Understanding a bank’s culture is key to finding out how risky it is, say Robeco’s engagement specialists.
The banking industry has lurched from one crisis to another in the past decade, from the global financial crisis and bank bailouts of 2008, to traders manipulating the LIBOR interest rate and the PPI loan insurance scandal which has cost the industry billions.
To get a better understanding of the risk profile of banks, engagement specialists Cristina Cedillo and Michiel van Esch conducted an elaborate research project into some of the most material governance issues that banks face. The results identified some key areas for engagement over the next three years in a program entitled ‘Culture and Risk Governance in the Financial Sector’.
“We believe that understanding the culture of an organization is of great importance to understanding the implementation of its risk management systems and overall strategy,” say Cedillo and Van Esch in the Robeco Active Ownership Report Q1 2018.
“Peter Drucker, the business consultant who is often called ‘the founder of modern management’, once said that “culture eats strategy for breakfast”. While this may be true, the problem with organizational culture is that it is difficult for an outsider such as an investor to assess.”
The engagement program aims to grasp how banks are setting their risk tolerances, implementing compliance and risk management systems, and managing their culture. “None of these objectives are easy to achieve,” the specialists warn. “Even if banks report a risk appetite framework and provide statements on their risk appetite, investors often do not get to know how risk statements are translated into practice.”
“We believe that the quality of a company’s risk management framework and the nature of their culture cannot be captured by only studying annual reports, risk statements and other company reports.”
As a first step to gain a better understanding, a questionnaire was drafted and sent to ten retail banks in Europe and the US. One of the questions specifically related to the bonus pools that were directly blamed for causing the financial crisis, as bankers engaged in risky financial bets in order to boost profits and therefore their own salaries.
“Incentive structures are used in many forms by corporate organizations: most of the time these aim to motivate people to chase specific targets, or to trigger desired behaviors,” say Cedillo and Van Esch. “If such structures are designed well, executives and employees might be motivated to keep improving performance and to act in the interest of all relevant stakeholders. Many plans, however, have significant flaws, and can trigger the opposite effect. Gaming and bonus blindness are often issues that create the negative side effects of financial incentives in remuneration plans.”
“Likewise, executive stock plans are intended to align management incentives with the interest of their shareholders. Yet these plans do not always achieve that goal. Even if provisions are in place to prevent management from benefiting from negative stock performance, management might still gain more from some specific stock plans by increasing stock volatility. In these cases, management may still have a very different risk appetite from most investors.”
The specialists say a textbook example of where bonus schemes go wrong was seen at the US bank Wells Fargo, where employees created millions of checking and savings accounts and thousands of credits cards that were never authorized by clients. One of the key driving factors was the sales-driven incentive structures which rewarded employees for creating these new accounts.
As a result of all these misdeeds, banks now face more regulation than ever, though some risks are measurable and some are not. “For investors, it is often unclear how several risks are measured and managed in practice,” the specialists say. “In our engagement, we will try to get a better grasp of how management sets risk tolerances, and how it measures, monitors and aggregates all relevant risks.”
“On the one hand, banks face a broad range of financial risks, including market, solvency, liquidity and credit risk. For many of these risks, measures are available that allow banks to set tolerances and report on and monitor the situation throughout the organization.”
“On the other hand, banks also face non-financial risks, which often include those relating to conduct, operations and crime. These risks are often harder to quantify and monitor. Still, we have recently seen in recent past that non-financial risks can be very material. So, we believe that in order to manage non-financial risks, an effective governance system and a strong risk culture are necessary.”
From the investment side, Robeco uses a number of measures to try to establish risk when buying bank bonds. These include assessments by RobecoSAM, along with standard metrics such as loan growth, remuneration packages and capital levels. Codes of conduct and whistleblower programs that can expose a bank’s ability to discover unethical or criminal activity are becoming increasingly important, but ultimately it still boils down to culture, says Taeke Wiersma, co-head of credit research at Robeco.
“Many of the conduct issues in the banking sector such as mis-selling can be attributed to a culture of chasing fees and putting short-term personal gains above longer-term client interests,” he says. “Ultimately this always backfires on the banks. The result is large fines and very costly settlements to make up for client losses.”
“This severely impacts the fundamental credit quality of the banks in terms of lower profits, and the ability to do business through the risk of license withdrawal, clients walking away, or other problems.”
“However, having the right procedures and policies in place is only part of the equation. To really understand the extent to which this is fully embedded throughout the entire organization, a regular dialogue with the bank is essential. The engagement project will therefore bring a lot of additional insights.”
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