The Conduct Risk Conundrum

Starling Team

Conduct-driven scandals continue to plague the banking sector, despite punitive fines in excess of $345 billion since the Financial Crisis, and attendant public outrage. Extensive regulation has been introduced in an attempt to prompt ethical behavior, and organizations have responded with reactive measures. What is needed instead is a proactive approach to the culture and conduct risk conundrum.

The global impact of misconduct

Misconduct and related scandals have been an unfortunate feature of the financial industry for decades, in every key financial market. Today, however, this challenge is receiving unprecedented attention: from customers, employees, shareholders, regulators, policy-makers, and society more broadly. Consider three prominent recent examples.

Perhaps most poignantly, at present, Australia has just endured a year-long investigation into misconduct among its banks, known as the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. To say that the findings were upsetting is an understatement.

As detailed in its Final Report, released on February 1st, misconduct among the Australian banks in recent years has been fairly shocking in both nature and degree: charging fees for no service; plundering the accounts of the dead for “financial advice” and even life insurance (without hint of irony); and more. High profile hearings that preceded the production of the Report have led to public uproar, punitive fines, rolling heads, and a reshaping of the Australian regulatory apparatus.

Events in Australia take place against a backdrop of misconduct scandals in several other major markets. As the Commission’s Report was being released Down Under, in the U.S., the headlines were filled with news that Goldman Sachs might withhold or even claw back millions in remuneration awarded to senior executives, to include former CEO Lloyd Blankfein, following the “1MDB scandal” in Malaysia, which involved alleged fraudulent activity on the part of Goldman employees.

And, at about the same time, in Europe, eight global banks were accused by the EU Commission of collusion in rigging the sovereign bond market. Investigations continue but billions in fines are expected. Again, this comes as a consequence of alleged misconduct that leadership failed to prevent.

Misconduct in the banking and finance sector may not necessarily be a larger issue now than it has been in years past, but today attention to such concern certainly seems to have reached new levels and, more and more so, firm culture is looked to as an explanation.


How did we get here?

As former NY Fed president William Dudley has styled it, “Context drives conduct.”

While “tone from the top” may be an important driver of what employees believe to be acceptable behavior, the far larger driver is the behavioral expectation of peers. Tone from the top acts a bit like the speed-limit sign at the side of the highway. How fast one actually drives, however, is largely a function of how quickly the cars around you are moving. Firm culture operates in a similar manner.

The ability to manage conduct successfully therefore turns on an ability to properly understand the underlying cultural drivers of that behavior. As leading network scientist Nicholas Christakis offers in a recently published column, “Dishonesty, proscribed behaviors, and fraud may well spread via processes of social contagion, like all other observed human behaviors. It is not about bad apples; it is about bad barrels. People will behave in a risky manner when they perceive that their peers are doing similarly.”
In the last few years it has become increasingly clear that regulators understand this, and they have begun to call for “culture audits” as a means of proactively anticipating misconduct and, thus, off-setting the risk thereof.


The path to better conduct and risk management

If culture is to be managed it must first be made “visible” and actionable.

In a recent speech, the NY Fed’s head of supervision asked how data analytics tools might be helpful in this regard. “The potential of big data analytics to revolutionize approaches in many areas of business has been talked about for years, and is now beginning to become a reality,” he argued, anticipating that “we might see firms routinely leverage broader data to make stronger predictions about potential misconduct risk.”

Computational social science has much to offer us here. It is well established that interpersonal trust and perceived ‘psychological safety’ among employees and managers is key to creating high-performance teams within the workplace. Computational social science techniques allow us to measure and map these interpersonal trust dynamics, sifting signal from company data sets to produce heretofore unavailable insights into the drivers of employee conduct.

RegTech firms like Starling are putting these new computational capabilities to work, building tools that provide management with actionable insights by sifting through massive company data sets to distill “digital artifacts” that point to likely behavior and performance outcomes, with high predictive reliability.

Through such data analytics, company leadership is positioned to engage proactively to anticipate, and shape, culture and the behavioral consequences that impact the organization and its stakeholders.


Starling Advisor Martin Wheatley on Regtech Trends | Thomson Reuters

Starling Team

Martin Wheatley, former CEO of the UK Financial Conduct Authority and advisor to Starling, recently sat down with Thomson Reuters to discuss current developments in Regtech. Martin brings a unique perspective the space as the former head of one of the most influential financial regulatory bodies in the world.

Now active in the private sector, Martin offers insights into the opportunities offered by new technologies which can help solve long-standing problems in the industry. At the same time, there remain obstacles that slow adoption. Martin goes on to describe how many regulators, including the FCA, have stepped into this environment to set up sandboxes and otherwise to encourage experimentation.

This interview was originally published for Thomson Reuters subscribers on Thomson Reuters Risk Intelligence service.

Read the interview in full here: THE BIG QUESTION: Martin Wheatley, Former CEO, UK FCA


An Industry Shift is Required in Response to The Australian Royal Commission

The Australian Royal Commission into Misconduct in Banking, Superannuation, and Financial Services publicly released their Final Report earlier this week. Today, the Governance Institute of Australia (“GIA”) weighed in with their perspective on how the industry must respond to the report which caps a traumatic year of testimony and public scrutiny into the culture and practices of its members.

Recognizing the fundamental impact the industry has on the economy as a whole, the GIA notes that “How these institutions respond to Hayne’s report will be vital, because building long term stability and performance of the sector will determine the health of the Australian economy as a whole.”

At the root of the scandals and misconduct revealed by The Royal Commission is a common culture which treated compliance as a purely mechanistic exercise while failing to as the fundamental question which is “Should We?”. Instead, management teams across the industry chose to ignore clear warning signs because their activity was technically ‘compliant’. In the GIA’s words, “[Reform] cannot be based around an attitude of it being a ‘box-ticking’ exercise for compliance purposes.”

What is needed is a wholesale rethink of governance and the tools that executives use to measure and manage their cultures for accountability and to rebuild trust with the public.

Read the article: Royal Commission: Governance Culture of ‘Box-ticking’ is Over

Read the Royal Commission final report: Final Report – Australian Royal Commission into Misconduct in Financial Services


Australian Royal Commission Signals Changes to Come in Australian Regulatory Oversight

Starling Team

The Australian Royal Commission into the financial services industry is entering its final phase but it is already having a profound impact on the Australian financial sector – and not just in how banks manage misconduct, but in how they are regulated as well.

To this point, following on the Interim Report from the commission, the Australian Financial Review offered an editorial on how the Commission will potentially change how regulation is handled in Australia. The report, published this past September, had an implicit message that “…trust in the banks won’t be restored unless the public trusts their watchdogs to enforce the laws of the land.” Initiatives such as the Royal Commission are finally recognizing that misconduct is not a problem of lone wolf actors. Rather, it is a systemic problem that requires both banks and regulators to adopt new strategies to manage.

The final report is due in February and whatever that report says, it’s clear that banks should expect greater enforcement efforts from ASIC and APRA and that “more legal cases, especially criminal matters, will sharpen the focus of boards and management on risk culture, and send a strong message to the public that misbehaviour is not tolerated, while acting as a deterrence.” In fact, the new Bank Executive Accountability Regime (BEAR) will hold individual executives liable for failures to provide adequate oversight.

The G30 adopts a similar philosophy to the Hayne interim report. They suggest in their most recent whitepaper titled Banking Conduct and Culture Change: A Permanent Mindset Change that stamping out misconduct doesn’t require extensive new regulation. Instead, the regulators will be looking to the banks to come up with better measures for and means (i.e. technology and tools) of managing such risks.

Read the article (paywall): Banking royal commission: How Hayne will change the regulation of banks


Elevating Risk Management Beyond the 2nd Line

Starling Team

As the risk management function matures, firms are looking to evolve beyond a focus on high-profile risk mitigation towards a more cost-efficient and strategic business function. This transformation comes as many banks are incorporating artificial intelligence into their 1st line of defence operations to increase efficiencies and to reduce opportunities for misconduct to affect bank activities. As these authors from Grant Thornton discuss in this article on the Risk Management website, bank leaders are increasingly looking to the risk management function to take on a more strategic role.

There are a number of forces driving this trend. First, banks are realizing that effective risk management must be tightly integrated into business strategy and receive strong support from leadership. Second, management is looking to streamline costs even as they also feel pressure to justify the effectiveness of that spend. Finally the scope of risk management is expanding as it must accommodate new innovations being introduced in the largely unregulated fintech sector. Going forward, risk management will not be viewed as merely a “second-line activity”, but will be viewed as having a prominent role in improving business performance.

The authors go on to recommend that, “Institutions need to establish a framework for measuring risk effectiveness as a first action.” At Starling we are working with executives across the globe to apply Starling’s predictive behavioral analytics platform to measure the key behaviors that support effective risk management and to predict how those behaviors drive critical risk outcomes.

Read the article: Transforming the Risk Function to Increase its Effectiveness