Better Board Leadership Needed to Save Banking's Reputation

The epic financial crisis of a few years ago inflicted immense damage on the process of financial intermediation, the fabric of the real economy and the reputation of banks and bankers. Even today, some five years later, little has happened to restore financial firms to their former glory near the top of the reputational food chain in most countries.

As memories of the crisis persist in the public consciousness, it's all the more curious that banks have run into an even greater firestorm of reputational losses. Consider the following questions: Should banks push in-house products to investor clients against superior third-party products to earn kickbacks from product vendors? Is it ethical to sell securities to institutional clients that you know will collapse in value, and then use your proprietary trading platform to speculate against them? Can you invade segregated customer accounts and borrow the money for your own operations? Ultimately, is it permissible to redefine a bank's central exposure hedging platform as a profit center and circumvent established risk controls to generate additional earnings?

There are many others. Each has the name of a major financial firm attached to it, sometimes several. Most of the offenses intentionally violate established regulations and legal statutes - or just common-sense definitions of what is fair, appropriate and ethical.

Banks and bankers, some would argue, have lost their way in carrying out their key role as efficient allocators of capital and creators of improved social welfare. They seem more like wealth-redistributors, from their clients to bank employees and shareholders, all the while privatizing returns and socializing risks on the back of taxpayers when things go badly wrong.  Fair assessment or not, it's no wonder the industry as a whole and individual banks have seen their reputational capital erode.

What might explain this? After all, some of the best educated, most highly talented and morally upright people in the world work for banks and do their best to serve clients, owners and other stakeholders well.

Perhaps it's that intense competitive pressure and heavily commoditized markets have made it increasingly difficult for banks to deliver ambitious promised returns to shareholders and attractive bonus pools to employees. This creates incentives to migrate banking activities to less open and less transparent markets, where transaction costs and profit margins are higher. It could also be that the definition of "fiduciary obligation" – the duty of care and loyalty that has traditionally been the benchmark of trust between banker and client – has morphed into redefining the client as a "trading counterparty," to whom the bank owes nothing more than acceptable disclosure.

Maybe it's the changing nature of the banks themselves. If bank size, complexity, embedded conflicts of interest and the ability to manage and govern themselves were contributory factors leading to the recent crisis, then these issues are even more problematic today – if only as a result of still bigger and broader financial conglomerates emerging from governments' efforts to stabilize the system.

Or it could be banks' underinvestment in risk management and compliance (the "defense") and its perennial disadvantage in questions of judgment and engagement against revenue- and earnings-generation (the "offense"). Usually this "tilt" is compounded by levels and systems of compensation designed to emphasize bonus against malus. Reputational capital is lost by people, acting individually and collectively. What drives people carries big consequences.

Nor can boards of directors be let off the hook. They are supposed to set the tone that dominates everything a bank does, and how these actions are projected into the marketplace. And who is supposed to control boards? Presumably it's individual investors and fiduciaries, which control share voting rights. Perhaps most important are institutional investors who fail to use the power of the proxy to challenge errant boardroom behavior – possibly because they themselves face conflicts of interest and do business with the same banks in which they exercise voting rights.

And not least, banking regulators seem to have plenty of problems understanding and approving conventional risk indicators and management practices in large, complex banks. Understanding the specific reputation-sensitivity of activities in the firms they regulate at the business-line level just may be too much to ask.

Frederick the Great of Prussia has often been quoted as pronouncing that "Banking is a very special business which should be the province of very special people." By "special" he presumably meant people who were honest and trustworthy to a fault, with a keen eye to their fiduciary obligations in handling other people's money, and to do so in confidence.

Maybe banking today attracts some rather un-special people who liberally use terms like "share of wallet," "asset gathering," "guaranteed bonus," "caveat emptor" and "Muppets" in connection with the work they do every day. Dynamic, fast-moving businesses where these negative characteristics are highly valued have become increasingly important in banks over the years. Meantime, educational institutions enthusiastically churn out more young talent with much the same mindset. Unfair? Probably. But it doesn't take too many bad apples.

One would like to believe that market discipline transmitted through the share price can be a powerful deterrent. But this depends critically on the efficiency and effectiveness of corporate governance, and we observe that banks continue to encounter serious reputational losses due to misconduct despite their impact on the value of the business.

If market discipline fails, the alternatives include civil litigation and external regulation aimed at avoiding or remedying damage created by unacceptable financial practices. Yet civil litigation seems ineffective in changing bank behavior despite "deferred prosecution" agreements not to repeat offenses. This again suggests continued material lapses in the governance and management process.

As demonstrated by the kinds of reputation-sensitive "accidents" that seem to occur repeatedly in the financial services industry, neither good corporate governance or stakeholder legal recourse or more intrusive regulation seems to be particularly effective in stanching reputational losses in banking. Maybe such losses are just "a cost of doing business" in this industry? One would hope not. The same argument in the pharmaceutical, petroleum or food industries would be considered appalling by most people.

The bottom line? In the end, it is leadership at the board level that more than anything else separates winners from losers over the long term. This leadership should embrace the notion that appropriate professional behavior reinforced by a sense of belonging to a quality franchise constitutes a decisive competitive advantage.

Ingo Walter is the Seymour Milstein Professor of Finance, Corporate Governance and Ethics at the New York University Stern School of Business.