Obsessing About Rules Won't Improve Culture

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The topic of culture filled the late-summer headlines following a New York Times piece critical of the "bruising workplace" at Amazon. How workplace environment can drive good or bad behavior has also occupied the bank regulators' time for a while now.

Following the financial crisis, a focus on culture is consistent with regulators taking a macroprudential approach to reduce systemic risk. Yet determining the "right" culture of financial institutions is still uncharted territory. What is more, the various financial regulatory agencies appear to have sharp differences over what is considered a healthy culture for a financial institution.

On one side, regulators like the Federal Reserve Bank of New York prioritize a need for organizations to develop an internal culture that then leads to positive behavior. Other agencies, such as the Securities and Exchange Commission, appear to favor a top-down approach, where institutions impose a culture of rules compliance among employees. But the latter is not culture by a long shot. It's control, and it's the wrong way to frame the issue.

Alberto Musalem, a senior official at the New York Fed, said recently that "culture drives behavior." If you "place ordinary people in a bad environment … bad things tend to happen," he said. "That said, place someone in a good environment, and good things tend to happen. This is just part of being human. We observe and adapt."

This echoed comments by New York Fed President Bill Dudley, who has repeatedly emphasized that the unfavorable state of banking culture "did not arise in a vacuum." Dudley sees culture as something that operates from within an organization, not as something that is driven externally. "Culture relates to the implicit norms that guide behavior in the absence of regulations or compliance rules — and sometimes despite those explicit restraints."

But in a recent speech before a group of compliance officers, Andrew Ceresney, the SEC's director of enforcement, urged his audience to "devote resources to controls that work to assure that employees obey the letter of the law." Ceresney also marshaled the term culture to his cause, calling for efforts aimed at creating a "culture of compliance."

He misapplies the term. Ceresney's is a top-down approach. It requires management internally to work towards placating regulators externally. The SEC's regulatory policy follows that mistaken idea. A recent rule revamping 2003 enforcement policy requires that companies "adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws," and to designate a chief compliance officer responsible for administering those policies. The SEC now holds these CCOs personally liable for lapses.

For example, in its case against BlackRock, the SEC found the firm's CCO responsible for failing to report conflicts of interest between an investment professional and the firm. The SEC did not focus on specific actions of the CCO, but rather found him responsible simply because of his position and the fact that the compliance program had failed in this particular instance.

This case is not necessarily an outlier. Ceresney warns that the SEC will prosecute compliance officials it deems to have failed to "act as good partners" with the SEC.  Effectively, the SEC is seeking to appropriate company compliance officials. This leaves CCOs attempting to serve two masters, with the SEC expecting to come before senior bank management and its board.

Culture matters — a lot.  And it is clear that the prevalent culture in banking promotes bad behavior, as is outlined in a disturbing study by economists at the University of Zurich.

Christine Lagarde, managing director of the International Monetary Fund, is right when she calls trust "the lifeblood of the modern business economy." The broad public has lost trust in the banking sector. Restoring that trust, as the Group of Thirty has declared, "is a public duty and economic imperative."

But the SEC's control-oriented approach is contrary to the way culture operates in practice and is likely to be counterproductive. We don't need more rules and regulatory overreach.

In contrast, Dudley's norms-based approach empowers bankers to take necessary steps — decided upon internallyand implemented from thebottom up — to identify and promote behaviors that support culture reform without creating more hierarchy and further distrust.

As the culture war in banking regulation begins, let's be sure we're focused on promoting culture, not control.

Stephen J. Scott is the founder and CEO of Starling Trust Sciences, a predictive behavioral analytics company. Jeffrey Kupfer served as deputy chief of staff at the Treasury Department and in the White House as a special assistant to the president for economic policy.

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