Are banks still behaving badly?

It seems we are confronted almost daily with sensational headlines of either a bank failure or another controversy relating to banking misconduct. The world was recently brought to the brink of a systemic failure with the collapse of relatively unknown US-based banks, such as Silicon Valley Bank, Signature Bank and Silvergate Bank. It took the US President to announce publicly that depositors in these banks will be protected in an effort of avoiding further bank runs and a potential collapse of the entire financial system.

This is reminiscent of the GFC, when several large banks such as the US-based Washington Mutual and the UK’s Halifax Bank of Scotland collapsed, after the now infamous Lehman Brothers arguably triggered the crisis. We’ve since realised that the bankruptcy of a large financial institution merely represents the visible iceberg lurking atop a larger potential calamity.

George Santayana put it best in his 1905 book, The Life of Reason, where he observed that “those who cannot remember the past are condemned to repeat it". Although we routinely conduct detailed post-mortems and government inquiries following a major bankruptcy or financial crisis, we fail to avoid a recurrence of the same mistakes. Governments customarily implement incremental improvements to financial regulations following a crisis, but this hasn’t prevented subsequent crises.

^{UOW finance expert Dr Paul Mazzola's latest book Countdown to the Global Financial Crisis analyses the lead up to the 2008 crash. Photo: Paul Jones}

The financial crisis–regulation

For example, following the US Panic of 1907, which featured a series of bank runs and a subsequent inquiry called the Pujo Commission, the US government introduced a number of reforms such as the establishment of the Federal Reserve system, the creation of the Federal Trade Commission to address companies engaging in unfair competitive practices and the passing of the Clayton Antitrust Act, which discouraged the formation of monopolies.

The same pattern of reform occurred after the Great Depression of the 1930s. In this instance, the government introduced the Glass Steagall Act 1933 which effectively prevented commercial banks from engaging in the riskier investment banking type activities such as equity underwriting and trading which brought down many banks following the 1929 stock market crash. It also created the Federal Deposit Insurance Corporation (FDIC), the same institution that came to the rescue of Silicon Valley Bank’s depositors. Ironically, politicians were persuaded in 1999 to repeal the Glass Steagall Act and coincidentally the GFC occurred nine years later.

More recently, in response to the GFC, the Dodd–Frank Act 2010 revamped financial regulation in the US. According to former President Obama, it was “a transformation on a scale not seen since the reforms that followed the Great Depression."

Again, conservative politicians rolled back some important provisions of the Dodd-Frank Act in 2018. The loosening of the regulation removed the requirement for mid-sized US banks to conduct certain stress tests on their portfolios. If these stress tests were carried out in accordance with the original regulations, the problems of Silicon Valley Bank would have been known to regulators months earlier with prospects of remediation.   

The ideas for bank regulation generally emanate from a brains trust that sits within the Bank of International Settlements (BIS) in Basel, Switzerland. The BIS serves as a bank for central banks with the primary goal to promote financial co-operation and standardise bank regulations around the world. However it’s up to each country’s bank regulator to determine which of the many BIS regulations they will adopt and therefore the process is subject to political influence. The latest suite of regulations known as Basel IV are currently being implemented in various degrees around the world. These regulatory improvements generally involve identifying and measuring less obvious banking risks and ensuring mitigating measures are implemented whilst adequate levels of capital are invested to ensure bank survival.

Unveiling the curtain of causes

So, why is the world repeatedly brought to the brink of systemic failure despite all these efforts in improving the regulatory line of defence? To find the answer we need to look behind the curtain of obvious causes.

The causes of the GFC were distilled by the G20 Leaders' Declaration in November, 2008 into a confluence of events including the creation of unsustainable asset bubbles (namely housing) unbridled and unsound lending practices combined with increasingly complex and opaque financial products, consequent excessive leverage, lax, misguided and outdated legislation and accounting standards, ineffective regulators and growing capital flows fuelled by extremely accommodative monetary policy setting.

However underlying the various causes, there existed a failure of the human condition where incessant greed was allowed to dominate. This manifested in misconduct and decision-making driven by excessive self-interest by a variety of financial market participants including bankers, politicians, credit rating agencies, mortgage brokers and others.

On an institutional level the associated behaviour is expressed in an organisation’s culture. Andrew Bailey, Governor of the Bank of England said in 2016 that "... there has not been a case of a major prudential or conduct failing in a firm which did not have among its root causes a failure of culture..."

SVB – risk culture at its worst

The failure of SVB is no different. According to report from 2 April, 2023 by the Washington Post citing former employees, when SVB identified the potential problems to its portfolio from rising US interest rates by using an established forecasting model, management simply changed the model’s assumptions to give the impression that the rising rates would have minimal impact. This shows that management were informed early of the problems and willing to manage external stakeholder perceptions. “Management always wanted to tell a growth story, one former employee involved in the bank’s risk management said … Every quarter, there was always this pressure to deliver earnings.” Referring to the CEO, another employee said “It’s fair to say he was more focused on the upside than risk management.” It’s ironic that the last annual report published by SVB just prior to its collapse praised its top executives for an area of achievement: managing risk and Dan Beck, SVB’s chief financial officer was credited for “promotion of a strong risk culture."

New Institutional Theory – A window into influence

The search for a solution to this problem may be found through applying the theoretical lens offered by Di Maggio and Powell who developed New Institutional Theory to help explain the institutional forces on large organisations. Two of the three influences they identify, coercive and normative factors, may offer some insight.

Coercive factors involve governmental power and political influence to generate outcomes consistent with the will of the state and political pressure groups. Numerous studies have shown how lobbying has been used to exert political influence in the US to either stave off bills unattractive to the banking sector or pass legislation supportive of bank profitability. In the US, the combination of money and political will speaks very loudly. However difficult it would be, finding a way to quieten the voices of these powerful political lobby groups would be a good place to start to ensure the regulatory process is not unduly captured. 

Normative influence can emanate from the pressure of the profession to conform to a social practice or norm. The banking sector is one where the pursuit of profits at all costs is not uncommon and in some financial institutions has been considered normal. When management is seen to be supportive of any behaviour that achieves this profit objective, the behaviour is validated and over time becomes normal. Massive financial incentives driving an aggressive sales culture within the industry has only spurred this phenomena and impacts heavily on organisational culture.

Normative influence may help explain how organisations such as Credit Suisse are repeatedly embroiled in scandals over many years. Wrongdoings have included spying on employees, a bribery scandal in Mozambique involving loans to state-owned companies, breaching supervisory obligations over $US10 billion in client funds invested in the collapsed Greensill Capital, operating accounts for drug lords and sanctioned businessmen, publicly known for their involvement in human rights abuses, drug trafficking, corruption, money laundering and other serious crimes, and failing to prevent money laundering by a Bulgarian cocaine-trafficking ring. All this in just the past four years. Oh, and the bank finally announced in March of this year that it will no longer pay bonuses to board members.

Education in Ethics – a piece in the puzzle

Norms within a profession are established through education, either through formal courses, professional training, workshops, and seminars. Professional networks where ideas are routinely exchanged are also influential in establishing norms. It therefore seems logical to embed ethical training at the university and professional body levels to instil the appropriate norms in business students. Getting in early before the minds and souls of the world’s future financial market operatives can be corrupted seems to make sense. Universities and some professional associations have already introduced ethical components within business degrees and accreditation courses respectively, but they should strive to do better.

Naturally, much can be done by boards in improving organisational culture within banks. Culture is consistently on boards’ agendas, yet progress appears mixed if media headlines of bank misconduct is any measure. In any case, there’s always bound to be ‘bad eggs’ that bypass cultural indoctrination.

There is also a role for selective mandatory reporting on compliance breaches to be made public. There's nothing like being shamed publicly to motivate a board. The International Integrated Reporting Framework is the ideal instrument to pursue this.

However, the fear remains that while the management of financial institutions continues to be subject to decisions influenced by greed and the pursuit of profits at all costs, bank failures and associated risks to financial stability will continue.