Introduction

On October 20th 2014 Governor Daniel K. Tarullo of the Federal Reserve (Fed) gave a speech1 in New York on banks’ compliance culture noting the need for change and presenting possible regulatory responses and suggestions for banks to consider.Governor Tarullo notes in his speech that while many events that took place prior to the crisis were disturbing, post crisis compliance failures have been noted including; LIBOR (London interbank offered rate) and foreign exchange rates, front running through the use of dark pools, facilitating tax evasion and poor money laundering controls.

The Governor notes that firms are still not going far enough to reduce compliance concerns:

“Behind much of this malfeasance lies something other than the excessive credit and market risk that led to the crisis itself, although there may be some common roots of these problems. The hypothesis that this is all the result of “a few bad apples,” an explanation I heard with exasperating frequency a year or two ago, has I think given way to a realization within many large financial firms that they have not taken steps sufficient to ensure that the activities of their employees remain within the law and, more broadly, accord with the values of probity, customer service, and ethical conduct that most of them espouse on their websites and in their television commercials.” 2

Influences on Behavior

The Governor stated that “The norms are of course related to the rules, guidelines, structures, incentives, and punishments that the organization creates. Indeed, one important determinant of behavior is the shared expectation as to which of the stated values and rules of an organization will be supported and reinforced by management action, and which are generally regarded as window dressing.”3

Besides the obvious written Board of Directors instructions to senior management; The Governor notes several other influences on behavior:

  • The revealed preferences and choices of employees and how these can affect a firm’s culture.
  • For a financial institution, external influences and constraints including:
    • Shareholders
    • Market analysts
    • Regulators
    • Prosecutors
    • Elected officials
    • The media
    • Public sentiment

Nature of Risk Management

The Governor states “Unlike most non-financial firms, a financial institution more or less continually makes risk decisions, whose implications can vary significantly based on the nature of the asset involved, market conditions, counterparty identity, and many other factors.”4

The approach to compliance risk management divides firms’ approaches into 2 categories:

  1. In some firms the attitude the Federal Reserve Board (FRB) perceives is one of mere compliance exercise. The firm proceeds to address the deficiencies identified by the Fed in a discrete, almost check-the-box fashion.
  2. Other firms, by contrast, seem to have internalized the aims of the risk-management processes and systems that the FRB expects of them. In these firms the dialogue can be quite different, with supervisors observing that, even as a specific problem is addressed, the firm has gone back to think about how the identified shortcomings fit into their overall risk decision-making and management processes.

The Governor clearly states in his opinion that the second process is preferred and is the direction the FRB will be taking going forward. He thus raises a likely question for concerned firms:

  • “Do employees understand their job to be maximizing revenues in any way possible so long as they do not do anything illegal, or do they understand their job to be maximizing revenues in a manner consistent with a broader set of considerations?“5

The governor referenced a recent academic text that may help in developing the underpinnings to any changes banks may wish to undertake.

  • “To encourage behavior among their employees that reflects something other than a narrow mentality of compliance and constraint, firms need to take tangible steps that reinforce stated norms such as respect for customers. Some interesting possibilities along these lines are suggested in a recent book by Thomas Huertas, a former UK banking regulator.”6

Mr. Huertas’ idea is to develop a compliance score similar to the credit score banks are accustomed to using.

Rewards and Punishments

“An important determinant of behavior in any organization is the system of rewards and punishments applicable to its employees. Assuming that they are able to discern factors that generally explain patterns of hiring, raises, promotions, demotions, and dismissals, employees receive very strong signals as to what those running the organization actually value. This set of signals has, I suspect, considerably more influence on employee behavior than a corporate statement of values or purposes, particularly if the system of rewards and punishments appears at odds with that statement.”7

The deleterious effects of many incentive compensation arrangements were recognized by firms well before regulators began to focus on them. However, the problem of matching the revenues that served as the basis for calculating bonuses, which are generated immediately, while the risks associated with these revenues might not have been realized for months or years after the transactions were completed, has not yet been resolved.

The Governor states:
“There is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees. In many cases risk metrics need to be better targeted to specific activities, and risk adjustments should be more consistently applied. And it is important that compensation arrangements, including clawback and forfeiture provisions, cover risks associated with market conduct and consumer protection, as well as credit and market risks. These kinds of improvements would give more precise signals to employees as to the risk calculus expected of them in making decisions that affect the firm. I hope the long-awaited interagency final rule implementing section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act will be forthcoming in the not-too-distant future, so as to provide a common objective baseline for incentive compensation programs.”8

Strategic planners may wish to incorporate the reference into current plans thereby documenting the blueprint that will be used by HR and management in developing future year compensation packages.

The Governor took time to note the “stick” which may be used if firms are slow in implementing changes:

“Banking regulators do not have criminal enforcement powers, of course. But we can, and do, require dismissal of employees as part of our enforcement actions against firms. And we do have the authorities to remove malefactors from their positions in any institution that we regulate and to prohibit them from working in the banking industry. Somewhat like criminal prosecutions, these are not easy cases to make. But it is important that we be willing to expend the resources to initiate such actions in appropriate cases.”9

Conclusion

By making a public speech and referencing the broad criminal powers at the disposal of the FRB, the Governor is likely signaling to other Central Banks, mainly Canada and the UK (which have moved more quickly into this area) and the US market as a whole, that this will become a future regulatory concern.

Accenture’s analysis indicates that this topic has moved up the radar with other international regulators (Canada and UK).We believe this topic is emerging and anticipate additional comments on the subject from US regulators.

Sound business practices would suggest that current work in this area by HR and/or compliance be identified and highlighted as a matter to bring to the attention of risk committees during their next scheduled meeting. As with other ongoing regulatory changes there is a high probability that sufficient documentation is in place to demonstrate the firm’s seriousness in addressing the concern.

References

1.     “Good Compliance, Not Mere Compliance,” Governor Daniel K. Tarullo speech at the Federal Reserve Bank of New York Conference “Reforming Culture and Behavior in the Financial Services Industry, New York. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20141020a.htm.

2.     Ibid

3.     Ibid

4.     Ibid

5.     Ibid

6.     Ibid. Governor Tarullo is referencing a book by Thomas F. Huertas published in 2014, “Safe to Fail, How Resolution Will Revolutionise Banking,” (London: Palgrave Macmillan), pp. 158-59.

7.     “Good Compliance, Not Mere Compliance,” Governor Daniel K. Tarullo speech at the Federal Reserve Bank of New York Conference “Reforming Culture and Behavior in the Financial Services Industry, New York. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20141020a.htm.

8.     Ibid

9.     Ibid

Newsletter Author: Craig Unterseher

Newsletter Contact Person: Hamish Wynn, Janki A.Shah

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Accenture Regulatory Compliance Team, Finance & Risk Practice

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