Banking StandardsWritten evidence from John N Reynolds OBE
1. Executive Summary
2. The major ethical failings in banking surround two issues: first, being prepared to ignore the duties of care to customers (and in some cases to deny that they exist), resulting in ethically unacceptably conflicts of interest; and second, a widespread tendency to subjugate truth to adherence to strict literal statements of fact which may nonetheless be actively misleading.
3. Banking, in order to protect its shareholders, customers and the taxpayers, requires both an external and internal impetus to require ethical behaviour, including proscribing both general and specific unethical practises.
4. Banks—and investment banks—need to reform their current inadequate codes of conduct to provide meaningful guidance to employees at all levels.
5. Background
6. This paper has been written by John N Reynolds, author of “Ethics in Investment Banking” (Palgrave Macmillan 2011, co-authored by Edmund Newell) and from 2006–2011 Chair of the Church of England Ethical Investment Advisory Group. I originally studied theology, including studying ethics, before commencing a career in investment banking. I am currently a director of a number of companies, and have recently been appointed a member of the Methodist Church Joint Advisory Committee on the Ethics of Investment (JACEI). I do not, at the time of writing, work for any bank or investment bank. I had a career of around 20 years in investment banking, and have worked for UK, European, Japanese and US institutions in various senior roles. As an investment banker, I have worked in four major areas: equity research, corporate finance, financial restructuring and principal investing. I have also been a client of investment banks, including the investment banking arms of universal banks. I do not, at the time of writing, work for any bank or investment bank. This paper is written in a personal capacity and represents the views of the author only.
7. This paper looks specifically at standards in investment banks and “universal” banks (integrating investment banking and commercial banking). It does not seek to comment specifically on retail banking.
8. Submission
9. An external requirement to behave ethically would enhance reforms to the banking and investment banking sectors to ultimately protect customers and taxpayers, reducing the scope for banks and investment banks to circumvent specific rules.
10. Professional standards in banking and investment banking are in general terms similar to those in business generally in the UK, but the impact of ethical lapses can be very significant, given the size of modern financial markets. This places an nous on the banking and investment banking sectors to behave with a heightened awareness of their ethical duties.
11. There has been increasing institutional pressure by banks to deliver high returns, a pressure which in a number of cases originates from the banks’ own institutional shareholders. Such pressure results in a management requirement on bankers to increase revenue and profit, and this can be at the expense of ethical standards and client care. Challenging such a mandate can be career limiting for a banker.
12. There is a clear dichotomy between the standards a bank espouses publicly (in its advertising) and the attributes looked for among employees (such as a desire to make money). Such a dichotomy is no different than that found in many areas of commerce, but is nonetheless unhealthy.
13. My personal experience of banks in the UK, over the course of the past 20 years, has been of strongly professional behaviour in most circumstances, in a prevailing environment where almost the only pressure on senior management is to deliver revenue growth. Bankers are aware of the need to behave professionally and ethically, but little thought is actually given to what is truly ethical or unethical, as opposed to what is legal or compliant.
14. There are two common failings which tend to undermine ethical standards, but which are commonplace and are not seen as unprofessional: first, being prepared to ignore any duty of care to clients; and second, preferring a reliance on strict factual accuracy over communication of the substance of a statement or situation.
15. The result of this would have been expected to reduce trust in the banking sector. However, as both a banker and a client of banks, banks do not seem to have suffered a loss in business from most categories of corporate clients. This is itself seems at first to be surprising. However, it can be explained by understanding the corporate clients do not tend to seek ethical behaviour in a banking relationship, so much as efficacious behaviour—the clients of a bank are typically looking for a “mercenary” rather than a “trusted advisor”.
16. The causes of the problems are complex, and relate primarily to: a general low level of ethics and understanding of ethics in business, not just in banking, often reflecting low prevailing ethical values in society.
17. In my own experience, the impact of the opening of the UK investment banking market led to a dramatic increase in technical standards, but a reduction in relationship-based banking. A major part of this has been the ability of US-based institutions to successfully develop businesses in the UK and Europe, directly resulting in increased competition in certain areas. The US market is characterised by a more atomised market place, where corporations will shop around for suppliers of individual banking products, which in Europe are more likely to be sought from a single bank.
18. The business practices in the UK, the US and in major European markets vary considerably. However, this does not mean that underlying ethical standards are markedly different. Business practices reflect many facets of a country, including prevailing social values, and industry structures. I have worked extensively in the US, for example, and have not found ethical standards in business or society generally lower than in the UK.
19. The internal culture within investment banks, and the investment banking arms of universal banks, is often based on patronage by individual senior bankers. This results in loyalty required to be shown to individuals rather than the organisation in order to achieve promotion (and pay). There is relatively little attention paid to management training in investment banks, and this can have a clear impact on culture, and may explain in part the recurrence of internal cultural problems in the sector. This is important in an environment where an increasing proportion of both profits and senior management in universal banks appear to come from their investment banking arms.
20. The standards of investment banking seen recently in some emerging markets are significantly short of those tolerated in the anglo-saxon world, and are a cause for concern about the industry generally, giving the increasing percentage of fee income achieved from these markets. This can be seen for example in the standards of care taken in the initial public offerings (IPOs) of some companies in parts of Asia with poorly considered business cases.
21. The integration of lending and advisory activities can give rise to clear conflicts of interest, which the investment banking sector has been allowed by regulators and clients to embrace. I was told by a main board director of a major quoted bank some time ago that “conflicts of interest = revenue”, which from a commercial perspective is very accurate, but from an ethical perspective gives rise to a number of concerns. Banks are not alone in this approach, and there are apparent conflicts of interest in other professions as well.
22. An obvious example of conflicts of interest relates to advising a seller of a business at the same time as lending to a buyer. It has become almost commonplace for a bank to advise on the sale of a business while simultaneously advising on the financing for potential buyers. This can be done on a basis formally agreed with the seller, and as a service to the seller, through “stapled” financing (that is, a financing product available to any buyer), or alternatively by advising individual buyers. This latter practice creates a particular conflict of interest, as financing fees are typically a multiple of advisory fees. A number of recent court cases highlight the problems inherent in this approach.
23. The management of conflicts is possible without requiring the separation of commercial and investment banking, provided appropriate regulation is adopted. The current practice of banks, which in general terms is to disclose such conflicts, is not sufficient to genuinely ensure that there are no meaningful incentives to breach the duty of care to clients.
24. Improved governance and ethical behaviour is not, in my opinion, possible without clear regulations regarding conflicts of interest, and also without specific external requirements for Boards to have regards to ethics in general terms.
25. I have found advisory-only investment banks to have a greater regard for ethics and standards of conduct than universal banks. This may be because such firms are hired almost entirely on reputational values, rather than on the basis of their capital strength. However, a corollary to this is that the presence of an advisory function within a universal bank may provide internal pressure for higher standards of behaviour, and mitigate against a separation of investment banking from banking.
26. Major banks and investment banks publish a code of ethics or code of conduct to guide their employees. Having reviewed many of these, they are universally disappointing and in practical terms useless. In large part this is because they (i) primarily aim to protect shareholders, rather than customers, and (ii) signally fail to explain in any useful detail what “ethics” or “integrity” should mean in practice for an individual working in the company. Such codes need to set out practical guidance on how to deal with ethical questions, which at the moment they fail to do. In doing so, the ethical duties of the bank need to be clearly set out, as well as the ethical rights, and a process for dealing with a conflicts between ethical rights and duties clearly explained.
27. It is noteworthy that virtually no code of ethics in the banking sector addresses the question of whether there are any sectors or companies which it would be ethically wrong to have as clients, even though such a view is the starting point of investment policies for ethical investment funds.
28. The argument that codes of ethics cannot go into detail on business practices because of the range of activities within a major universal bank is to my mind specious. It would result in a code of ethics being a lengthier document, in the same way that an annual report for a large company is typically longer than for a smaller one.
29. It is not feasible to assume that in any bank of a meaningful size it would be possible for non-executive directors to routinely review decisions over whether business is conducted. It is however desirable that non-executive directors should not be appointed because of their ability to refer business to the bank or to simply add prestige to the bank (both of which happen frequently).
30. It is difficult, and in practice counter-productive, for individual banks to adopt markedly different ethical standards to the sector as a whole. This would not be the case if clients would choose their banks—or stop using them—based on positive ethical standards or on particular public malpractice in this area.
31. It would be of significant value to have an industry-wide banking or investment banking ethics-committee able to give clear guidance on ethical issues, and to take sanctions against firms which did not comply with such guidance. The UK investment banking industry already has a similar type of approach involving the takeover of quoted companies in the Takeover Panel, a model which could be extended to cover ethical questions.
32. The widespread development of derivative products such as Credit Default Swaps which can provide an incentive to reduce the value of an underlying business is a cause for concern. However, some form of sanction against parties actively seeking to inflict economic damage may have some benefits, although it is unclear how the line could be drawn between that the result of legitimate competition or accurate financial forecasting. Given the complexity of this area, a high level of transparency in such products would be the most obvious beneficial step, without risking creating wider economic inefficiency which in turn would damage parts of industry.
33. Restrictions in the ability to short-sell would undermine market efficiency, and are not supported from an ethical perspective, as the underlying process of short-selling is not specifically destructive.
34. Criminal law regarding banking products and markets is inconsistent. For example, there are differentiations between products traded on and off recognised markets—it can be legal to trade in bank debt of a company at the same time it is illegal to trade in the bonds of the same company. Rationalisation of this situation is urgently required.
35. The compliance function within banks and investment banks is frequently seen as a necessary evil, and compliance officers as on a less impressive career track than their colleagues in the “front-office”. Compliance tends to become a “tick-box” culture. I have been in compliance training sessions where I have been told that I am legally required to be present, but do not have to listen to the presentation. This is mainly the case because of the irrelevance of much of the information which it is mandatory to cover in such sessions. The overall approach to compliance needs to be changed in order for it to be effective at more than ensuring strict compliance with legislation without considering wider ethical issues.
36. Board of banks/investment banks need to understand the underpinning theories of ethics. My experience of banks, and of other major companies, is that their ethical thinking is typically utilitarian eg along the lines of “we’re not as bad as the others”. Alongside utilitarianism, an understanding of rights-based, duty-based and virtue ethics is important, together with the limitations of utilitarianism and the dangers of moral relativism. As part of this, it is important to understand that being legally compliant is not enough to satisfy ethical requirements on an organisation or on individuals within the organisation.
37. Boards of investment banks should require all employees with decision making or client facing roles to confirm in each reporting period that they have complied with their employer’s code of ethics (which should be comprehensively redrafted to focus on protecting the duty of care to clients as well as to shareholders).
38. Without a change in ethical standards within the banking and investment banking sector, which requires both an external and an internal impetus, I do not believe that reform of banking practices will be successful in protecting customers and reducing risk to both customers and the taxpayer.
39. Summary of Recommendations
40. There is a need for a pragmatic, pluralist approach to ethics in banking and investment banking, in which deontological and consequentialist principles go alongside cultivating virtuous behaviour in the workplace, but where deontological ethics take precedence in order to give clear guidelines about what is good, acceptable or unacceptable behaviour from an ethical point of view.
41. There would be a benefit in the creation of a banking/investment banking “ethics committee” on an industry-wide basis, modelled on the successful Takeover Panel, able to determine major ethical issues. This would resolve the current risk of commercial under-performance resulting from ethical decision by an individual institution.
42. Boards of banks/investment banks should be required to have regard to ethics.
43. In addition to a requirement for banks to train employees in compliance, there should be a requirement for training in ethics, so that bankers at all levels are able to judge if what they are being asked to do is in breach of their requirement to behave ethically.
44. Codes of conduct should be revised and should be required to clarify that when in conflict a firm’s duties to its stakeholders outweigh its own rights. Clear explanations of the practical meaning of terms such as “ethical” and integrity” should be given, eg through case-studies.
45. The two specific problems highlighted above—conflicts of interest, and deliberate misrepresentation of facts—should be highlighted and addressed in codes of ethics and through either or both of legislation and regulation.
46. Legislation relating to trading practices and market behaviour which differentiates between on and off-market and recognised and unrecognised exchanges should be rationalised to ensure that a consistent standard of behaviour is required in all circumstances.
22 August 2012