If you’re walking down the street and you see a hundred dollar bill on the sidewalk, what do you do? Do you pick it up and put it in your pocket because this is your lucky day? Or do you try to find the owner? Would your answer change if someone were looking? Now take the analogy and apply it to banking. That hundred dollar bill on the sidewalk is like the money that bankers are dealing with. It’s never their money and they have a fiduciary duty, very simply, to do the right thing. But that doesn’t stop everyone from thinking that no one will notice when they put it in their pocket. That’s why we have internal risk management and compliance and external regulation. While the heart might say that people are fundamentally good, the mind says it’s best not to put that theory to the test.
This is why the ranting and raving about the evil bankers is interesting. It’s not so much the bankers as the system that allowed, and in many cases encouraged, those who were inclined to put the hundred dollar bill in their pocket, to do so. On the trading floor, there are two key situations which stand out as a problem. First, banks pay more in bonuses when they make more profits. Because risk and return go hand in hand, often the more profits a bank makes means the more risk they have taken. But risk can go two ways, and when it results in a loss, the employee doesn’t have to pay any money back to the bank. So, it’s entirely in his interest to take as much risk as possible. To be clear, both the trader and the sales person on the trading floor are incentivized to take risk. For the trader it is more about market risk. We’ve all seen the large “extraordinary” losses happen (frequently enough that they are no longer “extra” ordinary), which are caused by traders, some rogue and some not. For the sales person, it is reputation risk. They are deciding what types of trades are suitable to be doing with certain clients. Whether the client has conveniently decided to become less sophisticated after the trade goes sour or the sales person knowingly “stuffed” the client with something overly complex, it is clear that this is a risk that banks take with lots of examples of bad behaviour coming forth both from the bankers and the clients .
This is where the second situation comes in. The trader has some limits to the market risk he can take. Those limits are set by the risk management team. When those limits are breeched without prior approval, the employee should immediately be required to take a two week leave of absence so someone else can manage the risk and identify what is going on. This rarely (if ever) happens because of the first situation above. The traders taking the risk are paid a lot of money to do their job. As a result, they have enormous power within the bank. A risk management official asking questions or making demands is often not even given the time of day. Even more worrying are the more exotic financial products where the risk manager sometimes doesn’t know what question to ask. For the sales person, there are client classifications which are made and suitability questionnaires which are filled out, all driven by the compliance team. But often these are just box-ticking exercises. The compliance officer vis a vis the sales person is often in a similar situation as the risk management official vis a vis the trader. And again, the compliance officer may be afraid to admit lack of understanding of the more complex products and sign off in lieu of looking silly.
Clearly, banks need to nurture a risk management and compliance culture that is more than just window dressing. Both traders and sales people need to know that someone is watching and that it’s not acceptable to put the hundred dollar bill in their pocket. More important than that though, is that every young new hire to the bank needs to be taught what is acceptable behaviour and what is not. When banks hire more senior people externally, they need to question the risk culture that person is coming from and make sure it fits. Further and more complex, is that the banks need to make the risk management and compliance framework stronger. But how does this happen practically. The traders and sales people are paid to say “yes” and they are paid from the profit that the trades generate. How do you pay risk managers and compliance officers to say “no”?