Reputation risk rises on regulatory agenda

The headlines about systemically important financial institutions this week marked a new twist amid enduring concerns about how to wind down the affairs of big institutions, those considered too big to fail, in circumstances of financial distress.

The talk to this point had centered on financially troubled banks and institutions, presumably the consequence of serious asset quality issues, but now there’s a new question animating the discussion.

Are these companies too big to be managed?

Industry observers and some politicians have raised this issue before concerning the sheer magnitude of effectively governing such large institutions under normal circumstances. You’ll recall that about a year ago this was being voiced regarding Jamie Dimon of JP Morgan Chase and his ability, in the wake of the London Whale affair and more, to oversee such a big operation.

Double punch from the Fed

This week, William Dudley, president of the Federal Reserve Bank of New York, and Daniel Tarullo, a governor of the Federal Reserve System and the board member in overall charge of the Fed’s bank supervisory activities, spoke to an assembly of top executives of the largest institutions convened by the NY Fed earlier this week.  (The Workshop on Reforming Culture and Behavior in the Financial Services Industry)

The message was familiar, but the impetus differed markedly. The regulatory community is concerned about financial dislocations from the failure of these banks for the reason of the negative consequences of reputation risk.

Can reputation risk kill mega-banks?

Apparently some in high places consider the risk to be real. [Read Tarullo’s “Good Compliance, Not Mere Compliance.” Read Dudley’s “Enhancing Financial Stability by Improving Culture in the Financial Services Industry”]

Earlier this year the largest banks were subject to fines and penalties aggregating in the tens of billions of dollars arising from violations of law. Some of the activities warranting such sanctions could be categorized as consequences of poor management, such as allocation of insufficient resources and lack of proper oversight and attention.

But ominously, and particularly for the credibility of the banking industry, some of these activities were clear and deliberate violations of law. They centered on evasion of federal income taxes and the laws and regulations dealing with the Bank Secrecy Act. The latter aim at blocking the flow of money into the hands of those governments and entities that are subject to U. S. trading sanctions and the laundering of money used to fund international terrorist activities and other criminal organizations.

As bankers we are all painfully aware of the government’s response to banking’s alleged misbehaviors and excesses. Simply put, the consequences will increasingly be more regulation. Exhibit #1 is the Dodd-Frank Act, that onerous burden of regulations hastily imposed on banks in 2010 as a consequence of the financial crisis.

The case that Dodd-Frank is more punitive than corrective for any who doubted is proved in the fact that the Act was signed into law by President Obama within two weeks of the first meeting of the President’s own blue-ribbon commission into the causes of the financial crises.

Bluntly, Dudley and Tarullo told the assembled executives this week that the excessive risks to the reputations of these large institutions have been of a nature as to affect an institution’s safety and soundness.

This is a “sea change” in outlook and attitude at what so far has been an acutely embarrassing if also expensive consequence of misbehaviors and misdeeds by employees and agents of these financial institutions. One possible remedy often held out is to make the banks easier to manage by making them smaller and less complex in the diversity of their activities.

A literal reading of legislation relating to systemically important institutions suggests that there is no direct authority to break up these companies into smaller pieces by virtue of reputation risk alone. It would be foolhardy, however, to assume that the regulatory authorities would be unable to accomplish their objectives with the array of supervisory tools and means in their arsenal.

Dudley and Tarullo on today’s canvas

What makes this current initiative so urgent in the opinion of some industry observers and participants is the confluence of several factors.

1. The increase in stockholder activism.

JP Morgan Chase, for example, has beaten back challenges to the separation of the roles of chairman and CEO. Other large firms such as BofA have been forced to accede to similar demands. It’s now clear from a variety of sources that stockholder activism is a force to be reckoned with in Corporate America.

Virtually anything of a governance nature is now considered fair game by dissident stockholder groups, including such items as executive compensation practices and specific job duties of senior officials. The likely results of such activity applied to issues of corporate ethics will be a set of rules and regulations not unlike the consequences of additional regulation.

This reminds many of the efforts of the Gilbert brothers 30+ years ago to enhance stockholders’ rights in governance matters. This time, however, it’s a whole “movement” rather than the efforts of a couple of shrewd investors who were public-relations savvy.

2. The clearly stated intentions of the regulatory community to increase equity capitalization of all banks and in particular the largest banks in asset size.

This has the consequence of depressing the basic entrepreneurial metric of Return on Equity.

The issue from management’s view is likely to be the extent that shareholders will preempt management and mandate changes that will shrink the bank to alter the burden on equity and risk-taking activities but in ways that the investors rather than management will choose.

This can be likened to a back-door approach to a return to business models bearing more resemblance to Glass-Steagall than Gramm, Leach, Bliley. By curtailing asset size and eliminating high-risk activity and opportunities for mischief by rogue employees (such as the London Whale), institutions can alter the perception of supervisory authorities for a need for higher equity capital levels.

Get this right—or get more lawyers

I wonder if it’s humanly possible to eliminate human misbehavior in large, far-flung corporate activities, though it’s certainly possible to double down on rules, regulations and restrictions.

That’s what we face if we as an industry if we don’t effectively address these assaults to our reputations.

No business supposedly resting on a foundation of trust can survive in an environment of criminal activity and shoddy management practices. There’s a lot of blame to go around these days and it’s largely deserved by some very large institutions. The attitudes expressed by senior officials of the Federal Reserve this week signal that we can put off reforms no longer.

This is a problem a great deal deeper than the shallow responses of far too many who suggest that the issue is only a matter of messaging and spin.

These issues will ultimately be resolved by either the regulators and the stockholders or, one hopes, by management and staff.

From the employees’ point of view, will the fix be done by us? Or to us?