By David Grosse

Two Steps Forward and One Step Back

The phrase “two steps forward and one step back” is reflected in the anecdote about a frog trying to climb the slimy walls of a well. For every big hop of progress there is a slide down the slick bricks as gravity takes it’s toll.
Watching Bank Regulators attempt to tackle the slippery topics of conduct, culture and behavioural risk brings to mind the frog. Advances in some areas, but not always rapid and with some backsliding.
Recent activity includes:

  • The De Nederlandsche Bank (DNB) has long been acknowledged as a leader, and began supervising behaviour and culture at financial institutions in 2011. Nonetheless, in their 2023 research they acknowledged that whilst things have improved, there is still a lot of work to do.
  • DNB influence has seeped further into the approach of the European Central Bank (ECB), with a greater emphasis on Risk Culture. An ECB Paper in 2023 was followed by a series of speeches, most notably by Frank Elderson, which stressed a focus on behaviour and culture in ECB supervision, and flagged a new guide on risk culture due at the end of 2024.
  • Elsewhere in Europe the picture is patchy. For example, in Ireland a focus on bank behaviour and culture remains, and their new Individual Accountability Framework was signed into law in 2023. In the UK, whilst there has been a spotlight on consumer duty, the prior leadership of the FCA on wholesale conduct appears to be waning, perhaps due to the pressure to promote financial services in the UK post Brexit. Whilst not regulatory, the existence of the industry Irish Banking Culture Board paired with the 2023 demise of the Financial Services Culture Board seems apt.
  • In North America, the New York Fed continues with it’s valuable Governance & Culture Reform initiatives, but there still remains a need to plug the gap in supervisory capabilities as highlighted in a speech by Michael Barr, and as exposed by the collapses of SVB and Signature Bank in 2023. Meanwhile, the Federal Deposit Insurance Corporation (FDIC) is likely to be considering it’s own internal culture following recent misbehaviour allegations.
  • Canada’s Office of the Superintendent of Financial Institutions (OSFI) published a culture and behaviour risk guideline in 2023. In this it noted that Banks should identify behavioural patterns, and where this work raises concerns to assess their root causes. How this methodology will be implemented in Financial Institutions has yet to be concluded.
  • In Asia Pacific, the Australian Prudential Regulation Authority (APRA) continues with it’s approach to Risk Culture, and the Monetary Authority of Singapore (MAS) and the Hong Kong Monetary Authority (HKMA) retain an ongoing focus on aspects of conduct and culture.

Whilst all these initiatives have good intentions they appear disparate in approach, and can ebb and flow depending on the political climate, the latest crisis at a bank, or the interests and expertise of senior management and other stakeholders. Little wonder that the frogs can sometimes slip back down the wall of the well.

A Limited Perspective

A different parable of the frog in a well is used in Chinese culture. In this story the frog, having lived its entire life in a well, has a limited perspective of the wider world, and its views are challenged when it encounters the wise turtle from the Eastern Sea.
Taking a lead from this fable, perhaps the problem with bank behaviour and regulation rests with a restricted world view and narrow appreciation of the available solution space. Or more accurately, a lack of understanding (from many regulators and bankers) that there is a lack of understanding.

As a parallel, consider these complex situations in a bank:

  • The reliance on cloud service providers as critical third party suppliers;
  • The need for advanced cyber security infrastructure, expertise and capabilities;
  • The recognition and investigation of intricate money laundering structures;
  • An understanding of the capabilities and threats of AI and machine learning;
  • The role of blockchain technology, and the attendant fields of digital assets and cryptocurrency.

In each of these areas if a regulator asked a firm what they were doing about them they would get a response pointing to specialist capabilities, functions and expertise, and of budgets, technology and governance. Senior management would acknowledge their own limitations, but highlight the skills and resource they have put in place to protect the bank. An executive who bravely tells the regulator that there is no need for any specialist understanding nor spend in these areas would be on the fast track to special measures and sanction.
However, the complexity of human behaviour and decision making, the dance of psychology, the insights of behavioural science, neuroscience, anthropology and biology are not yet thought worthy of similar consideration.
In the darkness of the well, a code of conduct, communications and training, supported by an HR survey are often thought to suffice. Perhaps supplemented by some isolated pockets of good practice on D&I and psychological safety, accompanied by soothing culture metrics to maintain an illusion of control.

Climbing Up

Learning from the frog, regulators should look up to the light to consider what insight and understanding is available from the wider world, freed from the constraints of the well.
Good intentions and disparate initiatives need to be paired with behavioural expertise and supervisory intent, with the following steps taken:

  • Ensuring suitably skilled and empowered staff within the regulators, who can ask the right questions and comprehend the context;
  • Joining the dots between the behavioural subject-matter-experts and the supervisors, so that those on the front line are equally aware and equipped;
  • Supervisors asking each Bank on what expertise and resources they in turn have in place to identify, understand and manage behavioural risk, and challenging those institutions that have little.

Rather than splicing together disparate initiatives, or attempting to prescribe or proscribe detailed requirements around culture, a course of action likely to follow the law of unintended consequences, regulators should be encouraging Banks to build out their behavioural muscle, and challenging those who do not.

In that way, step by step, the frog will continue to climb the slippery wall towards sunlight.