Abstract and Keywords
Trust and trustworthiness are important in the financial services industry, in market transactions and in a wider economic sense, because their lack results in poor outcomes for the economy. The chapter suggests four steps for developing trustworthiness: defining obligations, identifying those responsible for delivering obligations, identifying mechanisms for encouraging trustworthiness, and holding those responsible to account. The chapter considers a number of case studies on the mechanisms that have been applied in other industries, as these provide useful lessons for financial services. The chapter summarises the key obstacles to trustworthiness and the regulatory responses that have emerged to date. It suggests that the reforms underway are important because they will remove or reduce adverse incentives. However they will do little to strengthen trustworthiness by encouraging other-regarding motivations. The chapter concludes by recommending a number of further actions that could be taken to improve trustworthiness by bringing other-regarding motivations into play.
16.1 Trust and the Financial Services Industry
Sue Jaffer, Nicholas Morris, and David Vines
The chapters of this book have argued that trust and trustworthiness are both important in the financial services industry. Trust matters in market transactions when one person’s decision depends on the actions of other parties, and those actions cannot be readily controlled or monitored. This is particularly true if the decision depends on information held by other people who may not reveal or tell the truth about that information (Hay 1999). In financial services, such information asymmetries are particularly strong, so it is important to be able to rely on other parties being trustworthy.
Financial products are complex and not well understood by ordinary people, making customers reliant on advice. Often a chain of intermediaries is involved, reducing the extent of face-to-face relationships and introducing principal-agent problems. In addition, time frames for judgements are long, so that the holders of assets often do not find out the real value of their purchases for many years, by which time it may be too late to rectify mistakes.
Moreover, trust in and the trustworthiness of the financial sector matters in a wider economic sense, because their absence results in poor outcomes for the whole economy. We have reviewed a number of ways in which these outcomes can occur. Without trust in the sellers of financial products, people are inclined to reduce their level of saving, resulting in lower incomes in retirement and greater reliance on the state (Springford 2011). For some, a lack of trust could result in (continued) exclusion from the financial system altogether, imposing higher costs and greater risk on the most disadvantaged. Without a bank account, utility bills are higher and services such as insurance and credit are difficult or impossible to obtain (Pomeroy 2011). The risk of withdrawal from financial services is greater than for other services because (p.351) people by and large do not naturally seek out financial products (Lipsey 2011). They have to be persuaded to purchase them, and to trust those who sell the services or products.
As Chapter 2 describes, the decline in the trustworthiness of individuals and firms in the financial sector created a raft of adverse effects. Many institutional investors bought what turned out to be toxic products on the strength of misplaced trust in those selling and rating the products (O’Brien 2010). The consequences included a significant loss of wealth for the ultimate customers and reduced retirement incomes. Misplaced trust in the ability of the financial institutions to identify, manage, and price risk appropriately imposed heavy costs on taxpayers and the wider community, through the need for bailouts, recession, and the other consequences of the financial crisis.
Numerous enquiries and recommendations for regulatory reform have been made in the five years since the Global Financial Crisis (GFC). Useful reforms are underway, and the courts are establishing precedents which will assist the policing of conflicts of interest. However, although these regulatory developments are useful, we do not believe that they will solve the problem by themselves. This has led to our search for additional ways of rebuilding trust.
Thus our aim in this chapter is thus to identify the requirements for trustworthiness. Drawing on the lessons from previous chapters and case studies of how these matters are dealt with in other industries, we recommend where and how it might be possible to improve the trustworthiness of the finance industry. In doing this, we draw particularly on the lessons from framing elaborated by Gold in Chapter 6, on O’Neill’s ideas about intelligent accountability from Chapter 8, and on experience in developing ethical frameworks and integrity systems as discussed by de Bruin and Miller in Chapters 12 and 14. We also recognise the potential contribution of the law in holding to account those responsible for delivering their obligations, as explored by Getzler, by Armour and Gordon, and by Awrey and Kershaw in Chapters 9, 11, and 13.
In what follows, we first reiterate what is required for trustworthiness to flourish. Then we set out four steps as to how trustworthiness may be developed and enforced: by defining obligations, identifying those with responsibility for delivering obligations, identifying mechanisms for encouragement of trustworthiness, and holding those responsible to account. How these mechanisms have been applied in other industries is explored to provide useful lessons for financial services. We then focus on five obstacles to trustworthiness, examining what reforms have been proposed, whether these reforms are likely to further develop strong trustworthiness in financial services, and what more should be done. The final section summarises our conclusions on what further needs to be done to achieve each of the four steps for improved trustworthiness.
The trustworthiness of a person depends on three necessary elements: competence, willingness, and reliability. Competence concerns the extent to which the person who is trusted has the necessary skills, knowledge, and abilities. Willingness concerns their intention to keep commitments. Reliability is concerned with whether the person performs as expected. We seek trustworthiness of this kind in the financial services industry.
These requirements for trustworthiness apply equally to individuals and institutions. However, the trustworthiness of individuals within an institution will not be translated into trustworthiness on the part of the institution unless there are mechanisms in place to ensure consistency of these attributes within the institution, and their transmission over time through institutional values and memory (Montefiore 1999).
Motivations are important, as discussed by Gold in Chapter 6. Gold distinguishes strong from weak trustworthiness. Weak trustworthiness can emerge even if the person being trusted is self-interested. Strong trust emerges only when there are other-regarding motivations, such as altruism or other pro-social motivations, procedural motivations including professionalism, or the desire for approbation or esteem. Given the obstacles to trustworthiness that exist in the financial sector, it is our belief that only the cultivation of strong trustworthiness will lead to better outcomes.
We can define four necessary steps which assist in achieving strong trustworthiness:
1. a description of the obligations to be delivered;
2. identification of the responsibility of different players;
3. establishment of mechanisms to encourage and enforce trustworthiness;
4. rendition of an account of performance and methods of holding the individual or institution to account for that performance.
The first step is to describe the duties or obligations to be delivered. Without a clear understanding of the ultimate ends of a person’s activity, or that of an institution, any method of enhancing trustworthiness is without direction. The purposes of an activity lead to the obligations which are assumed by the person or institution being trusted (Miller 2011b). As argued by O’Neill in Chapter 8, this involves focusing on the tasks to be done, rather than on second-order targets which can misrepresent overall objectives.
Next, those responsible for delivering the obligations need to be identified and they need to accept their obligations. Part of the public’s anger over the role of the banks in precipitating the GFC rests on the failure of (p.353) those concerned to take responsibility for their actions. For example, under questioning by the Financial Crisis Inquiry Commission, Lloyd Blankfein, Chairman and CEO of Goldman Sachs claimed that ‘The standards at the time were different’ (Harrington 2011). He did not admit to a lack of personal responsibility, or to a failure in fiduciary duty, or to any public obligation on the part of either himself or his banking colleagues. Similarly, Barclays suffered greater reputational damage because it sought to present its Libor transgressions as a failure of internal systems rather than as a failure of leadership (O’Brien 2012).
The third step is to establish the mechanisms intended to secure and support the delivery of obligations. A wide range of such mechanisms has been used by professions and organisations, including codes of conduct, reputational indices, membership and powers of exclusion, and fraud investigation units. Different mechanisms work to support different types of strong trustworthiness: for example, membership of a professional association and codes of conduct seek to encourage procedural motivations. Reputational indices and fraud investigations support motivations based on esteem and approbation. Ethics committees and ethics training are designed to support pro-social motivations directly. Such mechanisms have been discussed by de Bruin, by Awrey and Kershaw, and by Miller in Chapters 12, 13, and 14. These mechanisms can be reactive (such as exclusion upon wrongdoing) or preventative (e.g. education, elimination of conflicts of interest). Mechanisms to redress transgressions need to be proportionate, but at the same time provide serious remedies for failure.
The final step is to require those with responsibility to render an account of the adequacy of their performance in delivering their obligations, and to hold them to account for that performance. This is an essential part of the ‘willingness’ component of trustworthiness.
Of course, the implementation of these steps relies on self-interest as well as supporting other-regarding motivations. Self-interest is important both through the provision of positive incentives and through methods which promote compliance through the threat of punishment. The threat of punishment in itself only promotes weak trustworthiness. But at the same time it can support strong trustworthiness by reinforcing the desire for a good reputation and by reinforcing shared values.
16.3 Mechanisms to Promote Trustworthiness
A range of mechanisms can be used to ensure compliance with minimum ethical standards. These may include external regulatory mechanisms, which ought to complement and reinforce internal mechanisms within institutions (p.354) (Miller 2011b). They encompass compliance and enforcement mechanisms, as well as rules and principles for dealing with issues such as conflicts of interest. They need to be able to identify the causes of ethical failure, assign responsibility for their remedy, and ensure accountability.
The range of mechanisms that could potentially be used include codes of conduct, ethical risk management systems, effective complaints and discipline systems, internal anti-fraud and anti-corruption systems, an external independent ethics audit, and (building on the latter) reputational indices. In addition, products and markets can be designed and regulated so that it is easy for purchasers to understand what is being charged and to check whether it is offered at a competitive price. The nature of the different mechanisms that can be employed, the way in which they support strong trustworthiness, and the issues which arise in their use, are discussed below.
16.3.1 Professional Associations
Membership of a professional association implies that members are qualified and agree to act professionally, in a way that directly supports procedural motivations for strong trustworthiness (Phillips 2011). In effect, the association seeks to ensure that its members carry out their activities in a trustworthy manner, and to differentiate members from those who might carry out the activities of that profession in a less trustworthy way.
Professional associations protect the reputation of their members through requirements for qualification (often by formal examination), disciplinary procedures when the performance of members is below the standard required, and the ultimate sanction of exclusion. In the UK, professional lawyers, doctors, and architects, for example, can have their licences to practise withdrawn. The London Stock Exchange and Lloyds of London occasionally exclude those who fail to obey their rules from participating in the market.
By preventing the participation of unqualified individuals, professional associations attempt to raise the standard of service provided and to make it harder for the general public to be exploited by untrained or unscrupulous suppliers. They are designed to take responsibility for standards, and for this responsibility to be assumed by the association’s members.
Such professional associations attempt to ensure that ethical values are not undermined by market forces, and to avoid an outcome in which competition brings down the quality of service. Sometimes they enable members to charge higher fees for their services, in a way which is intended to support a higher quality of service. In this manner professional associations such as the General Medical Council and the former Law Society attempt to align the self-interest of members with the interests of their patients or clients.
(p.355) The issue of whether professional associations are able to create systems which operate to the public benefit has been much debated (Alexandra and Miller 2010). The perception that prices are higher than necessary has led to the criticism that professional associations mainly seek to protect the market position of their members (Loughrey 2012). Similarly, the ‘club culture’ created by professional associations has been derided as self-serving (O’Neill 2005). The nexus of self-interest, collective interest of the profession, and the interests of clients, customers, or wider society is subtle. Whether a professional association will focus on the latter depends both on how important reputation is to the members, and on the underlying values of those in the profession. In Chapter 8, O’Neill argues that genuine professional integrity grows out of ‘tough institutional structures’ which include robust systems for dealing with conflicts of interest and which contain serious remedies for failure. In our view, this is one of the major challenges facing the establishment of a professional association for banking if it is to be effective in promoting trustworthiness in the industry.
Self-regulatory organisations (SROs) perform a similar function to professional associations. The major difference between the two is that SROs focus on the behaviour of the firm, while professional associations focus on the behaviour of the individual. Properly applied, self-regulation can improve the competence, willingness, and reliability of firms within an industry.
Self-regulation occurs when industry members jointly pursue regulatory or standard-setting activities in the absence of explicit legal requirements. They might do this in relation to the disclosure of product information, the policing of deceptive practices, the establishment of minimum standards of safety and quality, the grading of products, and the creation of industry codes of conduct. An obvious extension of self-regulation is co-regulation, where regulatory responsibility is shared between industry bodies and regulatory authorities.
Proponents of self-regulation argue that it enables the expertise and practical experience of the industry to contribute to the development of regulatory policy, that administrative and compliance costs are lower, and that voluntary compliance is more likely if industry players are also stakeholders in the rule-making body. Opponents argue that self-regulatory bodies are often subject to conflicts of interest between their regulatory responsibilities and their business objectives, encourage anti-competitive practices, and lack transparency.
Garvin (1983) summarises the issues:
Self-regulation is no panacea. Like most public policies, it must be tailored to circumstances and employed with restraint. Applied wisely, it offers the opportunity for efficient, cooperative decision making with a degree of flexibility unlikely (p.356) from a more centralized federal agency. Applied improperly, it enables firms to cartelize their industries, with a few large companies dictating terms to other industry participants.
It is clear that there is a need for effective enforcement of self-regulatory rules (De Jong et al. 2004). Self-regulation can support strong trustworthiness through the promotion of procedural motivations. Explicit penalties and sanctions to prevent firms from free-riding off others’ efforts do not support strong trustworthiness, except insofar as it affects their reputation. However, the need for such sanctions can be reduced by the transfer of norms, and the diffusion of best practice (Greif 1997; Nash and Ehrenfeld 1997).
16.3.3 Codes of Conduct
Codes of conduct are frequently used to set ethical standards for professional behaviour. They typically form the basis of self-regulation by covering the basic requirements for establishing trust in a professional relationship. If adhered to, codes of conduct can improve the strong trustworthiness of individuals and firms within an industry by supporting procedural motivations. Such codes typically require that:
• professional activities are conducted with integrity and honesty;
• advice should be given objectively and impartially;
• all client information should be strictly confidential;
• standards of practice should be adhered to and conflicts of interest disclosed; and that
• business is conducted in a way that is considerate of the public interest (Daykin 2004).
Codes of conduct can be self-regulatory or enforced by an external regulator. Many of the codes which characterise self-regulatory activity in the US were written in the 1970s, following the Watergate scandal and the departure of President Richard Nixon (Cressey and Moore 1983). At the time, large public companies were keen to emphasise their social responsibility.1 Business leaders feared that unless they took steps to put their own house in order, the public might demand more restrictive regulation. At the time, the Cohen Commission emphasised the need for corporate executives to recognise the ethical standards, traditions, and concerns of society as well as company (p.357) profits in order to reduce the ‘substantial gap...between some corporate behaviour and society’s view of appropriate corporate conduct’ (Cohen 1977).
The influence of codes of conduct clearly comes under pressure when there is moral hazard involved, for example, where the disclosure of a competitor’s better offering would erode profits or reduce an individual’s remuneration. As discussed by Awrey and Kershaw in Chapter 13, the success of mechanisms such as codes of practice will depend on the strength of the countervailing incentives. Thus ethical codes will only work in some circumstances (Armstrong 2012). It must be possible to observe whether the code is being met for the desire for approbation to support the code. The ability to exclude those who fail to meet the required standards is also necessary to support strong trustworthiness.
16.3.4 Ethical Risk Management Systems, Ethical Audits, and Reputational Indices
Miller (2011b) suggests that an ethics risk assessment process is a useful mechanism for ensuring trustworthiness. Identifying ethical risks, such as conflicts of interest, is likely to support both procedural motivations and pro-social motivations (in the case of the latter by highlighting the consequences of ethical breaches). However, ethics risk assessments require data gathering and analysis. Thus Miller is in agreement with O’Neill that good evidence is essential in designing what he calls integrity systems and in improving professional standards. He recommends evidence-based institutional design and, in particular, the practice of what has been referred to as evidence-based designing-in of ethical standards.
Miller also recommends the use of ethical audits to ensure that appropriate processes are in place and that they are operating appropriately. An ethics audit seeks to measure the ethical performance of individuals or firms. It requires objective measures of performance, such as numbers of warranted complaints, but would also involve review of institutional processes such as codes of conduct, ethical risk assessments, ethics committees, and professional development programmes.
Miller suggests that a reputational index could be used to harness the desire for reputation, to create a self-reinforcing ‘triangle’ between reputation, self-interest, and ethical standards. Individuals and organisations benefit from a good reputation: it is in their self-interest to earn a reputation for complying with ethical and professional standards, and it supports strong trustworthiness through the desire for approbation. The purpose of a reputational index is to ensure that such a reputation actually aligns with ethical practice.
Encouraging trustworthiness depends crucially in all cases on rendering an appropriate account of performance. As O’Neill argues in Chapter 8, intelligent accountability requires that agents be held to account for meeting their primary obligations. Performance needs to be judged competently and fairly, which means that those judging must be both informed and independent. Their judgements also need to be communicated intelligently if accountability to wider audiences is to be secured.
O’Neill argues also that the intelligent placing of trust requires evidence, albeit necessarily incomplete. Thus, one aim must be to improve the information available to customers and regulators to allow the placing of trust that is warranted. Intelligent systems of accountability should provide evidence to allow those affected to judge whether others’ claims are true and their commitments reliable.
There are also issues surrounding the accountability of individuals who work within large complex organisations. One person within a system may act in a trustworthy manner, whilst others may not. It may also be the case that although individuals within a system act in a trustworthy manner, the system is itself designed to exploit customers. Several submissions to the Parliamentary Commission on Banking Standards quoted examples of employees being bullied to meet sales targets regardless of whether the products were appropriate for customers, with unachievable targets often being set (see, for example, Unite the Union 2012). It is necessary therefore, that senior management is held to account over the design of systems, as well as individuals for their performance working within them.
16.4 Improving Trustworthiness: Lessons from Other Industries
Other industries provide useful examples of self-regulatory and professional systems which have improved trustworthiness. Such systems have been introduced in a wide range of different circumstances. It is useful to consider, in each of these cases, the way in which the systems have carried out each of the four necessary steps which we identified as assisting in the achievement of trustworthiness: a description of the obligations to be delivered; an identification of the responsibility of different players; an establishment of mechanisms to encourage and enforce trustworthiness; and a rendition of an account of performance and the adoption of methods of holding the individual or institution to account for that performance. In particular, it is useful to see that a variety of mechanisms have been used to achieve the required (p.359) outcomes, including self-regulatory organisations, the setting of professional standards, the cultivation of reputation, and the encouragement and sustaining of mutually beneficial cooperative outcomes. Furthermore, the examples illustrate the range of procedures that have been used for holding individuals and institutions to account for their performance.
16.4.1 Response to Crisis
In some industries the emergence of new procedures and institutions emerged as a response to a major crisis which threatened the industry. The Three Mile Island nuclear accident in 1979 exposed severe failings of risk management and lax safety procedures in the US nuclear industry and led to a damning Presidential Inquiry (Kemeny 1979). The gas leaks from a Union Carbide plant in Bhopal, India (which killed thousands of people) in 1984 damaged the credibility of the chemical industry worldwide. Both events led to a realisation by industry leaders that a proactive approach to repairing reputation was necessary, and in particular that the perceived and actual trustworthiness of the industry needed to be re-established. In both cases an improved self-regulatory system was subsequently created which has remained in place, and been strengthened, for thirty years. The initiatives were also motivated by a desire to head off potentially damaging government intervention. These examples show that such actions can be made to succeed, even in complex and global industries, and that this is a workable alternative to formal regulatory intervention.
The US nuclear industry did not wait for a Presidential Inquiry, but took action within two weeks of the accident. A committee of nuclear utility Chief Executive Officers set up a private regulatory organisation, the Institute of Nuclear Power Operations (INPO). The system was aimed at increasing both the perceived and actual competence and reliability of the industry. Today, the INPO is a thriving non-profit organisation, and is credited with improving nuclear safety in the US. ‘Excellence in operating nuclear plants’ is INPO’s mission, seeking to ‘resist the natural business tendency to reduce the resources dedicated to fostering safe and excellent practices’ (Rees 1994). INPO carries out independent evaluation of the knowledge of plant personnel, the condition of systems and equipment, the quality of programmes and procedures, and the effectiveness of plant management. Nuclear plants are given a score, which is circulated to all CEOs of nuclear plants at an annual gathering, and which has become an important benchmark in the industry. Trustworthiness is expected from all companies in the industry, and systems are in place to monitor whether trust is warranted. Occasionally, adverse INPO comments can lead to the dismissal of management. INPO has also developed training and accreditation processes now used throughout the industry, coordinates (p.360) information exchange, and has become an effective professional association for the industry.
Industry response to the difficulties faced by the Japanese nuclear industry following the seismic shocks and tsunami of 2011 has also been rapid. The American Society of Mechanical Engineers (ASME) has worked with Japanese counterparts since spring 2011 to explore the impact of the events on nuclear codes and standards. A Presidential Task Force was set up shortly after the disaster and reported in June 2012 (ASME 2012). The report found that the Fukushima Dai-ichi accident revealed no fatal flaw in nuclear technology, and the reasons why the plants suffered core meltdowns were clear and correctible. Relevant safety improvements are now being implemented in the global nuclear fleet.
Taylor and Wolak (2011) compare the regulation of risk in the nuclear power industry today with that of financial services. They note that the safety record of the nuclear industry is considerably better than that of the financial industry, attributing this difference to the effectiveness of INPO in encouraging trustworthiness and enforcing self-regulation, to the legal framework under which nuclear regulatory agencies operate,2 and to the lack of regulatory capture (despite considerable potential for the use of informal mechanisms). For example, communication between parties prior to nuclear hearings (managed by an Administrative Law Judge) is strictly prohibited. Taylor and Wolak conclude by recommending that a financial industry analogue of INPO be given serious consideration.
The leakage of methyl isocyanate gas and other chemicals from a Union Carbide plant in Bhopal, India on 2 December 1984 led to a substantial reduction in public trust in the chemical industry (Rees 1997). Polls at the time, for example those carried out by Dow Chemical, showed that restoration of trust was not possible by the actions of a single company, as public attitudes did not adequately distinguish between ethical and non-ethical companies. Leaders of the industry decided that they needed to be proactive, partly to improve public image and partly to pre-empt government intervention. They recognised that unless attitudes in the industry changed, they would not be able to restore public trust. The Chemical Industry’s Responsible Care Programme (‘Responsible Care’) was initially launched by the Canadian Chemical Producers Association (CCPA) in 1985 (Moffet, Bregha, and Middelkoop 2004). Today it is run in fifty-two countries and covers chemical industries which account for nearly 90% of global production.
Responsible Care is a code of conduct which includes guiding principles, codes covering over one hundred management practices, and a Global (p.361) Charter. The codes cover interaction with the community (the community awareness and emergency response code), facilities management (the pollution prevention, process safety, and employee health and safety codes), and treatment of suppliers and customers (the distribution and product stewardship codes) (King and Lenox 2000). Compliance with the programme is achieved through peer pressure between companies, and through dissemination of best practices.
The experience of the chemical industry demonstrates the importance of coordinated action where industry-wide reputation can be damaged by the actions of one or few actors, and the ability of a global, complex, industry to establish such a system. The initiatives that were taken after the Bhopal disaster, and since, have made a substantial difference to the trustworthiness of the industry.
16.4.2 Self-Regulation of Output
The advertising industry provides an example of how an effective self-regulatory system can be developed by agreement between stakeholders. The development of sophisticated, internationally agreed controls over advertising content followed concern from major retailers about adverse customer reactions which were perceived to damage both the specific advertiser and the wider industry (Boddewyn 1989). Major issues covered by the self-regulation of advertising are deception and controls over advertising to vulnerable groups such as children. As with the examples discussed above, the objective was to re-establish public trust in the industry, in this case in order to prevent wide-scale consumer defection. The system has been successful in encouraging trustworthiness with regard to these issues using an industry-funded self-regulatory agency. Self-regulation is underpinned by cooperation with and reinforcement by government agencies such as the UK Office of Fair Trading, also providing a good example of co-regulation.
In the UK, the Committee on Advertising Practice (CAP) publishes codes of practice for both broadcast and non-broadcast media. CAP also runs extensive training and advice on how to comply with the codes. CAP set up an independent adjudicator, the Advertising Standards Authority (ASA), in 1962, and since 1988 the Office of Fair Trading (OFT) has provided a legal backstop through enforcement of various regulations on referral from ASA. Both CAP and ASA are funded by a levy on the industry. The European Advertising Standards Alliance (EASA) and the International Chamber of Commerce (ICC) also promote business ethics through codes and guidelines on commercial communications. All these bodies believe that commercial communications are best managed by self-regulation within a legal framework that protects consumers from false and misleading claims.
(p.362) A high degree of compliance is achieved by this system, partly because advertisements are easy to monitor and breaches are challenged by competitors or through customer complaints. Here self-regulation seems to be more effective than government intervention, because it allows the industry to deal with ‘soft’ issues such as taste, decency, and sexism. Subtle nuances which are misleading, unfair, or use ‘hidden persuasion’ are more likely to be uncovered by industry experts than by outsiders (Boddewyn 1989). Thus advertising provides a helpful example of mechanisms that have been established to encourage trust, because advertisers desire the esteem of their customers.
16.4.3 Professional Standards
A prime example of the promulgation of professional standards is provided by the medical profession. It has developed an integrity infrastructure which seeks to ensure competence, accuracy, and reliability of medical practitioners, and as a result the medical profession is mostly held in high regard in the UK, and medical practitioners are regarded as trustworthy in surveys (Goold 2002). The main elements of this system are qualifications for all types of medical practitioner, registration of doctors, pharmacists, and other key experts, ethical and performance standards, codified as Good Medical Practice, and fitness to practise panels which have the power to remove doctors’ registration. Doctors take oaths which emphasise that they will, at all times, act in the best interests of their patients. Because of the nature of the profession, and arguably of the type of people who undertake it, their actions exhibit and encourage a stronger form of trust than in many other industries.
The General Medical Council (GMC) has origins as far back as 1421, when physicians sought to prevent those who did not have the requisite expertise from practising medicine (Raach 1944). Today, the Healthcare Commission seeks to ensure quality of performance in institutions such as NHS trusts and health authorities. However, the system has not always prevented major breaches of trust (as for example the case of Harold Shipman who murdered 215 patients over a period of 24 years before being apprehended). The Shipman Inquiry led to the introduction of new public agencies, such as the National Patient Safety Agency, thus moving the system away from self-regulation by the profession and towards formal statutory intervention (Shipman Inquiry 2003). As Offer explores in Chapter 15, US experience shows that the introduction of market pressures in the supply of health can cause major conflicts of interest for doctors and consultants, with adverse effects for the trustworthiness of doctors and for the system as a whole.
The legal profession also has a well-established enforcement system, which until 2007 was administered by the Law Society (for Solicitors) and by the Bar (p.363) Council (for Barristers). Trustworthiness in the provision of legal advice has long been recognised as a key element of a successful society (Leland 1979). This system worked well from the nineteenth century for over one hundred years, until the 1990s. Then changes to the size and structure of the industry, and the introduction of Limited Liability Partnerships in 2000, put increasing strain on the effectiveness of this self-regulatory system. The Law Society was also criticised for combining representative with regulatory functions and there was a political concern to introduce greater competition to the profession. This led to the Legal Services Act 2007, which transferred regulatory responsibility to a new government agency, the Legal Services Board. The Act also opened up the possibility of alternative business structures in which non-lawyers can buy law firms or invest in them, and which give law firms the opportunity to seek out external investment to grow their businesses. The outcome is now much harder to self-regulate. The larger international firms have recently taken action to reinforce self-regulation through Authorised Internal Regulation (AIR), in an attempt to re-establish the trust mechanisms that they see as having been eroded.
Medicine and law provide useful guidance for financial services as to how professional standards can be established and maintained, and how such systems evolve from the self-interest of members. Both have succeeded in providing a framework that encourages professionalism on the part of members. These frameworks have made a significant contribution to maintaining trust in the professions, and have encouraged the trustworthiness of members. The formal processes for licensing, training, and enforcement of codes of practice provide valuable guidance for the establishment of such systems to create a more professionalised financial services industry. The medical profession provides particular guidance on how to reduce problems with asymmetric information, while the legal profession has been particularly concerned with conflicts of interest. However, recent changes to business structures for lawyers have arguably eroded their ability to self-regulate, emphasising the need to adapt trust mechanisms to evolving industry structures.
16.4.4 The Importance of Membership and Reputation
Financial exchanges have historically been active promoters of self-regulation, wishing to convince investors that they will be protected in order to prevent them going to another exchange with a better regime. Stock and futures exchanges have developed extensive sets of rules with which members are expected to comply. Failure to comply with the rules set by an exchange can lead to material penalties including exclusion from the market.
Self-regulation, based on a reputation for trustworthiness, is in the interest of participants, as they share a common interest in attracting investors to (p.364) the market of which they are a member. However, government support for self-regulation is also important, to give legal underpinning to the solution of contractual disputes and to reinforce investor protection (as for example through the Financial Services Compensation Scheme in the UK).
Futures markets provide an example where social control has proved to be more effective than formal regulation. Futures contracts have considerable social benefits, enabling hedging of risks which might otherwise be intolerable. However, because they are complex they provide considerable opportunities for deception, fraud, and criminal behaviour. These are difficult to counter through government-imposed regulation, so that rules and surveillance mechanisms imposed by the exchanges themselves provide the front line. These are backed up by systems based on peer group pressure, the leverage of large institutional clients, transparency in market dealings, and encouraging repeat business (Gunningham and Sinclair 1998).
The fact that self-regulation has developed and persisted in some complex financial markets is encouraging for potential improvements to trustworthiness in other parts of the industry. Recognition that the reputation of the market is important has led to agreement by self-interested participants on codes of practice and enforcement mechanisms. In some circumstances, the existence of an effective self-regulatory apparatus has removed the need for formal intervention (Carson 2011). Canada, for example, has several national self-regulatory bodies for the securities market but does not have a national government securities regulator.3
The success of self-regulation in financial exchanges has depended on the ability of the relevant exchange to detect and exclude those who do not abide by the rules of the exchange. As a result, the rules are mostly obeyed because exclusion has a large cost to those who transgress. In other words, they encourage only weak trust.
The New York Diamond Exchange provides a further example of how self-regulation in other markets can be made to work. In this case, exclusion has an extremely high penalty—inability to continue trading. The enforcement mechanisms used rely both on the threat of exclusion and the impact of publicity on reputation (Richman 2002).
In principle, regulating the diamond industry should be very difficult. Diamonds are small and easy to conceal yet valuable. Provenance is important to avoid trading in ‘blood diamonds’, but hard to establish. Yet the New York Diamond Exchange runs a remarkably successful system of self-regulation which rarely has to deal with cases of fraud (Shainberg 1982). The system also facilitates credit sales and ensures merchants fulfil their payment obligations, (p.365) despite the need to hold diamonds they would not have the liquidity to possess outright. The governance of the Exchange relies on a system of private arbitration, which spreads information regarding merchants’ past dealings and hence provides a reputation monitoring mechanism (Bernstein 1992). Entry is restricted to those who can inherit good reputations from family members. The outcome appears to be one which resolves an ‘endgame problem’ and induces merchants to deal honestly through to their very last transaction. The sustainability of trust mechanisms in this case provides useful guidance on how peer group pressure can be used to encourage trustworthiness.
16.4.5 Encouragement of Cooperative Outcomes
Several industries have responded when untrustworthy behaviour by some players has damaged the wider interests of the industry. The common problem they shared was that uncontrolled self-interested behaviour created externalities for other players, and cooperation in enhancing trustworthiness was beneficial in remedying such externalities. Similar initiatives to encourage and enforce trustworthiness may be possible for financial services on an industry-wide basis, or for specific product groups or locations.
Clothing retailers such as Gap and Nike introduced mechanisms to prevent the exploitation of child labour by their suppliers, in response to adverse public opinion (Kolk and van Tulder 2002). This initiative relied on the development of codes of practice, enforced by sanctions imposed by the main international purchasers of the goods (Gunningham and Rees 1997). The system succeeds because of the interest of major players in protecting their reputation, and hence brand value. As with previous examples, codes of practice encourage and enforce trustworthiness. They have proved to be an effective method of improving working conditions in South America and worldwide. This in turn benefited the industry as it countered pressure by non-governmental organisations which could have led to intrusive and costly external regulation. The system thus both improved brand value and reduced pressures for external regulation.
The Brazilian Extractive Reserve System provides another example of how peer pressure has improved cooperation and trust relationships. This system provided a method of using forest resources sustainably—something that was crucial for the longer-term sustainability of the industry (Assier 1998; Cardoso 2002). The principal method used was the creation of a locally run integrity infrastructure, including mechanisms both for assessment and compliance, in partnership with public authorities. Community associations were given exclusive use of particular land, but were required to produce utilisation plans, which had to be approved by a government agency. Each association was responsible for enforcement of the plan, including the (p.366) prevention of migration by unauthorised settlers. Peer pressure was used to deter non-compliers, and the association could also impose formal sanctions (for example, by withdrawing use of communal storage or processing facilities). This improved the competence of those involved (in ensuring a sustainable system for themselves and others in the longer run) and also their reliability.
The US Sustainable Forestry Initiative (SFI) has acted in a similar manner by bringing together a number of stakeholders in the forest product industry to develop principles, guidelines, and goals which guide sustainable forestry (Gunningham and Rees 1997). This is backed by certification processes, and implemented by some 200 member companies in the US Forest Product industry. To verify that the industry is following its SFI guidelines, a panel of independent experts, including conservationists and university scientists review self-reported data and observe operations. A comparable system was also established by the Canadian Standards Association, motivated by the threat of a European consumer boycott.
Taken together, these examples provide guidance for how cooperative outcomes may be established to address adverse external effects on others in the industry or more widely. Possible application within the financial services industry might include coordinated action to counter the poor selling standards which have damaged the reputations of banks and reduced trust in the financial products being offered to customers.
16.5 Obstacles to Trustworthiness
Earlier chapters have identified a number of obstacles to trustworthiness in the financial services industry. To what extent do the myriad of recent reform proposals address these obstacles, and in what areas does more need to be done to engender strong trustworthiness? Here we briefly summarise the key obstacles to trustworthiness which have been identified in these chapters, coming from the primacy of shareholder value in UK equity markets, from leverage and moral hazard, and from personal incentives. In what follows we concentrate on three key areas of the financial services industry: retail banking, investment banking, and pension funds.
16.5.1 The Primacy of Shareholder Value
Chapter 2 identified the primacy of shareholder value thinking as one of the factors contributing to the lack of trustworthiness of the financial sector in the run-up to the GFC. As explained by Stout (2012) and Mayer (2013), the emphasis given to shareholder value has encouraged managers of firms to (p.367) behave in an untrustworthy manner. Kay (2012) describes how this has led to managerial behaviour which is focused on short-term profit maximisation, so as to achieve a short-term influence on movements in share prices. Such behaviour has led managers to take risks which were excessive from a social point of view, by seeking short-term gains at the expense of longer-term outcomes for the business. Managers were rewarded for maximising short-term gains, both in terms of cash bonuses and also in shares, and were enthusiastic about taking on risks and passing them on to others.
16.5.2 Leverage and Moral Hazard
High leverage reinforced the incentive for financial institutions to behave in this way, and hence take excessive risks, since shareholders gained all of the upside but their downside was limited by the small portion of the balance sheet represented by equity. At the same time, the discipline normally provided by creditors was lacking due to the implicit guarantee provided by government for too-big-to-fail institutions. Furthermore, the loss absorbency of debt was compromised by fears of contagion, so that the burden of rescuing the financial system fell to governments and taxpayers. The mechanisms used to monitor leverage and risk taking were also found to be wanting. As described in Chapter 5, the risk weights specified by Basel II were arbitraged to gain the greatest returns achievable within regulatory requirements, and became unreliable measures of risk.
The imperative of removing these incentives for untrustworthy behaviour lies at the root of many of the recent reform proposals. Otherwise the task of reforming standards remains one of pushing against a headwind.
The Vickers ring fence (ICB 2011) seeks to limit the government guarantee to the parts of the financial system that provide essential banking services and support the payments systems. Keeping investment banking services outside the ring fence lessens the incentive to take on high leverage and excessive risk because the implicit guarantee (which subsidises too-big-to-fail institutions) is no longer available. Making institutions easier to resolve adds credibility to the ring fencing of retail banking as it makes it easier to avoid contagion.
Reforms have also targeted leverage directly, in order to increase the ability of institutions to absorb losses and in so doing ensure that the consequences of risk taking are borne by shareholders. Basel III continues to rely on risk weightings, imposes an equity requirement of 7% on risk-weighted assets, and has also introduced a minimum leverage ratio of 3%. However, the ICB was concerned that this level of equity buffer was too low, and recommended capital requirements of at least 10% of risk-weighted assets and primary loss-absorbing capital, which includes bail-in bonds and contingent capital, of at least 17% to 20% (ICB 2011).
(p.368) Some argue that still greater loss absorbency is needed if incentives for excessive risk taking are to be curbed. Thus the Parliamentary Commission into Banking Standards recommends that the Financial Policy Committee should have the discretion to set a minimum leverage ratio above 3%. Other authors recommend capital requirements of 20% to 50% of total assets (Admati and Hellwig 2013).
Together these reforms will provide an additional equity cushion and reduce the incentives for excessive risk taking. However, the requirements are regulatory rules and hence are open to arbitrage and lobbying. For example, the ring fence relies on a distinction between proprietary trading (which is outside the fence) and normal hedging activity (which is inside) and this distinction is difficult to make in practice.
At first sight, therefore, none of the reforms appear to strengthen the trustworthiness of the financial industry by bringing other-regarding motivations into play, or by limiting risk-taking behaviour. This is a point which was recognised by the Parliamentary Commission into Banking Standards (2013). However, as discussed by Mayer (2013), corporations are devices for making commitments: financial capital in the case of shareholders and human capital in the case of employees. Increasing the equity of the firm involves a greater commitment by shareholders and managers to the values of the corporation. Other-regarding motivations can help to sustain these commitments and so make it possible for a stronger form of trustworthiness to emerge. This might lead to a reduction in risk-taking investments, reflecting a greater commitment by shareholders and managers to the values of the corporation which themselves would involve acting in a less risky manner.
The ICB (2011) considered the arguments for and against complete separation of retail from investment banks, rather than the imposition of a ring fence. One argument in favour of full separation is that the type of people required to maintain a safe and secure retail banking system are different from those who seek high rewards through taking risks, and it is important that, even with ring fencing, the outlook of management in the risk-taking part of a universal bank is likely to influence the behaviour of management in the retail banking part. We consider below the extent to which the recent proposals of the Parliamentary Commission into Banking Standards (2013) are likely to assist in defining the obligations and responsibilities of these different parts of the financial system.
16.5.3 Personal Incentives
As we have seen in Chapters 2 and 3, the incentives provided by remuneration levels and structures work directly against trustworthiness. They encourage the kind of risk taking described above, rewarding the wrong things, and (p.369) measuring the performance to be rewarded in the wrong ways. In the run-up to the GFC, investment banks rewarded the design and sale of products which had a high likelihood of failure, using time frames that were too short to enable the true performance of products to be revealed. Pension funds rewarded asset managers on short-term performance relative to benchmarks, encouraging herding and the management of expectations rather than true stewardship of assets (Kay 2012). In retail banks remuneration rewarded revenue generation regardless of the riskiness to consumers of the products sold, or of their suitability.
Behavioural experiments suggest that people are more likely to act in a way which is of benefit to others if it does not cost them too much (Stout 2010). Conversely, the experience of the GFC shows that when the rewards are very large, the incentives towards selfish behaviour can easily overwhelm other, more other-regarding, cultural norms within an organisation. Indeed the Parliamentary Commission into Banking Standards (2013) argued that such incentives led directly to the dysfunctional cultures which allowed the Libor and other scandals. If other-regarding motivations are to gain traction, therefore, it is essential that the incentives be reconfigured, so that they do not incentivise selfish behaviour. This is what Stout (2010) meant when she said ‘conscience needs room to breathe’.
Many proposals for the reform of remuneration have been made, most recently by the Parliamentary Commission into Banking Standards (2013). Proposals focus on the need to align incentives with the long-term interests of banks and their shareholders. Approaches include changing the period of deferral of bonus payments, imposing clawback and fines in cases of blatant wrongdoing, restricting the form of payment in terms of equity and bailable-in bonds, and requiring increased disclosure of remuneration criteria and greater regulatory involvement in ensuring that risks and rewards are aligned.
These initiatives will help by reducing the countervailing incentives for untrustworthy behaviour. However, as discussed by Gold in Chapter 6, remuneration arrangements are often concerned with aligning self-interest with the interest of the organisation. These arrangements can only encourage strong trustworthiness if financial institutions articulate the standards which are expected from those who work for them, and if remuneration arrangements then reflect these standards. Doing this will then encourage what Gold, in Chapter 6, describes as ‘procedurally motivated strong trustworthiness’.
The difficulty of aligning incentives with the interests of others, without adverse unintended consequences, should not be underestimated. The Parliamentary Commission into Banking Standards warns of the potential for gaming remuneration criteria and rules, that sales-based remuneration rewards can continue informally, and the complications that ensue as staff move between employers (PCBS 2013).
(p.370) In addition, the complexity of products and the asymmetric expertise enjoyed by investment banks and their employees may make it difficult to judge whether any given product was appropriate for the needs of the client at the time or was simply taking advantage of fat-tailed risks as described by Noe and Young in Chapter 3. These asymmetries have enabled the industry to profit from selling products that customers did not understand and did not serve their interests.
A number of proposals have sought to improve the ability of customers to understand what they are buying in the retail market, only some of which have been successful. These sought to increase the ability of customers to compare between products by making simple and straightforward products available for comparison with other product offerings. Thus the Sandler Review (Sandler 2002) recommended that a suite of simple ‘stakeholder’ products be offered. The products were to be designed so that they could be purchased safely without the need for regulated advice. Instead, product features and annual charges were to be regulated, with limits on the level of risk attached to the product. In this way, the products were designed to provide embedded protection with a minimum of fixed costs.
However, these stakeholder products did not sell well. Their low profitability (a result of their regulated charges) meant that they were not marketed and the stakeholder pension proved unsustainable. Nonetheless, the stakeholder pension was seen as successful in acting as a ‘benchmark product’ and stimulating price competition in the wider pension market (Springford 2011).
Recently further proposals have been made to establish simplified products. The Sergeant Review (2012) recommended that simplified products be designed to meet basic needs, and be ‘non-advice’ products that can be bought directly from providers. This is intended to ensure that the products will be both affordable for customers and commercially viable for providers. Similarly Springford (2011) recommended the establishment of ‘trusted products’ to drive improvements in competition throughout the product market.
An important aspect of the proposals is the visible branding of products. For example, Springford recommended that a ‘trusted products’ kitemark be established under which products would have to meet certain criteria such as that they do not take advantage of customer inertia or exploit small print conditions. Likewise the Sergeant Review proposed that there be a ‘Simple Products’ brand, with accredited products clearly signposted with a badge.
The Parliamentary Commission into Banking Standards argues, along similar lines, that a ‘relentless drive towards the simplification of products’ is needed and may be more effective than detailed conduct regulation (PCBS 2013). This is because such proposals support strong trustworthiness. By enabling customers to better judge the usefulness and value of products on offer, (p.371) they encourage other-regarding behaviour, in that retail institutions will be encouraged by customers to pay more attention to the quality of products and the outcomes which they are likely to deliver.
16.6 How Can We Move Towards Strong Trustworthiness in Financial Services?
The discussion above suggests that the reforms proposed to date may make only limited progress in promoting strong trustworthiness. The reforms are nonetheless important because they lessen the obstacles to trustworthiness that we have identified. In a number of cases the reforms encourage weak trustworthiness and in a few cases they directly support strong trustworthiness. Some reforms have the potential to encourage strong trustworthiness, provided attention is paid to the way in which the reforms are implemented and their effect on other-regarding motivations.
We turn now to what further changes are needed to encourage strong trustworthiness more directly. We do this by returning to the four steps which help to achieve strong trustworthiness: a description of obligations, identification of where responsibility lies for the delivery of obligations, mechanisms to ensure appropriate delivery, and methods for holding individuals or institutions to account for their performance. In the discussion that follows we examine to what extent current practice and recent proposals make adequate provision for these four steps, again focusing on three key components of the financial services industry: retail banking, investment banking, and pension funds. In this discussion we make use of suggestions which come from our review, earlier in this chapter, of other industries.
16.6.1 Description of Obligations
As de Bruin emphasises in Chapter 12, the values of a firm encapsulate its other-regarding obligations. Mayer (2013) suggests that all corporations should elaborate a set of values, and give expression to these values, and that such values will enable the corporation to make commitments as an institution, as well as encouraging commitment from shareholders, employees, and other stakeholders. This is something which we support.
Recent proposals, for example by the Parliamentary Commission into Banking Standards (2013), have focused on the imposition of specific obligations on directors to ensure the safety and soundness of banks and on the duties owed by these banks to their customers. But there has been little discussion of the broader need for financial institutions to specify their purpose and values. This is despite the fact that the GFC and subsequent conduct (p.372) scandals have called into question the purpose and structure of financial institutions, and that neither regulation nor integrity systems can resolve the resulting problems until these questions on purpose and values have been understood (Miller 2011a).
Mayer’s proposal for the articulation of firm values would achieve a change in the objectives of financial services firms away from the maximisation of shareholder value. The commitments given by firms would—in principle—enable them to constrain managerial behaviour focused on short-term profit maximisation, to constrain excessive risk taking, and to move towards satisfying the needs of customers, over a longer-term time horizon. The aim would be to strengthen the trustworthiness of the financial industry by encouraging other-regarding motivations, and so enable what we have called a ‘stronger’ form of trustworthiness to emerge.
The formation of a board-level ethics committee would form part of the process by which this articulation of values would be carried out. This committee would be the place in which the obligations to be placed on individuals would be set out. Moves towards the implementation of an industry-wide professional body for financial services would help with the articulation of standards expected both from firms and from the individuals who work within these firms.
There is of course a wide range of activities undertaken by the financial services industry, and these activities vary in the extent to which they involve a relationship of trust, and so in the obligations which are necessary. In each of the different activities which we discuss below we seek to identify the nature of the trustworthiness which is required and hence the obligations which are appropriate. These are obligations which would be in addition to the normal relationships between contracting parties, and in addition to regulatory requirements.4
Activities which necessarily involve a relationship of trust are those of financial advisors to their clients and those of pension fund managers to their investors. Each of these activities gives rise to a necessary obligation. Financial advisors owe their clients a duty of care to take into account their particular circumstances and requirements, and to recommend products that are appropriate to these circumstances. Following the various mis-selling scandals, the need to avoid any conflict of interest in the provision of advice (p.373) has been highlighted by Miller in Chapter 14. Where such advice is provided by retail banks, fiduciary duty could be strengthened and a clear separation made between advice and sales activities, in order to avoid the conflicts of interest which drove mis-selling in the past.
The obligations of asset managers and trustees—not only pension fund trustees—are also of this kind; these too cannot only be managed by contractual means. The Kay Review (Kay 2012) made this clear. That Review articulated a set of obligations which need to be accepted by asset managers and trustees. These obligations have two parts.
First, the Kay Review recommended that a fiduciary relationship be recognised between asset managers and investors, and that this duty be incapable of being overridden by contractual terms. This view is reinforced by the arguments made by Getzler in Chapter 9. Other commentators have made similar calls for the application of fiduciary duties; for example, Johnson (2012) calls for all pension funds, including contract-based defined-benefit schemes, to be subject to fiduciary-like obligations to pensioners. Such fiduciary duties would be designed to prevent the kinds of risk taking described by Noe and Young in Chapter 3, in which fund managers engage in risky activities which are not in the interests of those who provide them with funds to invest, by, for example, making investments with tail risks which allow the possible loss of all of their assets.
Second, the Kay Review recommends a form of stewardship between fund managers and the firms in which they invest. Such stewardship would involve a commitment to engage in longer-term investment, in such a way as to avoid pressure to deliver short-term investment returns. Companies can attempt to build their core competencies over the longer term, or they can aim for shorter term rewards. An unwillingness by financial institutions to invest for the longer term leads to a focus by firms on delivering short-term rewards and the pursuit of short-term financial deals, as distinct from long-term productive skills, pushes further in this direction. Instead there should be a willingness to invest for the long term. This willingness must be based on analysis by the financial intermediaries. The ability to carry out analysis requires a specialisation of a few companies in which money is invested, and the investment of resources in analysis. Such stewardship will be costly.
Banks also need to have obligations which go beyond contractual requirements. Banks owe a duty of care to customers, in terms of the provision of information, dealing with complaints, and in the design and sale of products. The Parliamentary Commission into Banking Standards proposes that these obligations be specified in the Corporate Governance Code and the Senior Persons regime.
Obligations for a duty of care in product design are relatively uncontroversial on the retail side of banking. However such obligations run against (p.374) notions of caveat emptor under contracting arrangements for the so-called sophisticated customers of investment banks. In Chapter 10 O’Brien argues that the past bifurcation between sophisticated and unsophisticated customers is untenable, citing a recent Australian court decision regarding the duty of care owed by Grange Securities to a local council in NSW.
There also need to be obligations concerning disclosure and product testing. The approach of the Parliamentary Commission into Banking Standards to this question appears to be surprisingly conventional, suggesting that sophisticated customers can understand the transactions entered into, so that obligations are not needed, at least for these customers. However, the discussion provided by Noe and Young in Chapter 3 suggests that this may not be enough. Asymmetries of information and expertise are too pervasive and it appears possible for investment banks to design products which are not in the interests of even sophisticated customers. In our view there should be an obligation on investment banks to owe a duty of care in relation to the products/services created, one which is applied irrespective of level of sophistication of customer. Where products are created which are known to have toxic effects or include tail risk, there should be a duty to make this sufficiently clear to the consumer. There would be a breach of trustworthiness if consumers were not made aware of these risks. The sale of such products should thus be permitted only if these facts are sufficiently identified. The failure to take sufficient care in the design of such products, so that products of this kind are unknowingly supplied, should also prevented. That is, the obligation should not only extend to disclosure, but to a requirement that there be a thorough investigation of the risks involved.
Many recent proposals about obligations focus on preserving the safety of the overall financial system, on the protection of the payments system from failure, and on the need to avoid excessive risk taking to ensure these requirements are not jeopardised. Thus the Parliamentary Commission into Banking Standards proposed that directors of banks outside the ring fence should be required to have regard to the safety and soundness of the firm (PCBS 2013) and that such a requirement should apply to other institutions as well. This requirement is to be implemented through changes to the UK Corporate Governance Code, the PRA Principles for Business, the Senior Persons responsibilities, and changes to the Companies Act.5 Similarly, the Treasury’s report on sanctions for the directors of failed banks recommended a regulatory duty for directors to ensure that banks run their affairs in a prudent manner (HM (p.375) Treasury 2012a). The desire to avoid punishment (whether legal or regulatory) leads to only weak trustworthiness, with its effectiveness dependent on the realistic threat of being caught. Strong trustworthiness requires that such obligations be recognised and accepted by directors and others, rather than merely being imposed. For this reason, the way in which this obligation is formalised by each bank will be important, and in particular the extent to which internal processes are designed to manage risk. This is discussed further below.
16.6.2 Identification of Responsibility
Assignment of responsibility for the delivery of obligations is our second step towards securing trustworthiness. The Parliamentary Commission into Banking Standards considered that insufficient personal responsibility was a key problem, and a centrepiece of the report is its recommendations concerning the Senior Persons Regime, the Licensing Regime, and board governance (PCBS 2013). Together these proposals attempt to assign responsibility for all key activities and risks to nominated individuals within the banks. The reforms respond to perceived evasion of responsibility by senior bankers following the GFC, which was a source of much public anger. We see these as useful reforms, which should contribute towards improved trustworthiness in the industry.
The Senior Persons Regime is intended to assign responsibilities for all prudential and conduct activities, including product design. The Licensing Regime covers a wider group of staff and seeks to ensure that staff understand and demonstrate the behaviour expected of them. Under the governance proposals, greater protection is to be given to the independence of the heads of risk, compliance, and internal audit, alongside increased accountability to the board (PCBS 2013).
A particular area of tension is the supervisory relationship between regulators and banks. Thus the PCBS expressed concern that regulators not become shadow directors. Similarly the PCBS suggested that banks retain responsibility for the design of products, with the FCA’s new tools not being used to intervene too early and distort the market. This reflects concern that the asymmetric information and skills involved in the development of products enable banks to develop innovative products to the benefit of clients. These same advantages put the regulator at a disadvantage in terms of detecting products that are abusive. Strong trustworthiness requires that the responsibility for preventing the design of abusive products lie within and be accepted by the industry.
Defining responsibility for the appropriate design of products is complicated by the fact that the appropriateness of products depends on the (p.376) circumstances of the customer, and that those selling the product may be different to those designing the product. The product engineer has a clear responsibility to the product seller to ensure that information about the product is accurate and not misleading. The product seller has a responsibility to his customer or client to ensure that he investigates the product sufficiently. Neither should sell to third parties products they would not be happy to invest in themselves. In submissions to the Banking Standards Inquiry, retail banks have recognised that the products they sell need to serve customers’ interests, with some seeking ‘more certainty up front that product attributes and sales processes are acceptable’ (HSBC 2012).
Within pension funds the management of assets is typically carried out by a wide range of different entities, with trustees coordinating the activities of others such as custodians and investment managers. The responsibility of those managing pension assets involves ensuring that investment is directed to profitable ends, so as to ensure low costs of intermediation and moderate levels of risk. This responsibility rests primarily with asset managers and with trustees, but, as we discussed above, there is scope for clarifying the responsibility of other parts in the chain of intermediaries. The PCBS recommended that fiduciary duties apply to all elements of the investment chain.
Where a business is very complex, as in much of financial services, there is also a role for gatekeepers. Gatekeepers include accountants, lawyers, and credit-rating agencies, and their responsibility is to certify to the quality of a firm’s activities and the truthfulness of its promises. Yet the gatekeepers are widely seen as having failed in that role in the run-up to the GFC. Credit ratings were undermined by a combination of conflicts of interest and excessive regulatory reliance which undermined market processes (Morrison and Wilhelm 2013). Accountants signed off on accounts that were subsequently found to have been highly misleading—with many now facing litigation over their failures. This has led the PCBS to conclude that it is essential for regulators to reduce their dependence on credit-rating agency ratings when assessing capital adequacy (PCBS 2013). In Chapter 10 O’Brien describes responses in Australia to the perceived decline in trustworthiness of accountants.
There are a variety of mechanisms that can be used to try to encourage strong trustworthiness, several of which are discussed in detail in earlier chapters of this book. In the present chapter, we have described how these mechanisms have been used in other industries. Here we focus on the mechanisms which have received most attention in the context of financial services, and examine their potential to support strong trustworthiness.
(p.377) Professional bodies and codes of conduct have been used in a variety of industries to ensure the maintenance of standards, in ways which we have described above. However, the Parliamentary Commission on Banking Standards considered that neither could be relied upon for the banking industry, arguing that ‘robust regulatory underpinning’ was required to bring about a change in standards and culture (PCBS 2013). The Commission’s concern was that banking consists of a broad range of activities which lack a common core of learning, that a professional body does not necessarily guarantee high standards, and that its development could divert attention away from the regulatory changes needed. The Commission accepted that a professional body has the potential to promote higher standards, but argued that such a body will take time to develop and prove itself.
A professional body provides a mechanism for defining expectations and promoting understanding of what those expectations imply for individuals, and hence we believe that a professional body could contribute towards improved trustworthiness. As discussed by the Commission, however, there would need to be a commitment on the part of the banks to ensure that such a body was effective. Only with such commitment would the body be in a position to engender a positive change in the norms of the industry, and to provide a countervailing influence to the existing culture of self-interest. In doing so, a professional body would assist Senior Persons to fulfil the responsibilities given to them under the regulatory framework.
The existing code of conduct under the Approved Persons Regime has low credibility and was widely disregarded. The principles for behaviour were simply overwhelmed by the incentives for self-interested behaviour provided by remuneration systems and by the general culture which these incentives created. Lack of enforcement and the inability of customers to detect abusive products were also contributory factors. It is not surprising that the Parliamentary Commission on Banking Standards considered that it was not a sufficiently robust foundation for improving standards.
However, as de Bruin discusses in Chapter 12, there is a role for codes to articulate both general values and specific norms in order to provide guidance for the reinforcement of trustworthiness. Thus a well-designed code should present a set of principles reflecting the general values of an institution, as well as concrete rules of conduct and practical guidelines. This could include guidance, for example, on sales of inappropriate products, on misrepresentation of the characteristics of products, and on how to identify and deal with conflicts of interest. Methods of implementing codes of conduct, and the forms which these may take, are discussed in detail by de Bruin in Chapter 12.
A large part of the value of codes of conduct lies in the framing they provide to individuals to encourage other-regarding motivations. Important in this is the morally-orientated discussion which codes engender—for example, in (p.378) discussions of how to manage a specific conflict of interest or how to balance the interests of different customers. By reinforcing procedural motivations, they make staff less tolerant of breaches and encourage strong trustworthiness both directly and through motivations based on esteem.
Awrey and Kershaw discuss in some detail in Chapter 13 how firms might go beyond codes of conduct in the promotion of norms which might encourage other-regarding behaviour. Their chapter has canvassed some of the ways in which we might seek to engender a more ethical culture within the financial services industry. It discusses how process-oriented regulation, combined with restructuring of the internal governance arrangements of financial services firms, might be used to achieve this objective.
The ‘tone at the top’ will be important in bringing this about, something which is identified by the Parliamentary Commission on Banking Standards (PCBS 2013). This ‘tone’ includes the implementation of appropriate disciplinary measures for violation of codes of conduct. The advantage of internal discipline mechanisms is that violations are likely to be more visible within the firm than to the regulator, and more capable of nuanced response. In turn this encourages stronger procedural other-regarding motivations and strong trustworthiness.
Particular emphasis was placed by the Kay Review on the value of a stewardship code for the pension fund industry. The Review argued that short termism and a lack of engagement by shareholders are having a damaging effect on the performance of UK businesses, and that this should be recognised through the development of a stewardship code for asset managers, supported by good practice statements (Kay 2012).
The ‘tone at the top’ is likely to be both enhanced and more effective in terms of filtering down with the introduction of an ethics committee. It would signal real engagement by senior management in improving standards and culture and indicate that the Senior Persons Regime will not be treated as just an exercise in compliance. An ethics committee could be responsible for identifying ethical risks and implementing processes for managing problem areas. To this end it would need to collect evidence, identify transgressions, design systems, and conduct audits to ensure that these systems are working (Miller 2011b). An ethics committee could then play an important role in ensuring that Senior Persons are able to deliver the responsibilities given to them by the regulatory framework. ‘Trustee’ firms, of the kind advocated by Mayer (2013), would adopt a set of obligations broader than the obligations to their shareholders, and this would clearly influence the ‘tone’ of a firm. The board of trustees would act as the guardian of the firm’s values. As noted above, the ethics committee could then be responsible for ensuring that these values are adhered to, as proposed by Awrey and Kershaw in Chapter 13.
(p.379) An ethics committee of the board of trustees would also address the difficulty of identifying objective measures of ethical performance. This difficulty (raised by O’Neill in Chapter 8) includes the risk of diverting attention onto secondary targets which capture the underlying obligations only imperfectly. For example, how should socially excessive risk taking be defined? Being integral to the firm, such bodies would also assist in countering the problem that measures of performance tend to be subject to gaming, particularly when they are imposed by regulation.
Another proposal with merit is the establishment of an independent authority for the industry which would certify products which are kite-marked or branded as being safe and having well-understood characteristics. The advertising industry provides an example of how mechanisms to enhance trustworthiness in sales processes through the creation of an enforcement agency (the Advertising Standards Authority) can be implemented. In the finance industry such an authority would reflect a commitment to market easily benchmarked products. Such products would enable customers to compare value for money in a transparent manner and would improve competition between banks (including competition across non-simple products as customers would have a better point of reference). The authority would publish prices and information, and could also develop and publish reputation indices. This would enable retail banks to compete on reputation to improve the trust of customers (Armstrong 2012). It could also be given powers to punish those who do not comply with the ethical standards agreed by the industry.
A particular concern is that neither internal risk management systems nor regulatory rules have proved effective in managing the risks generated on the investment banking side of the industry. Incentives to ‘bet the bank’ overrode the concern of risk assessment officers. Regulatory rules were comprehensively arbitraged. To counter these problems, a cooperative agreement to an industry-sponsored risk control mechanism could be established if managers of (important) firms regard the dangers of another major crisis as sufficiently great, as was the case with the nuclear and chemical industries. To some extent, the opportunity and motivation for a voluntary arrangement is being overtaken by regulatory reform. Nonetheless, a voluntary arrangement could bring benefits, including reduced risk of arbitrage, greater flexibility, and potentially greater expertise being brought to bear on the process of scrutinising performance.
In the nuclear industry an industry-wide risk control apparatus emerged after Three Mile Island because key players in the industry wanted to prevent a subsequent crisis which could result in the public turning against the industry. The Institute of Nuclear Power Operations (INPO) now provides effective risk management for the industry, with which all companies involved in the industry comply (although what happened in Japan shows that further (p.380) improvements in risk management processes are still needed). Similarly, the process which followed the Bhopal disaster led to the creation of the chemical industry’s responsible care programme.
16.7.1 Holding to Account
Strong trustworthiness, willingness and competence in keeping commitments, requires that the person/institution responsible for delivering an obligation both render an account of their performance, and be held to account for that performance. This requires an informed and independent judgement about what has been done (in comparison with what ought to have been done), and this assessment needs to be communicated in an accessible manner.
Accountability is not just about sanctions and enforcement. As Gold emphasises in Chapter 6, strong trustworthiness does not follow from the desire to avoid punishment. Rather, it is about intelligent processes for judging the performance of obligations. A major failure of accountability in the period prior to the GFC was the resort which was made to ‘tick box’ regulation and compliance testing. Northern Rock’s celebration of compliance with Basel II was short-lived, and demonstrated a lack of judgement of the underlying risks to the company’s financial stability.
In the pension fund industry the Kay Review has sought more intelligent accountability by changing the criteria and time horizon by which asset managers are assessed (Kay 2012). Instead of short-term assessment of relative performance, the Review advocates that performance be judged and rewarded on the basis of the long-term value of investments. Consistent with this, the Kay Review is critical of the current disclosure regime, which produces a ‘cascade’ of data that focuses attention on short outcomes (which are often the result of little more than noise) rather than long-term, underlying value.
Any assessment of performance requires clarity on the standards of performance to be met. The absence of agreed standards to which key roles should be performed was identified by the Treasury as a major barrier to holding directors of a failed bank to account (Treasury 2012a). Similarly, Awrey and Kershaw provide some discussion in Chapter 13 of the difficulties of defining socially excessive risk taking, let alone identifying it in advance. They suggest that process-orientated regulation can help, stimulating dialogue and promoting firm engagement. On this basis, the assessment of performance, and enforcement, could be based on the effectiveness or otherwise of the engagement.
Part of the process of holding to account involves the provision of information to allow customers and stakeholders to assess trustworthiness. (p.381) Reputation can assist in this way, but reputation needs to be warranted. Reputational indices could be helpful, provided they capture internal processes honestly, and measure the features of concern to people placing trust (rather than comprising a set of second-order targets which then become the subject of manipulation). The creation and publication of reputational indices could be undertaken by the independent authority established to certify products.
But while recent proposals address obligations, responsibilities, and enforcement, there is little consideration of how performance can or should be judged intelligently. The Parliamentary Commission on Banking Standards suggests that regulators provide guidance on standards in the form of a new set of Banking Rules, and that the regulators will need to make judgements, but there is no discussion of the difficulties of assessing how well or otherwise obligations are performed. The discussion of Special Measures perhaps comes the closest in this regard, sketching out the approaches used by the PRA and FCA to identify conduct risks and the increased reporting requirements that accompany the identification of ‘red flags’ (PCBS 2013). Much more detailed work on this is necessary.
We have argued throughout this book that reform of the financial sector needs to rely upon motivations which go beyond the selfish-motivation assumption on which economic analysis is normally based. The authors of the chapters have suggested that other-regarding motivations might lead those in the financial sector to act in a more trustworthy manner, and that they might help to underpin a public policy which is directed towards such an end. We have described how other professions, including medicine and the law, are built upon a sense of professional responsibility for patients and clients. The task is to ensure that those who work within the financial sector become more strongly bound by professional standards of behaviour, as in these other professional sectors, and as once happened in finance. We have discussed how changes might help to bring this about, at the personal level, at the institutional level, and through legal and regulatory intervention. These changes need to include a description of the obligations to be honoured by players in the financial sector, clear identification of who is responsible for honouring these obligations, well-specified mechanisms designed to ensure that these obligations are in fact honoured, and a well-informed process through which those involved can be held to account. Only with such changes is reform of the financial sector likely to succeed.
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(1) F. T. Allen was quoted in the Wall Street Journal (19 October 1975) as saying that ‘corporate officials were beginning to be perceived as “little more than manicured hoodlums”.’
(2) The Nuclear Regulatory Commission (NRC) and the Federal Energy Regulatory Commission (FERC).
(3) The Investment Dealers Association, Mutual Fund Dealers Association, Market Regulation Services, and the Montreal Exchange.
(4) Our aim here is different from that of Morrison and Wilhelm (2013). Morrison discusses how legalised contracting and regulatory requirement have become more necessary when relationships of trust break down, and argues that this becomes increasingly important as the scale of financial systems increases, and personal contact between parties is replaced by large impersonal markets. Here we seek to argue the reverse—that trustworthiness remains necessary in impersonal markets, that it is important to foster strong trustworthiness in such markets, and that means must be found to make this possible.