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this is frm part 2 book 3 operational risk and resiliency and the chapter on banking conduct and culture this chapter is part of a series of chapters on operational risk with an emphasis on behavior and culture so of course there's going to be some overlap in topics that we've discussed before but there are a few added value items inside of this chapter that are worth noting and of course worth knowing for examination purposes as you look at the learning objectives some of these might sound familiar from previous chapters look at that second one explain methods to improve corporate culture that has been a theme throughout these first several chapters in this in this book and then of course will have to summarize national regulators we always have to talk about regulators and their input into the corporate structure and the decision-making process and then we'll go ahead and have a slide on best practices let's go ahead and start discussing about this topic of company culture and we've seen this definition in some previous chapters but it probably bears repeating system of shared beliefs and values and behaviors that shaped conduct I like that part of the definition and then I like the positive reputation for banks when I think of culture in an organization I can't help but think about one of my favorite sports and this is going to be one of my sports analogies that translate back in to the operation of financial industries you know I have been I've been a golfer my whole life but I've never done it at any kind of competitive level however one of my son's is a pretty competitive golfer ever since he was just a little boy and when you go and show up at these junior golf tournaments or the tournaments that he plays in now there is a culture and the culture is based on the simple fact that everybody playing and everybody spectating expext expects the golfers to play by the rules of golf which have been established by really really smart men and women for a really long time period and here's my point about the culture you can do it you can do a search and you can find out that there are a few golfers over the years who have been accused of boy bending the rules of golf maybe can I even use the C word maybe they they cheated and the rules of golf and this is pretty much how they're remembered and so one of the great lessons I've taught my son is that look I don't care if you shoot 150 count your scores just do it honestly this is the whole idea of integrity and so I can't help but think that this golfing culture that promotes and it encourages and punishes individuals for violating the culture of honesty and the mathematics of adding your scores and then the mathematics of playing by the rules can't be applied to financial institutions I mean look at this company culture as a strong influence on employee behavior the culture of honesty in golf influences every golfer that's competing from the junior level all the way up to the professional tours look both written and unwritten rules this is extremely important in golf although golf has has written rules but there are unwritten rules as well and this applies to financial institutions as well if you have a strong leadership in the board of directors and those banking executives then that leadership will filter down to all of the golfers throughout the organization of course now some important points that the introduction of this chapter discusses are shown in those two block points there at the bottom all right culture also comprises Banks values and ethics so whatever the source of those values and ethics are is going to be the idea of bringing this corporate culture bringing this company culture together so that everybody inside of the organization can act can act as a team now I've used this example in the past and and maybe you guys remember this now you think about it if we're a bank and and you and I are the bank representatives inside of this physical location and we have two clients come into the bank one of the clients has money and wants to invest it another client needs money and wants to borrow it and so here's the idea we need to have a culture that enables us to make the most efficient and effective decisions for those particular clients let's take an extreme example let's suppose the one client comes in and says I would like to borrow a million dollars because I'm convinced that this particular horse is going to win the Kentucky Derby and I want to bet a million dollars on this race the person that comes in the client that comes in that has a million dollar says look I have a million dollars I want to use it as maybe collateral or maybe a margin account and I want to take the long or the short position in a Kentucky Derby futures contract all right so we need to take a deep breath remember we're agents of this financial institution we need to think back alright what does the board of directors say about horse racing and maybe they don't say anything about horse racing but clearly the board will say something about risk management principles do we want to take this amount of risk right horse racing who knows how much risk there is you know do I want to go that far out and so it might be that it's our job it's our responsibility it's being good stewards of the bondholders and the shareholders capital on the right hand side of the bank's balance sheet that we can take these two clients we can mold them in something that is better for them and better for us clearly leveraging to play a horse race is probably not consistent with the risk-return objectives outlined by the board of directors all right but do you see my point and my point leads right into the second block point at the bottom each firm has its own unique culture and so it's probably true that most financial institutions are not going to get involved in in gambling and horse racing betting right probably not but but we have these clients they're not our only two clients and they're come one right after the other and we need to decide that we have low risk clients and we have high risk clients and so this company culture is going to allow us to make these decisions okay so let's swing back up at the top a system of shared beliefs and values and behaviors that shape conduct all right so this is extremely important what are we trying to do goal of any business is to maximize the value to the owners of the business right and so we have these clients come in it's our job then to provide a scenario under which both of those two individuals can walk out of the bank with smiles on their faces here's an interesting figure that relates inputs versus outputs and so go let's just start at the bottom left down here Bank history and I'm gonna go back to my golf example those of you who are golfers probably know that golfing as a sport you know wasn't invented 5 or 10 years ago I mean it was developed over I mean literally hundreds of years most people attribute this back to the Shepherd's you know somewhere in Europe but it could have been in almost any part of the country because Shepherds had a stick and and they had rocks and so they probably just hit those rocks around and so over I mean literally a thousand a thousands of years I mean there's evidence that Shepherds were existing you know back I don't know three thousand four thousand years ago and so over time there was a culture of rules and then there was you know a sidelight to this a culture of gambling you can see two Shepherds out there saying I bet I can hit this rock farther than you can and so they had to play by rules so this golfing culture of honesty has evolved for a really really long time and so this is important to his view in terms of a bank's history now of course with in the financial institution industry we have got lots of mergers and lots of acquisitions so it's not like every bank out there can go back to the time of the Roman Empire but clearly there is a bank history that has individuals and teams of individuals well that whether they started inside of this particular Bank or came from other banks so the bank history is extremely important the Board of Directors then is charged with the responsibility of consuming this Bank history and then forming it to some strategic plan for a layout of the future and so look where culture fits in their conduct and behavior values and ethics and again let me emphasize it doesn't really matter where those values and ethics come from as long as they are based on the notion that all clients are created equal all clients should be treated fairly and with respect and all clients should be informed of the risk and return opportunities that are available for their specific needs and so education of the client and education of the financial managers of course as all part of that culture so you take those inputs and then you throw them over into outputs and what does this mean so here's our two clients walking in walking into our Bank reputation and Trust value and ethics so these two clients come in and they want to invest somewhere in the Kentucky Derby and and they walk out and maybe instead of instead of a million dollars investing in the Kentucky Derby maybe we get them down to $10,000 in the Kentucky Derby and then we take the rest of that and we form some weld Sofya portfolio that fits their needs and their particular aspirations for future outcomes alright so if you think about that having those two clients leave our bank with smiles on their faces then that has to translate into some acceptable preferred desired financial performance that will be Illustrated and evidence will be shown in the financial statements now here's a great question why are we even having this conversation now of course hopefully the last few minutes of this conversation will indicate that this is really important but here are some examples high profile public scandals I do know a little bit about some of these and I'm guessing you guys do as well so I won't comment on them too much but I will go over to the JP Morgan the London the London way I think that guy's name was Bruno you know he was just trading credit derivatives and trading credit derivatives and it was almost like he was working in a closet and nobody even knew the closet was there and then somebody opened the closet and looked at him in there and then closed the closet door and then sooner or later somebody opened it and then all those losses came out and so if you if you look at these examples I mean these are examples of of I don't know illegal behavior criminal behavior unethical behavior immoral behavior you know something like this and they are this these scandals can be seen in each almost each part of the balance sheet for a financial institution now trying to address this concept of why is conduct and culture so important there was a survey done in which clients out there were asked the question how much do you trust in each of these different kinds of sectors and so if you look at you know this is 2015 out to 2019 this is technology 74 to 78 so you know there's a trend I look over in the right right column you know those trends are pluses but you know the interesting part of this table is that financial services starts out at the bottom and ends up at the bottom and so it's the responsibility of the individuals which is you and me inside of the financial services industry to who move that barometer from being at the bottom you know all the way up all the way up to the top I mean seriously think about financial services to do clients and potential clients and consumers of this services inside of these industries are we really that far behind energy and entertainment sure seems like it oh I be fascinated don't you think would be fascinating to see what the 2020 results would be after the kovat 19 now of course one of the learning objectives has to be it has to be alright so we know that conduct and culture are important so the question then becomes alright how do we make sure that we get there so what measures what measures have banks taken to improve in in these areas and this is where there's been some there'll be some overlap and so I'm just gonna quickly go through a couple of these I mean look at that first one board a board of directors so heightened engagement by the board and don't forget the senior leadership communication and training programs of course now remember we've got this umbrella and then we have these different silos or business lines and so you've got to train and communicate inside each silo and then and then cross siloing I'm pretty sure siloing is not a word we've also had some good conversations about remuneration and compensation of course if you want your employees to behave in a certain way then it makes sense to provide them with some incentives and so you know you're gonna say something like you know what I want you to do this and this and this when a client comes into the office and if you do this and this and this and the outcome was positive well then I'll pay you a bonus or something like that and then let's skip down to the bottom one and just pretty quickly you know of course you guys know this better than I do that you know financial services industry you know it's it's innovating and it's engineering all the time and so one financial institution that is has a history of mortgage-backed securities may find itself belief may find itself itself leaping pretty quickly over to credit derivatives all right so new product approval and then the appropriate governance structures in accord with that new product approval and then everything with pricing and risk management and so those four those four block points we have had a conversation with those before but look at the fourth one there and this is one of the important components of this particular chapter and it probably should be a point of emphasis on the exam so how about not just a first line of defense but a second and a third line of defense now I have a slide a little bit later on that I'll explain these in more detail but historically what's happened is that most financial institutions have have a first line of defense so I want you to think about you know a football game and you know the defense they're 11 people on the defensive line of scrimmage and so there's usually three or four or five defensive linemen that's the first line of defense and then there's usually two or three or four linebackers there's the second line of defense and then there are three or four secondary people in the back they're called secondary even though it probably was the third line of defense secondary because of the people up front don't make the tackle then they are responsible for making a tackle so I want you to think about these lines of Defense's as the defense on a football field you got the first line you have the second line and you have the third line and of course those of you who are football fans know that sometimes running backs are fast enough and quick enough and elusive enough that they can score a touchdown right however in a financial institution if that first line in that second line and that third third line you know fill in the gaps and complement each other then then there should be no touchdowns and given up from the 50-yard line right I mean there going to be some losses in any organization but we don't want to give up the big loss now this slide is a summary of some extra value added in this particular chapter that we've kind of danced around in the previous chapters but this is a good one to probably know and and this is one of those common-sense kinds of slides you know motivations to do this art to build trust and reputation all right we you know we can live with that regain public trust but I want to come back and talk about that here in just a second let's skip ahead the second one and look at this third one here you know what's the goal of the business maximize shareholder wealth of course we know that one of the ways that financial institutions do this is to of course beat the other bank - whatever that market share is look at this fourth one here of course how do we maximize shareholder wealth well we hire people who are way smarter than we are I mean I tell my children this all the tim
I tell my students that's the greatest decision that I ever made in my life was 30 years ago I married my wife who is smarter than I am she's funnier than I am she better-looking than a half she's not more athletic than I have but anyway you know so what so what no my wife has brought me up and has helped bring my children up and and of course you know that has lots and lots of positive consequences and so I love that fourth one there to encourage new talent to join the industry you you don't want to have this you know one of the seven deadly sins of envy you don't want to envy so you want those smart people to come to be on your team so that they can they can leapfrog you to maximizing shareholder wealth which will then of course come in the form of higher compensation and benefits to all the individuals inside of that firm and of course that fifth one there we always have to talk about regulators and government officials that you know lots and lots of politicians are saying you know greedy Wall Street greedy Wall Street and so a lot individuals hear that and so it's our job to push back on that and push back on that yes we're trying to maximize shareholder wealth but we're doing it in a system in which the culture is benefiting everybody now let's go ahead and skip back to that second one up there to stabilize the broader financial system boy this is a goal that I'm not I'm not quite sure that that we can have that as one of those specific goals that sounds like one of those you know kind of general goals you know like Oh to benefit all people in the world and and but what I want to do is emphasize this you know you can go back what is it now two hundred and forty years or so to that dude Adam Smith who talked about the invisible hand my point here is that that invisible hand and the Adam Smith economics you know in the 1760s and seventeen individual acts in their own self-interest to bring their self-interest to some kind of a trade then everyone's going to be better off because the price that results from that trade is going to be fair right the only way too greedy people can trade is if they have a fair price and so that's part of this motivation is the Adam Smith invisible hand that if we do you know if we do not one and and three and four and five if we do all of those effectively if those clients come into our financial institution and then they leave with smiles on their faces then the mekel will be achieved now of course nothing is easy and there are all sorts of challenges culture and conduct fatigue all right so I experienced this where I teach I don't know if I would call it fatigue but I would call it something like well less than enthusiasm and so you know you get these things and you're thinking okay okay but my point in a previous video was that the way to attack culture and conduct fatigue is to make it part of each individual and each team's DNA another challenge is that of course when you think of a financial institution you think of a lot of really smart men and women with their HP 12c calculators out just punching away and punching away and punching away and doing lots of numbers and so of course of course financial managers have tremendous quantitative skills but this conduct and culture shifts away from the quantitative into the qualitative you know some behavioral issues a lot of a lot of people call these soft skills and so this is the job of the board of directors to emphasize how important these qualitative items are and in fact the board should hire and fire the host qualitatively skilled managers who meet or don't meet the conduct and the culture of the financial institution and then of course the last one there has everything to do with hiring highly skilled leaders now I've seen this and I'm sure you guys have seen this there are just some individuals who are natural leaders and I have had multiple leaders where in the institution's where I have taught or I have thought to myself boy this man or this woman they know what they're doing when they talk I'm going to listen and I'm going to learn and then of course there are others who just get up and talk and talk and talk and you're thinking what am I doing here so so what's that third one say more refine and effective management style what that means then is is finding individuals who are highly skilled leaders so that they can they can form a team and have these team members buy-in to the conduct and culture movement now conduct conduct in the retail banking industry might not be the same as conduct in the ultra high-net-worth portfolio management industry and so they're going to be new and challenging areas inside of each of those gonna call those a silo or a business line and and so this is why you need these business unit managers to be excellent leaders so they can provide guidelines for you know new areas rollin bad apples boy look at this one here poor conduct records freely move from one bank to another alright I have a lot to say about this but I but I won't you know when I've interviewed people over the years whether it's for a you know a teaching position or some of the other committees that I have served on in the not-for-profits in the area when I interview someone well the first thing that I do is I look at the references and I say well let me see what these people have to say about the individual and the candidate and so yes let's pick up the phone and call and let's see what they have to say because you know a letter of recommendation I've never read a letter a letter of recommendation that says you know dear Jim this person who is applying for this job really stinks I've never read one of those so you can't really read between the lines and among all the lines in a letter of recommendation and so so this is what I'm my suggestion here is that you know if we're in the hiring process process it should be relatively easy to identify boy what do I have they're individuals with poor conduct records and then this idea of conduct arbitrage you know they might be able to get away with with pork if the business line managers or the supervisors are not consistent in their application of the guidelines and what is acceptable and unacceptable behavior alright let's go ahead and talk about some recommendations so this is referencing back to a 2015 report by the g30 working group which is actually the author of this particular this particular chapter actually if you go to the G 30 working group web page today I think I I think there are actually 32 in the G 30 but I'm not I'm not a hundred percent on that who cares what the number is but these are really really smart men and women who are trying to figure out what what is important for the financial institution industry today and how does that reflect into more and more behavioral conduct as it moves into the future all right so I think there are six of these recommendations all right fundamental shift in the overall mindset on culture of course that makes perfect sense based on all the stuff that we've been talking about senior accountability and and governance so starts with the board and then goes to the senior executive team performance management and incentive alright so this goes to of course of course you have to have contracts that outline acceptable behavior and unacceptable behavior and part of that contract means that you need to compensate individuals who are going to abide by these new guidelines and in fact promote the financial institution into the whole goal of maximizing shareholder wealth staff development and promotion of course this makes perfect sense so you promote and you've developed teams based on their ability on their ability to continue on this idea of promoting appropriate Bank conduct and Bank culture and then remember a few slides ago I said I had a slide about these three lines of Defense so I so what we have where the football team our first line of defense staff and management in that particular business line all right second line of defense should go to you know the risk management officers and then the third line of defense is some kind of an audit function all right so you think you think about that you got the linemen you have the linebackers and you have the secondary on a football field and here we have these lines of Defense's so imagine this are we going to experience heavy losses because of some mismanagement of operational risk if we have excellent first and second and third lines of defense and I hope the answer to that question is is probably no and then of course you have got regulators and supervisors and government authorities who are kind of hanging around home watching what goes on how much progress has been made boy this is one of those this is one of those areas where you know I think about this as a as a parent you know my children you know the two steps forward one step back whether it's in athletics or academics or socially and so this is probably this is probably what probably a good answer for this particular question and then of course the next slide is one of those ok the bank can make two or three steps back but then we have these high profile cases where we're taking two or five or ten steps bank I'm sorry ten steps backwards I will make one comment about Wells Fargo my father who is no longer with us but in 2016 he was a Wells Fargo client and he was one of those clients who was very interested in the bank making sure that they were taking care of all his all of his money not that it was millions of dollars but to him it was substantial and when this scandal broke my debt my father who was a good watcher of business news every night as came on Wells Fargo he got on the phone and he goes I sure hope you're not doing any of this stuff with my account so you know can I go back can I go back to this slide here where was that you know look at the look at the bottom one they're regulators supervisors and enforcement authorities well my dad was was none of those yet yet when this scandal occurred he was part of a line of defense he was like the safety who was away way in the back of course in 2016 my dad was uh how old was he he was 79 or so so he wasn't tackling anybody on a football field but he was able to tackle and make certain that those Wells Fargo employees were aware that he knew what was going on and by golly they better not be named they they better not be fooling around with his accounts here's a slide that's taken from this CSI webpage and what it does is these what these people do is they they have established a you know a fairly unique and customizable scorecard for measuring performance and there's the link there you can go to this webpage which I have done multiple times and this is just one example of a monthly evaluation of whether or not a particular financial manager was meeting a specific goal so look on the top up there you know it's an objective and so these objectives could be anything you know they could be something as specific as when somebody comes in to borrow a million dollars we lend them a million dollars now of course you know that's a silly that's a silly one but it could be that specific or it could be general saying when someone comes in with a million dollars they leave with a smile on their face you know so some of these can be quantitatively measured but some of these you know may not be how about a quick slide just on on training programs we've talked at length about the need for communication and education and so training it's quite it's quite a challenge I mean you know do you or I do we want to take time off this afternoon let's say from 2 to 3 o'clock from our busy schedule and sit in front of our computer or go to a meeting room or have some kind of a zoom conference call and listen to an individual talk for an hour about some particular topic and the answer is you know probably not unless it's engaging in all that kind of stuff so these training programs have to be done by professionals whether they're done internally or outsourced to some external organization look at that last block point down there I chuckled when I read about this you know investing in surveillance technology now as a good parent who tries to make my children read you know when they were 7th and 8th grade I made him read Animal Farm and then when they got older I said you guys need to read 1984 and they're like that look at that book it's it's too long we know all about 1984 where you know there's big brother' out there keeping track of all our stuff so you know there are benefits and there are challenges and then there are consequences to surveillance technology but this goes back to what I've said in some previous visits that we've had with each other one of the things I try to teach my children is integrity right they make decisions as if mom or dad were standing right over your shoulder and you know this surveillance technology is having mom or dad stand right over your shoulder at all times now the next learning objective asks the question regarding viewpoints from different countries standpoint on culture and conduct and so what we've done here in these series of I think it's three slides is make some bolded phrases for each individual country so none of this is really new but what I would do if I were you guys is I would you know try to memorize these bolded words for each particular country you know if I read these for the UK raise standards promote forward-looking conduct individual accountability all right so if you can remember those for the UK that's probably I would think that would be sufficient to answer a question if they say if a question asks you about you know different countries attitudes and then Japan intention to shift focus on firms governance and cultures senior management odd auditors and so you know you just look at the difference between those two individual accountability and UK senior management in Japan so there's a little bit of a difference there Hong Kong accountability of senior management supervisory measures for bank cultures I mean this is interesting in Hong Kong to have some kind of a measure that can be placed you know near it at or near the top and so of course if all of the team members can view this at the top then then hopefully they would they would follow suit boy look at the United States you know what do we have here in the United States we have lots of politicians who like to say you know what we know what's best for everybody out there so look at all these things that we have so we got all these different kinds of organizations that have pressured financial institutions to focus on culture and conduct Canada Bank require bank employees obligation to obtain customer consent fees and cost domestic retail sales practices and then Australia accountability etc etc here we go best practices so this is always a good idea of all the stuff that's out there what's going to best provide us with an opportunity to satisfy everything that we've talked about in this particular slide deck and in previous slide decks all right so look at that first one there management should be a continuous effort of culture and of contact and of conduct look at that culture is not static so this is a dynamic environment leadership always matters I mean I can't emphasize this enough I've said to you guys in the previous videos that part of my dissertation was on board of director compasses composition and and leadership and so I looked at about 2,000 different corporate boards and you know you saw you find some that are really good and you find some that are lacking leadership always matters that's important look at the third one the scope of conduct management is changing from misconduct to conduct risk management so the focus is not trying to find individuals out there who are doing something that they shouldn't be doing but rather educating and providing leadership so that individuals when they're faced with that decision the thing that they don't make that decision to perform poorly or to make unethical decisions cultural norms and beliefs cannot be explicitly measured of course of course they cannot but it's like you know what you know what do people say about art people say you know what I don't know anything about art but
I like looking at that piece I don't know anything about art but that thing is ugly same same thing here so read that last one down that restoration of trust will benefit the entire industry as a whole of course these behaviors if they start down here from from you know let's suppose we're talking about a bank teller all the way up to the chief executive officer if this system of culture and conduct is consistently applied all the way through then what does it say on the bottom on restoration of trust boy doesn't it stink that it appears as if the consuming public maybe has not lost trust in the financial services industry but doesn't have as much trust as it should I mean let's face it what what do we do in the financial services industry we help people achieve their financial goals they should trust us more than anybody and I think that takes us through through the learning objectives it's probably hard to identify which of those five is most important but you know look at the title of the chapter conduct and culture and so I would know I wouldn't know everything about that [Music]
