been significantly increased.

Most banks have introduced a more stringent product approval process. This typically includes the requirement for authorisation from a senior Reputational Risk Committee before products can be launched.

Some banks have conducted front-to-back sales process redesigns for frontline retail banking sales activities to mitigate the risk of mis-selling liabilities.

Improved whistleblowing mechanisms are in operation in both banks and the regulator.

Many banks are recognising the importance of a robust culture that supports prudent decision-making and good conduct, from the “tone at the top” to front-line staff. A number of banks have commissioned reviews to better understand and identify steps to strengthen their own culture.

The creation of the Financial Conduct Authority (FCA) as part of the twin peaks regulatory framework will be a major influence in the future. The FCA has been established to “protect and enhance confidence in the UK financial system”. Early indications are that the FCA will be more interventionist and pro-active on conduct-related themes than the FSA has historically been. They are likely to require improved and more consistent use of support mechanisms, such as processes, training and management supervision to ensure that all decisions are taken with the appropriate consideration for standards and ethics. Banks will need to adapt to the new regulatory approach and work closely with the regulators to implement further changes to governance, standards and processes. It is hoped that these will be introduced mindful of the global context and the benefits of striving to achieve an international level playing field which will, over time, offer consistency and stability.

7. Product simplification

The inherent complexity of the UK tax structure and customers’ desire to protect against uncertainty (eg interest rate or exchange rate movements) will always create a base level of demand for some complexity in financial products. However, banks have taken steps to begin to simplify product structures to make it easier for customers to make informed decisions about the products they are purchasing.

For example, in retail banking, some banks have withdrawn parts of the packaged current account range to ensure that all products represent good value to customers. Another example is the drive towards simplification of overdraft fees and charging structures. In wholesale banking, the shift towards flow products is in part driven by simplicity considerations. Furthermore, Basel III will increase capital requirements for complex illiquid or structured products.

There is further to go to reduce product complexity and ensure that all products offer customers a fair value exchange and that all are suitable for the customer. We welcome the creation of the FCA, and anticipate that the recommendations from the Simple Financial Products Steering Group and increased competition in the retail banking market will support the continuation of the current trend towards reduced product complexity.

Suggestions for the Commission

We have identified the following themes as having relevance when considering governance issues, and request that the Commission take these into account:

1.Provide a balanced review. We hope that, alongside an objective analysis of the historical and current failings in the industry, many of the above areas of progress will be recognised by the commission and given time to take effect

2.Consider how a “charter for bankers” may practically raise standards in institutions that operate globally. A poorly structured “charter” could do more harm than good. If it duplicates other similar lists (eg the FSA approved-persons list), then this is unlikely to be useful. We understand the BBA will be coming forward with specific points on this matter.

3.Avoid ex post revisionism. Certain outcomes cannot be guaranteed for customers: many financial products will have uncertain outcomes and it is important to recognise that some unfavourable outcomes (eg base rates rising during the term of a variable rate mortgage or base rates falling during the term of a fixed rate mortgage) do not directly equate to a failure in banking standards. For banks to continue to fulfil the role of financial intermediation, they need ex ante regulatory, surety not ex post revisionism

4.Differentiate between markets and between banks. It is important to recognise the difference between retail customers and institutional or market counterparty clients. The sophistication of different types of customers varies dramatically and the approach to “conduct” beyond universal ethical principles (eg regarding burden-of-proof compliance requirements, relevance of caveat emptor principles, acceptable levels of product complexity etc.) needs to be tailored accordingly. It is also important to note the different structures of banks operating within the UK, the different degrees to which institutions have made progress with regards to governance and conduct in recent years, and the implications for regulatory cross-over between UK and non-UK regulations

5.Support the Walker review. We believe that the Walker recommendations are being acted upon and provide a solid foundation upon which new regulation should build and support rather than replace. We also believe that the impacts of UK regulatory super-equivalence on competitiveness should be carefully considered

6.Support the role of the FCA. The new twin-peaks UK regulatory environment is a major change. The FCA has the potential to be a force for good in the industry by providing a more focused view on conduct and standards issues. We believe this should be supported by the Commission, with realistic expectations as to what can and cannot be achieved through regulation alone. The FCA will lack the resources to investigate all idiosyncratic instances of failings in conduct and standards and therefore it is important that the Commission support the development of an appropriately defined mandate to that effect. We also recognise the importance of prudential supervision for the sector as a whole.

All of the above should be considered in the context of the UK as a global financial centre. As noted in both The City of London Corporation and TheCityUK submissions to the Commission (23 and 24 August respectively), a strong financial and professional services sector enjoying confidence and trust are key to the UK’s future prosperity. This is further evidenced in TheCityUK review “UK competitiveness in financial services” (9 November). When conducting its deliberations, we encourage the Commission to be mindful of the international competitiveness of the sector and its position as the nation’s leading net export earner contributing £47 billion to the Exchequer last year, its role as a major employer employing 2 million people across the UK (two-thirds outside London), and the fact that it has many aspects that extend well beyond banking, such as insurance, asset management and investment.

15 January 2013

1 “Control functions” include Risk, Compliance, Internal Audit and Legal functions. UK control function FTE as proportion of total UK banking FTE: 2007: 3.7% 2011: 4.6% (increase of 26%)

Prepared 24th June 2013