Financial Ethics: Preventing the ‘Stupid Stuff’

Ethics in financial services is suddenly a major concern for the most prominent US bank supervisor.

In a speech at the Bank of England on 20 January 2015, Thomas C Baxter, Executive Vice President and General Counsel of the New York Federal Reserve Bank, proclaimed, “At the New York Fed, we have made ethical culture a priority for financial services.”

As tangible evidence of this priority, the New York Fed held a workshop on 21 October 2014, on ‘Reforming Culture and Behavior in the Financial Services Industry,’ in an effort to understand the causes of ethical failures and to develop strategies for improving the ethical cultures of large financial institutions.

The New York Fed’s concern with ethics was heightened by a recent controversy over reporting by ProPublica and a related one-hour radio news programme on This American Life, broadcast on 26 September 2014, which focused on the firing of a New York Fed employee, Carmen Segarra, who had secretly recorded interactions with her superiors.

Her 46 hours of taped conversations revealed tensions within the New York Fed over the supervision of Goldman Sachs and focused mainly on whether Goldman had complied fully with a regulatory requirement for a comprehensive, firm-wide conflict of interest policy.

This embarrassing media coverage occurred in the context of the inadvertent release of a confidential 2009 report, commissioned by the New York Fed and prepared by a consultant, David Beim, which criticised the New York Fed for being unduly deferential to the banks it supervised by avoiding confrontation and seeking consensus.

In a Senate hearing on 21 November 2014, William Dudley, the president of the New York Fed, was questioned about the handling of Ms Segarra’s assessment of Goldman’s compliance. In that same Senate hearing, Mr Beim testified that Ms Segarra’s recordings “illustrated in Technicolor” the problems he had identified in his 2009 report.

One issue raised by the New York Fed over ethics in financial institutions is whether preventing ethical misconduct in banks by reforming their ethical culture is an actual responsibility of the Federal Reserve System.

In his London speech, Mr Baxter explained, “We have done this [made ethical culture a priority] not as a formal part of a supervisory program, but more as a call for reform,” suggesting that reforming ethical culture in banks is merely a hortatory exercise rather than an official mission. Mr Dudley explained further in the Senate hearing that the Fed’s role was not to be a police force. “It’s not like a cop on the beat,” he said. “It’s more like a fire warden.”

However, the Fed’s charge to “to ensure safe and sound banking practices and compliance with banking laws” opens the door to the reform of ethical culture as an objective insofar as ethical misconduct poses risks to “safety and soundness” by damaging the banks themselves and undermining trust in the banking system, which in the recent financial crisis threatened financial stability. Mr Dudley expressed this point in a speech by saying, “In my view, this loss of trust is so severe that it has become a financial stability concern.” Furthermore, ensuring “compliance with banking laws” is facilitated by a strong ethical culture, especially when it supports respect for law.

The recordings by Ms Segarra raise another critical issue about the Fed’s responsibility with regard to ethics. A transaction between Goldman Sachs and Banco Santander, which enabled the Spanish bank to present a possibly misleading appearance of its capital soundness, was considered by Ms Segarra’s superior, Michael Silva, to be “legal but shady.” Such a “legal but shady” transaction posed a challenge for the Goldman examiners: Should they intervene and attempt to prevent the deal, or let it pass? The answer to this question depends not only on their assessment of the ethics of the transaction but also on their understanding of the Fed’s role.

In this case, Mr Silva decided to intervene, but the manner in which he attempted to prevent the transaction was so ineffectual as to invite ridicule in the This American Life radio programme. Ironically, Ms Segarra thought that Mr Silva’s focus on what Goldman “should” do was “fuzzy” and “esoteric” and that the focus of bank supervisors should be merely on strict regulatory compliance, where she felt the New York Fed had been deficient. Ms Segarra’s apparent position was that concern over the ethical conduct of banks was not within the Fed’s supervisory role.

The challenge posed by “legal but shady” transactions, such as the Goldman-Santander deal, extends beyond the concerns of the New York Fed and confronts all financial institutions. It is difficult for any business to turn away from a profitable venture that is approved by the legal department, no matter how questionable the ethics. However, many egregious ethical failures at banks are also viewed in retrospect as bad business decisions. Few bankers, looking back on these painful episodes, would willingly repeat them. Preventing bad business decisions is no easy task, however, and ethics may not appear, at first glance, to be even relevant to such prevention. Many bad decisions seem to exemplify Hanlon’s Razor: “Never attribute to malice that which can be adequately explained by stupidity.” This admonition is echoed in President Obama’s oft-repeated phrase “Don’t do stupid stuff!”

A strong ethical culture in a bank can serve to prevent some bad business decisions or “stupid stuff” by drawing attention to consequences which might otherwise be neglected or discounted, including the public reaction to a bank’s misconduct and legal or regulatory actions. The direct accounting costs of misconduct can be substantial, and they show up in the bottom line. However, bankers should also consider the indirect costs, which occur in the form of reputational risk. An impaired reputation may reduce the value of a firm’s franchise and increase its costs of doing business through defecting clients, dispirited employees, wary investors, increased regulatory scrutiny, and, in general, a more difficult business environment.

Although a concern for reputational risk might seem to fit easily with the risk management systems of banks, the benefits of managing reputational risks are “soft”, while the returns from ethically questionable deals are “hard.” Inexperience in managing reputational risk is a further source of uncertainty. Moreover, an ethical culture is often seen as an impediment to profitable short-term deal making, rather than as a facilitator of long-term success. More crucially, developing an ethical culture in order to better manage reputational risk is a rather unfamiliar idea in banking, and a daring leader who wants to make it a priority for a bank must overcome considerable skepticism and resistance from many quarters.

Given the undeniable value of an ethical culture for financial institutions but the understandable reluctance of institutions to build one, the New York Fed’s “call for reform” should be welcomed by the banks themselves. Although banks may view these efforts as an intrusive moral crusade, which seeks a higher level of ethical conduct than is necessary for success, the Fed is, instead, seeking to protect the banks against the damage that misconduct inflicts on the banks themselves and the entire banking system.

A strong ethical culture is a valuable safeguard against “doing stupid stuff.”