Bank Risk Culture: An Alternative View On The Causes Of The Last Financial Crisis

The following is the sixth in a series of articles on bank risk culture. The previous articles can be accessed here or by clicking the HOME tab on the blog.

A total meltdown in any system requires nothing less than a total rethink of the way forward.

Legislators and regulators have blamed the subprime financial crisis on a whole host of issues including derivatives, proprietary trading, deregulation, the collapse of Glass Steagall and the integration of retail and investment banking, as well as the overall failure of risk management and corporate governance. What we have learned so far in this series of articles is that the actual reasons are somewhat different as they relate to the overall culture of banking.

How do we define and assess this total culture?

Over the five previous articles we have developed a more holistic view of the nature of risks within banks and financial institutions. We have determined that the proper management of risk is not limited to risk management and risk culture but that leadership and strategy are vitally important. We have also determined that the management of risk internally includes organisational; processes, systems, growth, size and structure, as well as employee integration.

However, we do realise that total risk has external elements in terms of the culture of values which an institution adopts when dealing with customers, suppliers and the wider community.

It is within this context that we can now properly define the root causes of the last financial crisis by taking a holistic view of all elements within the banking ecosystem and understanding in each case, how the lack of an appropriate system of values, or as some would say culture, undermined the industry.

The elements and the system of values, or lack thereof, are as follows:

Mission & Values

Banking culture in its totality was oriented towards size and market domination without a fully coherent approach to either. This resulted in Too Big To Fail institutions which by definition were also Too Big To Manage.

Individual Employees

Perverse incentives for traders and salespersons meant that profits and bonuses were prioritised over longer term sustainability.

Employees

Good teamwork was either poorly developed and/or not really understood. Too many employees had no idea of what their colleagues to the left and right of them were doing. Overall banks exhibited poor integration of employees in operations, internal control and governance functions.

There was also an overreliance on rigid command and control structures which were inadequate for the needs of complex and dynamic institutions and the free flow of information between employees.

Management

Too much faith was placed in complex mathematical models. Economic theories such as Portfolio Theory and Modigliani Miller were tested to destruction. An analysis of the history of financial crises and their overreliance on false paradigms would have been far more instructive. In addition, management teams suffered from Groupthink.

Organization, IT & Systems

Not enough attention was paid to acquisition and expansion beyond the strategic logic of markets and customers. The result was large and overly complex organisation, IT and systems environments which significantly diminished the effectiveness of governance and internal controls. In some instances banks could not properly identify their total risk exposures.

External Environment

Banks did not effectively manage their external environment. CEOs and leaders were unable to break out of their industry echo chamber and simply followed their competitors rather than focusing on developing the strategic advantages of their own institutions.

Some banks lobbied extensively for less stringent liquidity standards and used this as well as a sustained period of cheap money from central banks to fuel the asset price inflation which eventually brought down the global economy.

Suppliers

Banks did not properly manage their supplier value chain. Unlicensed brokers provided small banks with poor quality loans which in turn were passed on to large banks for securitization. This value chain was further diminished by the fact that the rating agencies that assessed the quality of the securitised loans provided a less than creditable service.

When the loans went bad, as they inevitably would, the entire system collapsed.

Customers

Large and small banks failed to act in the best interest of investors, corporate customers and consumers. This is evidenced by what happened in the aftermath of the financial crisis which has been characterised by large investor losses, a credit crunch and a huge number of homeowner foreclosures.

The Wider Community

Elaborate CSR programs were unable to limit the damage to the wider community and indeed the world; proving once again that business strategy and leadership are more important than risk culture and mechanisms for managing risks—irrespective of how well-intentioned.

It is quite obvious from the above analysis that more legislation, more regulation and more corporate governance on their own are not enough to forestall another financial crisis. The best way to accomplish this is by focusing on the lack of appropriate values and the cultural limitations within the totality of the banking ecosystem. This is precisely what we will do next week in the seventh and final article in this series.

A total meltdown in any system requires nothing less than a total rethink of the way forward.

Jonathan Ledwidge is the author of the book Clearing The Bull, The Financial Crisis And Why Banks Need A Human Transformation (iUniverse).

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