This article was first published in the Finance Dublin Yearbook, March 2023.
Focus on culture
A subtle but palpable shift in the emphasis of regulation is underway. Have you noticed the CBI's increasing emphasis on culture? Unfortunately, this doesn't mean spending pleasant nights at the theatre but organisational culture – the influences and behaviours that create a corporate culture and the effect of that culture on the financial health of the organisation and the well-being of its customers.
In on-site inspections, speeches from senior officials and reports (most prominently the report on "Behaviour and Culture of the Irish Retail Banks"), the CBI has consistently made clear that it wants to get beyond assessing compliance with specific rules. Instead, it is focused on getting under the skin of organisations to understand their corporate culture.
Why is this the case and how can the industry meet the CBI's expectations?
The reason goes back to the financial crisis and, particularly, the way in which corporate governance, culture and behaviour contributed to risk taking and financial collapse.
Amongst EU supervisors, Dutch Central Bank (DNB), is a leader on assessing corporate culture and behaviour. In fact, it supported the CBI in compiling its behaviour and culture report on the Irish retail banks.
The DNB's view is that one of the lessons drawn from crises in the financial sector is that governance, behaviour and culture can have a major impact on an organisation's soundness, risk profile and integrity. Its view is that poor financial results are often caused by risky or unethical behaviour. It follows that supervising governance, behaviour and culture allows supervisors to detect risky behaviour and intervene at an early stage to avert future problems.
This provides helpful background to the CBI's approach. For example, applying this approach, if an organisation contravenes a rule, it is no longer enough simply to address that contravention. The organisation needs to consider whether the contravention might be a symptom of deeper underlying problem. Addressing an individual contravention won't address the deeper problem but a better understanding of the organisation's culture and governance just might.
I can't argue against this proposition. In 2014, I published an article entitled "Responding to a Financial Crisis: Can we Ever get it Right". The article analysed the then recent financial crisis, focusing on the reasons why rational and intelligent people can make irrational and (with the benefit of hindsight) foolish decisions.
I concluded that adding further layers to existing financial regulation was not necessarily the best way to prevent financial crises. Instead, good outcomes were far more likely if institutions and supervisors were to incentivise prudent behaviour, monitor common sense warning signs and prioritise rules based on a better understanding of the drivers of human behaviour. I added that, while it will always be difficult to achieve the ideal mix of professions in a supervisor, supervision will be deficient unless supervisors include experts on human behaviour.
Half of my wish came true. Since 2014, regulation has evolved and increased beyond recognition but so too has the supervisory understanding of the central importance of organisational culture. The CBI's decision to employ an organisational psychologist in the insurance division was a significant step towards developing that understanding. CBI speeches in recent years have begun to display a greater focus on how the environment in which an individual works can have a significant effect on that individual's behaviour – For example, Deputy Governor Derville Roland's 2018 speech "Bad Apples and Bad Barrels? How Effective Culture Mitigates Conduct Risk".
The results of behavioural science experiments support this approach. They show, for example, that peer behaviour, the influence of authority figures and an individual's perception of what is expected of them have a disproportionate effect on individuals within an organisation. These factors can sometimes lead good people to do bad things – even if this is completely contrary to the organisation's professed values.
Like it or not, it is very important for financial institutions to understand their own culture, to recognise what drives that culture and to consider whether their culture is appropriate.
How to build an appropriate culture
The detail will be different for every organisation. However, building an appropriate culture starts with making an honest appraisal of existing culture and the governance structures that support it including assessing (in no particular order) whether:
everyone in the organisation understands the organisation's values
remuneration arrangements support those values
the governance structure, internal rules, systems, processes, controls and oversight operate effectively to avoid giving anyone in the organisation an opportunity to act inappropriately
ethics policies lie at the heart of the organisation's operations or lie unopened and gathering dust out of sight
the messages, conscious or unconscious, that organisations give to our employees about the organisation's priorities are appropriate – these messages will drive employee behaviours
directors and senior management step back to ask whether a proposed action is right, rather than whether it is legal
employees understand the reasons behind rules and processes
senior management's understanding of values permeate the entire organisation
senior management has ever asked the organisation's employees for their understanding of values and how these are reinforced throughout the organisation
the organisation regularly polices first-line compliance
the organisation's reaction to wrongdoing, cover-up, whistleblowing is appropriate
the organisation's employees would agree with management's view on all of the above
Important building blocks for creating an effective and appropriate culture include:
setting out the organisation's values and ethical standards clearly for all employees
implementing a customer-focused approach to every aspect of the business from product development, through sales to after sales service and, very importantly for insurers, the claims process
regularly reinforcing the organisation's values and ethical standards
building a governance structure, oversight systems, processes and procedures and remuneration arrangements to support the organisation's values
ensuring that employees understand the reasons behind rules, processes and procedures
regarding contravention of a rule as a helpful warning sign that something may be wrong and ensuring that investigating the contravention examines the reasons behind the contravention, what enabled it to occur and whether those reasons could result in other contraventions in other areas of the organisation's operations
Honest self-appraisal is never easy but the ultimate reward is a well-run, compliant organisation where employees understand the organisation's values, feel empowered to challenge wrongdoing and know that good behaviour will be rewarded.