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.”
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.