Reputation issues breed more trouble

It’s been a busy year to date for banking supervisors and the very largest of the banks they supervise. As we’ve discussed in recent weeks, by late summer the authorities had extracted settlements totaling tens of billions of dollars from America’s largest banks and many foreign chartered banks doing business in the U.S.

The issues involved violations of law, money laundering activities, real estate fraud dating in many cases to before the banking crisis of 2008, and foreign exchange and LIBOR rate fixing. The costs including legal fees expended in the process are believed to exceed $100,000,000,000.

(I deliberately inserted all the zeros to further make the point on the size and financial consequences of these actions.)

Risks range far beyond reputation

We’ve talked about the possible consequences of reputation risk on these companies and their business plans.

The Federal Reserve Bank of New York and the Federal Reserve Board weighed in on the issue last month asserting that American banks faced compulsory down-sizing on the basis of “too big to manage” if these ethical lapses continue. (See my earlier blog, “Reputation Risk Rises On Regulatory Agenda.”)

The story continues in the financial press in a somewhat different way. Commentators are now questioning what components of a bank organization may be the prime contributors to the temptation of many to skate on the fringes and beyond of ethical behavior. 

• Tying pay to behavior. An article the other day in The New York Times cited the work of a professor at Queens University in Scotland who had conducted a study of Citibank’s ethics policies. The work was substantially written and implemented in the aftermath of the dot.com scandals of several years ago.

The bank created a series of rules and requirements designed to thwart the fast and loose practices that created legal havoc for the bank. The professor argues that today it will be necessary to align compensation with behaviors to significantly address the problem.

Until bank managers have compensation at risk the questionable behaviors are likely to remain unchanged, the professor concluded.

• Competitive impact of lapses. Though not recent, something I came across recently also resonates. Richard Posner, a federal judge in Chicago who has a background as a professor at the University of Chicago opined in a published blog two years ago:

“Any firm that has short-term capital is under great pressure to compete ferociously as it is in constant danger of losing its capital to fiercer, less scrupulous competitors who can offer its investor and key employees higher returns.” 

Posner also noted that such an environment attracts individuals who have “a taste for risk.”

Impact of risky behavior on bank liquidity

This links risk-taking behaviors of bankers to liquidity. Banks are businesses that operate with significant funding from short-term sources. Bankers understand how vulnerable such sources can be during times of financial distress.

How many of us, I wonder, make the connection to our industry’s funding and the pressure it has created on financial performance in the sense of return? 

This seems precisely what the president of the New York Fed was getting at last month in his remarks to the bankers by linking these behaviors to the issue of safety and soundness. (See William Dudley’s speech, “Enhancing Financial Stability by Improving Culture in the Financial Services Industry”)

The sources of ethical behaviors are more comprehensive than this interesting insight. Yet such an insight is useful in the diagnostic sense and also in the curative sense as well. 

Is it a variant on “What have you done for me lately?”

Most of us are aware of politicians and industry practitioners advocating for tying pay to “sustainable” performance. This could be done by a variety of means designed to claw back bonuses based on subsequently discovered unethical consequences of individual behavior.

We’ll no doubt see much more of such activity on the agenda of bank holding companies at the upcoming round of annual meetings of shareholders this spring.

The consequences of ethical misbehavior are enormous in financial terms. The Federal Reserve has signaled that they will become expensive in organizational terms as well if they are not reigned in.

Wells Fargo settlement negotiations stalled

Wells Fargo announced this week that ongoing settlement talks relating to mortgage fraud arising from the origination and sale of mortgages to Fannie Mae have been suspended and that litigation over the issue is a near certainty.

This is interesting on two levels.

First, many industry observers believe that the regulatory agencies are making “financial raids” on banks and that the banks are settling rather than pursuing litigation and exposing themselves to the costs and the attendant publicity. Many bankers and bank directors are persuaded that the litigation is not as meritorious as the trail of negotiated settlements might suggest.

Second, others have taken the view that the regulators have been too lenient on the banks for a variety of reasons, including the difficulty, time, and expense involved in successfully concluding large and complex lawsuits.

Well, now maybe we’ll see.

Has Wells “bowed its back” on settling, preferring to try the issues on their merits? 

Or, has the federal government and its agencies decided to be much more aggressive on the litigation front and are less willing to compromise?

An increase in litigation targeting high-ranking officials of big banks would likely please Senator Elizabeth Warren (D.-Mass.), who has been a vocal advocate for banking reform and highly critical of the alleged “coziness” of Wall Street banks and high government officials. 

It’s ironic that Wells, headquartered in San Francisco, has become a “Wall Street bank” in this context.

“Politics makes strange geography” could possibly be a tag line to this and similar stories in the months to come.