Newcastle University Business School

MSc Finance and Financial Regulation

Dissertation (NBS8246)

“Critically discuss the potential of regulation to change the culture and behaviour of the UK banking industry”

Student Name: Sophie Anna Agathe Thurner

Student Number: 100865109

Supervisor: Professor Joanna Gray

Date of Submission: 1 September 2014

Table of Contents

Abbreviations

Introduction

Chapter 1: The need for change in the banking industry 1.1 The rationale behind changing the behaviour and culture of banks

1.1.1 A wake up call for the banking industry

1.1.2 Trust in the banking sector

1.2 Different perspectives on moral nature in banking

1.2.1 Defining morals – a philosophical perspective

1.2.2 Defining morals – an economic perspective

1.2.3 Defining morals – alternative views and insights

1.2.3 Concluding remarks

Chapter 2: Regulation from the government

2.1 The rationale behind government regulation

2.2 Government regulation in the UK

2.2.1 Ring fencing

2.2.2 Conduct of persons working in the financial service sector

2.2.3 Evaluating government regulation in the UK

Chapter 3: Regulation from the industry

3.1 The rationale behind self- regulation within the industry

3.2 Incorporating self- regulation in the UK banking industry

3.2.1 Establishing the Banking Standards Review Council

3.2.2 Reactions towards the Banking Standards Review Council

3.2.3 Evaluating self- regulation in the UK

Chapter 4: Towards a nexus between both types of regulation

4.1 The rationale behind operating both types of regulation

4.1.1 The influence of meta- regulation

4.1.2 The relationship between the regulators in practice

4.2 The limits of regulation

Conclusion

Bibliography

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Abbreviations

BoE…………………….Bank of England

BSRC…………………. Banking Standards Review Council

CBI…………………….Confederation of British Industry

CDO…………………...Collateralised Debt Obligations

CISI…………………....Chartered Institute for Securities and Investment

FCA……………………Financial Conduct Authority

FOREX………………...Foreign Exchange Market

FSA…………………….Financial Services Authority

GDP……………………Gross Domestic Product

ICB…………………….Independent Commission on Banking

IMF…………………….International Monetary Fund

LIBOR…………………London Interbank Offered Rate

MoU…………………...Memorandum of Understanding

PCBS…………………..Parliamentary Commission on Banking Standards

PPI……………………..Payment Protection Insurance

PRA……………………Prudential Regulation Authority

UK……………………..United Kingdom

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Introduction

In 2006 UK banks’ assets, as a percentage of GDP, had increased from 50 percent to 500 percent in less than four decades (Prieg, 2011). This highlights the importance the banking sector has to UK economic growth and prosperity. However, the most recent recession, which was heavily driven by misconduct in the banking sector, also demonstrated the far reaching consequences of bad behaviour endemic to the industry. As this sector is one of the UK’s biggest economic driving forces, a well-functioning system is vital for the country's economy. Yet its efficacy has been eroded by a loss of trust born from a profound lapse in banking standards and driven by a decline in banking ethics. Scandals in the sector such as the mis- selling of PPI and the manipulation of LIBOR, both of which occurred post financial crisis, indicated that further reform to address cultural problems is needed. Mark Carney, the governor of the BoE, predicts that by 2050 UK banks’ assets could exceed nine times GDP and therefore stengthen their position in the economy (Wolf, 2013). However, in order to make this growth sustainable, the behaviour and culture in the industry must be aligned with better conduct and standards. The following examination addresses the extent to which regulation can foster and deliver such change of banking culture and behaviour. The background chapter will provide an overview of the rationale for this change. This is delivered by addressing the key motivations, which underline any possible transformation of behaviour. It is complimented by a focus on the implications caused by a loss of trust within the banking industry. Moreover, this chapter approaches the topic of morals in banking from different philosophical and economic angles. It outlines the necessity of understanding these different perspectives in order to make a judgement about what change in the banking industry is desired through regulation. The examination will critically consider two different types of regulation, which both have the potential to deliver change. Chapter two outlines regulation from the government, highlighting its rationale, before moving on to practical examples. These practical examples illuminate the impact that parts of the Banking Reform Act 2013 have on regulating and influencing a change in banking culture. Chapter three provides a similar approach although focuses on industry self-regulation. It examines the rationale for industry self-regulation and uses the BSRC as a case study on how this type of regulation influences change. The examination will outline the functioning of the BSRC, as well as its potential impacts and limitations, before evaluating the effectiveness of industry self-regulation more generally. The final chapter of this dissertation provides an insight into what a nexus between both types of regulation would incorporate. Furthermore, it outlines how an optimal interaction between both types of regulation has the biggest potential to foster change in the behaviour of bankers. The chapter examines forms of meta- regulation as a potential way of achieving this as well as looking into the practical issues a nexus approach might face. The final paragraph of this chapter highlights the limitations regulation has in achieving a change in banking culture and conduct.

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Chapter 1: The need for change in the banking industry

Fines and damages paid for misconduct within the banking industry over the past five years amount to an estimate of nearly six billion pounds per annum in the UK (McCormick, 2014). This has led to a continuous negative media portrayal of banks with a focus on the behaviour that has caused such fines. The increased presence of media coverage regarding such misconduct has raised serious public awareness and has put ever-increasing pressure on the industry and bankers to change their behaviour. It provides evidence of fraudulent actions, which have become a common feature of the industry rather than an exception. In the interest of future economic prosperity of the sector this behaviour has to change. The present chapter further investigates the background and the rationale of the demand for change. Moreover, an emphasis will be made on how this behaviour has influenced the position of banks in financial markets with a particular focus on the consequential erosion of trust. The latter part of the chapter will critically assess different philosophical perspectives on which ethics and morals are desirable and should be fostered by the industry, in order to improve banking standards. This clarification of different moral backgrounds is of essential importance for the subsequent chapters. 1.1 The rationale behind changing the behaviour and culture of banks 1.1.1 A wake up call for the banking industry It is generally accepted that market capitalism is the most efficient economic system for the UK, as it fosters wealth creation and thereby allows humans to flourish (Reynolds and Newell, 2011, p.13). Financial institutions, such as banks, are at the heart of the financial intermediation process and essential to the smooth functioning of a market economy. Moreover, banks are intrinsically linked to society. They operate with an implicit social licence, and misconduct puts this licence in danger of being altered or even cancelled (Leigh, 2014). Given the vital role that financial institutions play, their exposure to moral hazards may be more acute than in other industries, providing the rationale for anchoring ethical standards in the industry (Black and Anderson, 2013). This highlights, that from an ethical stance, the market and its key players – banks – make an important contribution towards economic and human development. However, since the most recent economic crisis, the UK banking system has been haunted by a series of financial scandals threatening this implicit social licence. During the 1980s and 1990s, events such as the Barings Group collapse led to the introduction of a series of codes on corporate governance. A key figure in these events was the world’s most famous rogue trader, Nick Leeson, whose misconduct led to the bankruptcy of Barings Bank in 1995. He described his feelings at the peak of his fraudulent operations in the following way; “Like the light bending in the strange world of the plate glass, my morals had bent in the unreal world of the trading I was doing. I had become crooked. I’d allowed

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myself to bend under the pressure to perform and I was now a step removed from myself.” (Leeson, 1996, p.106). His words reflect the behaviour of bankers during more recent scandals who appeared to have switched off their morals too. The problems in the 1980s and 1990s demonstrated that the existing framework of regulation at the time, as well as the ability of the judicial system to identify and penalise misconduct, was ineffective, leading to the introduction of a series of reforms and regulations (Joyner and Payne, 2002, p.298). Nonetheless, these reforms have not prevented the most recent financial crisis, stemming from a disregard for moral codes and misconduct in banking standards. Moreover, this failure to change behaviour and culture in a more ethical perspective is impacting on the potential profitability of banks. It is illustrated by the fact that the cost of alleged misconduct has, in recent years, overtaken the provision to cover bad loans (Arnold, 2014). This is most notable in the manipulation of the benchmark LIBOR, the mis-selling of PPI and numerous tax evasion cases. Furthermore, the current enquires over FOREX market manipulations by banks are more than likely to further damage their image. Bank profits have often been used to pay off regulatory fines, deal with litigation costs and finance compensation schemes. To illustrate this in figures, for the five biggest banks in the UK, conduct costs and remediation amount to approximately 80 percent of their cumulated profits in 2013 (McCarthy, 2014, p.4). This can be seen as an exceptional threat to the profitability of banks. Such behaviour has not only led to record fines, but has also eroded the reputational capital of the industry. Plender argues that such conduct appears to be a persistent rather than occasional phenomenon, which is likely to develop into an ever- increasing problem for the banking industry. He highlights that such wrongdoings appear to have transformed the financial system into an ethic- free zone (Plender, 2014). The PCBS argues that this behaviour has contributed to a sentiment that the general public has been taken advantage of and questions the integrity of the banking sector (PCBS, 2013, p.14). It is possible to adopt a more radical view and consider this bad behaviour as life threatening for the industry as a whole (Leigh, 2014). These facts highlight the need for regulation and reform to achieve change at several fronts, most notably in the behaviour and culture of the banking industry. 1.1.2 Trust in the banking sector One of the main casualties as a result of the banks’ behaviour has been a loss of trust in the banking system by the general public and other members of the market process. Scholars such as Kotikoff have evaluated this lack of trust and suggested different solutions to restore it. Kotikoff proposes the solution of limited purpose banking, meaning there would have to be a 100 percent equity support for loans (Kotlikoff, 2010). This is an extreme move and would change the nature of the UK banking industry in a significant way. Boatright also emphasises Kotikoff’s claim that the kind of honest and trustful banking described in the movie “It is a wonderful life” no longer exists and instead should be titled “It is a horrible mess” (Boatright, 2011, p.472). Even though Boatright broadly agrees with Kotikoff’s view, in particular that there is a crisis in banking, he insinuates that his explanations are too harsh and his solutions are too extreme. Paulette argues a similar point to Kotikoff and Boatright, most

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notably that antagonism between profits and ethics can be solved if banks refocus upon their core business operations (Paulet, 2011). The scholar tries to reinforce the point that aggressive capitalism, without ethics, has reached its limit. Boatright notes that the failure in the banking system cannot be solely attributed to a loss of trust, and its restoration would not solve all the problems inherent within the sector (Boatright, 2011, p.474). To some extent, this certainly remains a cogent perspective. Yet it appears that the implementation of large-scale reforms to the banking system regarding other issues, such as the prevention of the build-up of systemic risk, has led to serious negligence in terms of a global response to combating unethical banking. Greater efforts to introduce standards into the banking industry are needed. The PCBS’s findings indicate that the loss of trust can only be restored when the deficiencies in banking culture have been addressed (PCBS, 2013a, p.12). Attempts to change the culture and behaviour in the banking industry are therefore not just desirable but essential to prevent unethical behaviour, which has been a contributory factor in the financial meltdown. Nonetheless, there are some attempts around the globe to restore this necessary trustful relationship. In the Netherlands, the introduction of the Bankers Oath to board members of Dutch banks in 2014 has meant that bankers are bound by an oath to act in a moral and ethical way (Van Gaal, 2014). Such an oath has also been called for in the UK by scholars such as Steare, Llewellyn and Trevellick in their research conducted for the think tank ResPublica (ResPublica, 2014). Other supporters of the oath, such as Silverman, highlight that with sufficient importance attached to the oath bankers are more likely to conduct themselves in line with it (Silverman, 2014). Yet a widespread unilateral response aimed at restoring trust in the British banking profession has been left severely wanting. The current head of the FCA, Martin Wheatley, recently indicated that there was only a narrow window of time, in which improvements of cultural standards at companies can be made, before memories of the recent financial crisis would fade away (Fleming, 2014). This highlights that it is necessary to implement change sooner rather than later. The previous analysis indicates that in the globalised economy trust is hard to earn and easy to lose. The Managing Director of the IMF, Christine Lagarde, demonstrates this belief by noting that; “confidence leaves on a horse and comes back on foot” (Lagarde, 2014). She therefore suggests that efforts to regulate banking culture and behaviour, in order to regain such trust, are continuously challenged by the culprit of time.

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1.2 Different perspectives on moral nature in banking 1.2.1 Defining morals - a philosophical perspective Having established the reasons underlining the necessity for change within the industry, subjective interpretations of key components to such reforms must be acknowledged. These include delineations of morality and human nature and further complicate the direction in which regulation must proceed. In order to examine the question of whether regulation can change business culture and behaviour in the banking sector it is necessary to define how the industry was and is behaving and what change is possible, if not desirable. The financial crisis and its aftermath has led to a crisis of ethics for financial intermediaries, such as banks. The increased spotlight on ethical aspects of financial institutions unleashed a debate about the future of the banking industry, which throws down the gauntlet to philosophers and economists (Koslowski, 2010, p.2). Ethics can be classified as a branch of philosophy that involves concepts of right and wrong conduct. The term is derived from the Greek word ethikos, which can be translated as custom or habit (Society of Corporate Compliance and Ethics, 2014). Different perceptions of ethics can be applied to the modern banking industry. When investigating why humans behave in certain ways, some prominent theories based on philosophical foundations are particularly relevant. Thus scholars such as Hobbes, Mill and Marx need to be considered when identifying the basis of human conduct and human nature. The libertarian Mill upholds the importance of the individual as a member of society (Maslow, 1993). When talking about regulating bankers, one must account for striking a balance between ensuring the good of the individual, in terms of personal fulfilment and prosperity, and the greater good of society. Mill advocates that the government should not interfere with the private domains of the individual. However, difficulties can arise when the private domain of the individual interferes with the greater good of the society as a whole. This is the problem with greedy bankers whose impact has been identified by many as one of the main contributors to the severity of the financial crisis (Dowd, 2009). The individual, in this case the banker, gains bonuses from selling Collateralised Debt Obligations, whereas the impact of these financial instruments has a negative outcome for the overall economy. Thus, Mill claims that the government can only interfere with an individual to protect another from being harmed (Mill, 1859). However, a problem occurs when governmental financial regulation is unable to detect the harm happening, as was the case in the most recent financial crisis. This highlights the necessity of a scheme in which bankers operate a self-regulating mechanism, which encourages them to stop acting in ways that are harmful to other members of society. Marx and Mill have similar views of human nature in terms of morality. They believe that humans are naturally good creatures with key elements of social and dynamic measures. However, it must be noted that Mill’s, unlike Marx’s, view of human nature has more

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elements of egoism. According to Marx, human beings are social creatures who exist as part of a larger society, which he regarded as a living organism. Marx postulated that people are naturally cooperative and not competitive, and these tendencies are only eroded due to social arrangements, such as the capitalist economy (Geras, 1983). In Hobbes contrasting theory, humans are born with original sin, thus building a pessimistic view of human nature wherein egoism and antisocial traits are key features. The human being is, as a result, naturally more sinful than moral (Green, 1993) – a common perception adopted during the recent crisis. Nonetheless, scholars such as Graafland and van de Ven argue that not all bankers behaved in an immoral and egoistic manner during the financial crisis (Graafland and van de Ven, 2011). Some simply did not understand what they were selling, irrespective of incentive. This however can also be considered poor conduct as selling a product you do not comprehensively understand is, within a critical view, equally reprehensible. 1.2.2 Defining morals - an economic perspective One key scholar in the field, Avgouleas, suggested as early as 2009 a set of far reaching reforms to the framework of financial regulation (Avgouleas, 2009). The consequences of the crisis and the findings of behavioural economics provide the basis for his research and proposals. Classical economists such as Smith claim that humans maximise economic utility by making solely rationally based decisions (Smith, 1986). The most recent financial crisis evidenced that an overreliance on the rational homo economicus can lead to significant suffering (Levitt and List, 2008). The emerging field of behavioural finance provides explanations for this human deviation from rational economic behaviour. In their book “Animal Spirit” scholars Akerlof and Shiller provide an insight into how human psychology is an underlying driving force of modern day global capitalism. The essence of the book, as suggested by its title, is a phrase coined by Kenyes. Keynes appreciated the claim that most economic activity results from rational economic motivations but revolutionised economic theory by postulating that much activity is governed by animal spirit (Akerlof and Shiller, 2009). These ideas are also examined and reiterated by Levitt and List who outline non-economic motivations, which are not always driven by rationality (Levitt and List, 2008). Other key scholars in the field such as Kahneman apply this theory to financial regulation, emphasising how the absence of accounting for human psychology as part of the economic driving force has prevented regulators acting in the most efficient manner (Clift and Kahneman, 2009). The concept that a leading contributor to the financial crisis is human nature itself is also emphasised by Reinhart and Rogoff (2009). Without defining a precise human nature, these scholars base their investigations around the behavioural finance studies of rational and irrational economic decisions. One core conclusion of their work is that the difficulty lies in ensuring that people, most significantly those within the financial sector, uphold regulation and wholeheartedly support its implementation (Strauss, 2012). Therefore it is necessary to end the cat and mouse game by which the industry currently operates and change behaviour and business culture in a way, which shares a common denominator with government regulations.

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When considering in what way regulation desires to change business culture and behaviour in the banking sector, one must also consider other literature surrounding the topic. Tett has identified unrestrained greed among bankers as having the potential to unleash a catastrophe in financial markets (Tett, 2009). This has been evident in the most recent financial crisis. Nevertheless, measuring and analysing ethical behaviour is often difficult due to the subjective nature of the concept. Boatright underlines the general acceptance for trust and integrity as important features of the banking sector, due to the distinctive nature of an industry based on asymmetric information. Yet he also acknowledges the difficulties in defining clearly what trust and integrity mean with regards to the banking industry (Boatright, 2011, p.475). Bucholz and Rosenthal criticise the general lack of codes of ethics in the banking industry. They even go as far as blaming the lack of such universal codes as the reason for the exploitation of what is right and what is wrong in this profession (Bucholz and Rosenthal, 2008). These scholars make the case for the establishment of such a universal code as seen in other professions, for instance, in medicine or law. 1.2.3 Defining morals - alternative views and insights By drawing on MacIntyre’s concept of virtue ethics, scholars such as Graafland and van de Ven examine concepts surrounding what should be classified as desirable business culture and ethics (Graafland and van de Ven, 2011). They define their core virtues in the banking profession as honesty, due care and accuracy, subsequently comparing this with the actual behaviour of banks. When evaluating the behaviour of professional bankers they investigate several codes of conduct within banks by examining their mission statements. Graafland and van de Ven concluded that the values of banks mentioned in their codes of conduct did little to prevent the bad behaviour of bankers during the built up of the crisis. Furthermore, they indicated that even if bankers followed the mission statement of their financial institution and acted in an honest way, they failed to understand the risk associated with some financial products, ultimately reducing their daily business to gambling (Graafland and van de Ven, 2011, p. 614). Ethics and values shape the attitudinal context of regulatory governance and may foster environments that deter deviant, fraudulent and other antisocial behaviour (Drennan, 2004, p.258). Painter critically examines bankers and their moral values. Furthermore, he considers the question whether they can be changed in any way (Painter, 2011). His compelling arguments outline why there is a need to transform behaviour in this industry. Most notably, he argues that government regulation by itself is not sufficient to deter irresponsibility. He makes the case for self-restraint within the industry in order to encourage good behaviour, which is past the margins of the legal limit. This should encourage the development of a stronger sense of professionalism, which fosters a collective ethos reinforcing personal morality (Painter, 2011). Johnson comments on Painters claims and reiterates the need to go beyond a simplistic governmental regulatory compliance mind-set in banking, highlighting moral responsibility via encouraging self-restraint (Johnson, 2011). Both scholars highlight methods of change in the banking business culture via a mechanism greater than simple government regulation.

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The literature highlights the lack of a coherent and precise definition of what business culture in the banking sector and behaviour should look like and how to achieve these aims. Nonetheless it indicates that the understanding of what ethics are may change according to the social, economic, political and ideological context (Galaville, 2004, p.14). This indicates that the nature of ethics is in a constant state of flux, dependent on external influences. One must note that there is an on-going debate regarding the factors that cause this state of flux. Galbraith argues that there is always the existence of negative moral capital, which he calls bezzle. His work indicates that when there is economic boom this bezzle increases and when markets experience a turndown society becomes more suspicious and the bezzle shrinks (Galbraith, 1997). This can be seen as a cyclical phenomenon, which is positively correlated to the business cycle. However, Plender disputes that the problem of ethics is not one of cyclical nature, as suggested by Galbraith, but moreover a structural one. He highlights this by claiming that the current banking culture fosters a transactional environment in which profits and personal rewards come increasingly from playing the system (Plender, 2014), implying that it is the structure of financial culture that allows for such behaviour. Even though Plender and Galbraith’s views are not aligned entirely, regulation has the potential to provide a solution for both. The 2008 financial crisis and the events following this economic downturn evidently led to a growth of importance in ethics. Such a reaction does not surprise commentators who evaluated responses to major crises, different in nature, such as finance and security crises (Posner and Vermeule, 2009). The scholars initiate a comparison on various levels of the most recent recession and the 9/11 terror attacks in the United States. Their work highlights how the financial crisis has triggered affective dimensions such outrage and vengeance. During the financial crisis, outrage was directed against the banking sector. This has resulted in a backlash against the rich and a division between the country’s elite and its public (Posner and Vermeule, 2009, p.41). In the UK an erosion of trust towards and within the sector has reflected such notion. Similar results have been put forward by Haines, who emphasises that those faced with a devastating crisis, such as financial collapse or terrorist attacks, respond by urging governments to do something to prevent it from happening again (Haines, 2013, p.161). This means that even though there might be an intellectual conflict about the precise meaning of ethics and how external circumstances influence them, it is clear that they should be fostered due to their increased importance within the realm of popular demand. 1.2.4 Concluding remarks Moral doubts about finance are nothing new; indeed they are as old as finance itself (Hendry, 2013, p.31). Banking history is littered with examples of manipulative conduct driven by misaligned incentives. Yet evidently history has failed to enforce important lessons and bankers, as well as regulators, repeatedly did not to learn from their mistakes (PCBS, 2013a, p.17). For example, the Kay Review and the Walker Review have both provided insights into the changing nature of culture in the industry and clearly address the need for bankers to alter their behaviour, to regain public trust (Kay, 2012, p.46; Walker, 2009, p.18). Hence there is

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an urgent need for reform to align the culture and behaviour of bankers with morals. Even though there is a philosophical disagreement of the exact nature of these morals, common concepts such as integrity and honesty should be clearly embedded within the industry. The following chapters will address the extent to which different types of regulation can achieve an incorporation of such values and a change in behaviour and culture within the UK banking industry.

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Chapter 2: Regulation from the government Having considered the literature surrounding moral questions that arise within the banking industry, one key element has emerged. In order to restore confidence in the banking sector, which is essential for smooth operation of modern day capitalism, values such as integrity and trust must be fostered by the system. In order to ensure a sustainable level of these standards, the behaviour and business culture of the industry has to be transformed. The following chapter critically examines how regulation from the government has the potential to deliver such transformation. Before giving an in-depth analysis of recent government policies, the chapter briefly provides a general outline of the rationale for government regulation, with a focus on altering the behaviour of bankers. Following the receipt of Royal Assent in December 2013 the Banking Reform Act changes the environment of the UK banking industry, by providing statutory powers for structural change to the banking system, which facilitates fundamental cultural change. The Act, which provides the basis for evaluating the impact of hard law on the present debate, has been seen as delivering the most significant reform of the UK banking sector in a generation (The Law Society, 2014). This post financial crisis legislative reform can thus be evaluated as an example of government regulation and its potential to change behaviour and culture in the banking industry. In the following chapter a light is shone on specific aspects of the Act, which attempt to deliver such transformation. Following the implementation of the Act one can assess the impact of the “ring-fence” policy on the behaviour and culture of banks. In particular the power to enforce a full separation of individual banks by the regulator is of interest. Another significant change this Act introduces is the fostering and imposition of higher standards of conduct on the banking industry, by introducing a criminal sanction for reckless misconduct that leads to a banks failure (Financial Services (Banking Reform) Act, 2013). Both policies are used as examples to evaluate the potential impact and effects government regulation has on behaviour within the industry. 2.1 The rationale behind government regulation A strong case for government regulation is exemplified in an experiment carried out by Fehr and Gächter. The scholars conducted an experiment on the grounds of previous research carried out by Kahneman, Knetsch and Thaler who looked into acceptable and unfair behaviour (Kahneman, Knetsch and Thaler, 1986). Fehr and Gächter developed this research, considering fairness in economics. Their findings can also be applied to demonstrate the implications of selfish behaviour of bankers in the banking industry. Key observations concluded that subjects were willing to pay to punish other participants who acted selfishly in the experiment rather than for the mutual benefit, delineated in this case as the greater good of the group. Punishing other subjects was associated with an individual cost in order to inflict such punishment. The overall outcome provided evidence for the fact that allowing subjects to punish selfish behaviour reduced selfish behaviour overall (Fehr and Gächter,

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2000, p. 789). As Akerlof and Shiller highlight, the findings of Fehr and Gächter’s study reflect an innate human desire for fairness (Akerlof and Shiller, 2009). This notion of fairness can be transferred as guidance for good business culture and conduct in the banking industry. Additionally this experiment provides further substance to Cuilla’s argument that ethics are a communal exercise, meaning that individual misbehaviour leads to communal desire to punish wrongdoing (Cuilla, 2004, p.29). Furthermore, this study makes the case for advocating government regulation. If the government regulator has the power to punish selfish behaviour, overall selfish acts are likely to be reduced and general fairness levels increased. This selfish behaviour has been very apparent in the most recent financial crisis as bankers have acted in their own interest to maximise revenue at the expense of putting the customer’s best interest at risk. The recently introduced legislation reflects this notion, with the possibility of using hard law to disincentive unethical behaviour such as the introduction of electrification of the retail ring fence and the ability to hold individuals in the banking industry personally responsible for certain kinds of conduct deemed undesirable (Financial Services Banking Reform Act, 2013). Different scholars have highlighted distinct objectives of financial regulation by the government (Aspinwall, 1993; Llewellyn, 1999; Goodhart, 1998). One of which is the enhancement of the robustness and integrity of the financial system. Andenas and Chiu highlight that government regulation has the power to foster more honest behaviour in the industry, which in turn leads to a positive effect on financial stability (Andenas and Chiu, 2014, p.17). This is in line with suggestions made by Haines who claims that the ever-increasing demand for government regulation, especially post financial crisis, reflects the risk averse attitude of modern society (Haines, 2011, p.1). Haines analysis suggests that even when regulation can be effective in avoiding a catastrophe, it needs sufficient political support to ensure its implementation, without overbearing political intervention. Healy highlights that Haines’ arguments also suggest that government regulation can be used as instrument designed to solve a defined problem. The defined problem at issue is unethical behaviour in the industry. Such behaviour appears to be condemned by society not just for its nature, but also due to the potential increase of unacceptable levels of systemic risk (Healy, 2013, p.163). Even though it is difficult to evaluate what different ethical behaviour might have meant for the impact of the financial crisis ex ante, the UK government has reacted to pressure from the public, demanding improvements to the culture in the banking industry. The previously mentioned LIBOR scandal and the mis-selling of PPI highlighted that the lack of ethics in the banking culture has become of crucial public concern (Andenas and Chiu, 2014, p.107). Yet demands for government regulation need to be balanced, due to fears of overregulation and ever increasing paternalistic behaviour of the state. A survey of financial services professionals, conducted in the UK in 2012, addresses this essential question, whether government regulation can effectively strengthen corporate ethics especially in the banking industry. Most alarming were results outlining that one quarter of respondents believed that financial services professionals need to engage in unethical or illegal conduct in order to be successful. This highlights the widespread perception of misconduct in the industry. Moreover, only 25 percent of participants believe that law

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enforcement authorities and regulators are effective watchdogs (Labaton Sucharow, 2012, p.14). This indicates the need for better government regulation in countering bad conduct in the industry. Nevertheless, as Wehinger notes the government has been working towards reforming the financial sector, as demonstrated by the Banking Reform Act. He particularly emphasises the need for government regulation to address reforms promoting fairness and trust in the system (Wehinger, 2013, p.15). This highlights the importance of government financial regulation and its potential power to transform the culture in the industry, yet simultaneously hints towards the limitations of this process. Furthermore, it is key to stress that government regulation must be of high quality. This is because poorly targeted regulation has been a major contributory factor across the full range of banking standard failings, including ethical failure in the industry (PCBS, 2013a, p.15). Thus, if attempting to use regulation to change behaviour in the banking industry this regulation must be of appropriate reach and excellence in its nature. This includes avoiding regulatory capture at all times, in particular any influence over government decisions by lobbying from the banking sector. 2.2 Government regulation in the UK In the UK a great emphasis has been placed on satisfying the demand for better quality government regulation, with the aim of changing behaviour in the banking industry. The Independent Commission on Banking, chaired by John Vickers, had a great say in shaping the ring- fence proposal contained in the Banking Act. Furthermore, the Parliamentary Commission on Banking Standards, chaired by Andrew Tyrie, conducted a significant amount of research into essential themes for reform, most notably banking ethics and culture in the sector. Its recommendations and findings have been crucial to the shape of the Banking Reform Act. Moreover, the research conducted by this body is of key importance for the debate considering banking ethics and regulation in the present examination. The PCBS’s final report “Changing banking for good” contains a set of recommendations to raise standards. Notably it includes recommendations of making senior bankers personally responsible for their misconduct in the management of a bank, which contributes towards bank failure (PCBS, 2013a, p.27). It is therefore necessary to consider the new government regulation of the Banking Reform Act with regards to its potential and ability of changing behaviour in the banking industry. 2.2.1 Ring fencing An essential part of the Banking Reform Act is the ring fence policy, which ring fences banks that accept retail deposit; so called commercial banks. The rationale behind this policy is that such separation leads to a divide from those branches of banks undertaking activities exposed to market risks. Such activities would include derivative trading, except in instances when it is undertaken in order to hedge against risk (Andenas and Chiu, 2014, p.299). This regulation insulates critical banking services from shocks to the financial system and simultaneously attempts to reduce the implicit government guarantee for institutions operating under the

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belief that they are too-big-to-fail. According to the PCBS removing this implicit guarantee is essential to improving banking standards and culture in the sector (PCBS, 2013a, p.11). Furthermore it addresses the cultural deficit at hand. Cultural problems appear to be more prominent at investment banks or the investment branch of a universal bank, as highlighted by the fact that the majority of banks were fined for misconduct by the investment branch of the operation. Volcker argues that the very large compensation in the trading parts of the bank, as well as the continuous demand for ever increasing performance, intensified the cultural problems and eventually infected the behaviour of the institution more generally (Banking Standards Joint Committee, 2013). For example proprietary trading evidently influences culture at an investment bank as the bank is de facto competing with the client. Thusly it can be argued that the growth of universal banking has led to a cross contamination of bank wide culture (Banking Standards Joint Committee, 2013). Consequently, the ring fence is not just aiming at structural change but contains the potential to effect cultural transformation in the industry itself. In order to deliver fundamental change in the industry, the electrification feature of the retail ring fence must be seen as essential. Electrifying the ring fence gives the regulator power to enforce full institutional separation at the level of individual banks. This measure is aimed to reinforce the ring- fence and its endurance over time. Most notably it acts as a deterrent against the temptation of banks to play the ring- fence (PCBS, 2013b). Such nuclear powers of the regulator can be seen as a flagship policy to discourage and punish bad behaviour in the industry. Thus an electrification of the ring fence for a bank would have severe consequences for the individuals who caused it and the bank as a whole. The individuals are likely to lose their job and gain a negative reputation. The bank as a whole has to structurally separate its investment and retail operations entirely. One can therefore argue that the fear of severe consequences, if a bank erodes the fence, are likely to provide adequate incentive for banks to stick to the rules and spirit of the ring fence. This policy is in line with the rational for government regulation as outlined before as it punishes selfish behaviour, which is in principle reducing overall selfish acts. In turn such measures increase the fairness of the ring fence, a feature that is deemed vital to improving culture in the banking sector. This means that the electrification of the retail ring fence provides a good example for how structural statutory measures must be developed into hard law in order to deter certain actions by bankers. Thus one can apply this measure to the influence of statutory regulation over changing behaviour and culture in the banking industry. A scandal such as the attempted piercing of the ring fence and the following electrification could destroy confidence in one bank even further. In order to prevent this, banking culture is forced to change in a way that makes obeying the ring fence more likely and therefore fosters behaviour desired by the ring fence. The ultimate aim could then be seen as influencing behaviour in the industry to the extent that the nuclear weapon of electrification is no longer forced upon the industry, instead there is a notion and willingness to comply.

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2.2.2 Conduct of persons working in the financial services sector Scholars such as Ryder ask the question of why bankers have not been held accountable for their reckless, immoral and unethical conduct during the financial crisis in 2008 (Ryder, 2013, p.1). The PCBS sets out a compelling case for change in the industry to address this problem, providing a solid basis for government regulation to change the behaviour and business culture of the banking industry. Such research is mirrored in Part four of the Banking Reform Act, which partly amends the Financial Services and Market Act 2000 and additionally introduces criminal sanctions for misconduct by individuals causing a financial institution to fail. Introducing criminal offences is aimed at deterring a repeat of the occurrences the UK banking industry has experienced during the 2008 financial meltdown. Black and Kershaw have provided an in depth account on the topic of criminalising reckless behaviour of senior bank managers. The scholars agree with the assertion by the PCBS that introducing criminal liability for such actions provides a strong signal of society’s disapproval of this behaviour. Furthermore, they outline that the introduction of the Banking Reform Act addresses the scope and problems encountered by criminal law. Criminal law has been viewed as unjust with regards to the financial meltdown as it criminalises smaller scale misconduct but fails to hold those accountable, who are responsible for the economic destruction brought by the 2008 financial crisis (Black and Kershaw, 2013, p.2). This point is emphasised by Ryder who argues that the introduction of a new criminal offence makes a welcome addition to the armoury of those agencies that have been given the task of prosecuting white-collar crime (Ryder, 2014, p.198). Sections 36-38 of the Act outline the offences and proceedings relating to the failure of financial institutions, caused by individuals under the scheme. The regulation incentivises bankers to make decisions based on considerations, not just of their own profit but also for the overall good of the banking institution and its customers. Thereby the individual accountability of senior bankers is strengthened and simultaneously a deterrent is introduced against misconduct, as individuals will be liable (HM Treasury, 2013, p.1). This type of top down regulation can coherently be argued as a significant part of ensuring the recovery of trust in the financial system. Plender provides a meaningful contribution to this debate as he advances the argument of punishing bankers in particular senior executives themselves, rather than corporations as a whole as reflected in the ring-fence policy measure. Besides that, he suggests that a simple increase in fining banks is much more likely to only address the problem on the surface, leading to window- dressing results, rather than real structural change (Plender, 2014). Plender’s argument is more in line with part two of the Banking Act, such as the effects of the legislation on individual misconduct, rather than the results an electrification of the retail ring fence would have. Most notably because punishing innocent employers, for example via an electrification of the retail ring fence, for crimes committed by unprosecuted individuals seems contrary to essential elements of moral duty. Yet it is important to note that for any sanction to be effective, it is necessary for the person who infringed upon the standards to be detected, and the sanction has to be meaningful (Black and Kershaw, 2013, p.3). Additionally it must be acknowledged, as Andenas and Chiu

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argue, that by introducing more regulation, regulatory governance must take care not to become a relation paradigm between the regulator and the regulated (Andenas and Chiu, 2014, p.107). This point is enhanced by scholars such as Schein who provide insight into how the influence of the banking industry impacted on regulatory governance in the sector (Schein, 1990). Drennan suggests that one of the key aims of the government regulator should be to reshape the attitude of the industry and foster an environment that deters fraudulent and anti -social behaviour (Drennan, 2004). 2.2.3 Evaluating government regulation in the UK As Graafland and van de Ven highlight, reinforcing a renewed sense of virtue in the banking sector is considered by many as not sufficient to restore trust. Therefore, one must simultaneously change regulation to allow banks to put their mission statements and moral stances into practice (Graafland and van de Ven, 2011). Such an attempt has been made with the policies put forward in the Banking Reform Act. Yet Andenas and Chiu take a critical stance regarding post- crisis reform within the financial sector. Their investigations into the surge in regulatory control over finance indicate that the fundamental premise of financial regulation is changing. This does not simply include evaluating change in terms of moving towards a judgement led approach in regulation, but furthermore, embraces the values at which this should be achieved; most notably ethics (Andenas and Chiu, 2014). Thus it can be said that even though the precise impact of the policies considered above, on behaviour in the industry is uncertain, they have the potential to improve culture in the industry. Martin Wheatly highlights that a key challenge to the regulator remains further cultural reform due to the unique difficulties associated with quantification and rectification (Wheatley, 2013). This point is emphasised by Steare who acknowledges simple obedience to the government regulator alone cannot change the business culture of the banking industry. Steare advocates moving towards a culture of ethics of care rather than ethics of obedience. This fits into the concept of not simply relying on government regulation to change the industry but also using industry self-regulation (Steare, 2006). This reflects an argument which has been also been advanced by the PCBS. It emphasises the idea that a self-regulating body from the industry is necessary to change the behaviour and culture of the banking industry (PCBS, 2013, p.45). To summarise this argument one must remember the thoughts put forwards by Painter who notes that laws are in place partly because they have the power to actually transform behaviour (Painter, 2010, p.10). However, one must also acknowledge the limits of regulation and legislation from the government, meaning that law is necessary but not sufficient to rectify certain social ills. Therefore, a simple reliance on government regulation is not enough to transform the behaviour and culture in the banking industry. This is due to several factors such as costs or difficulties on behalf of the regulators when keeping pace with the constant dynamism of financial innovation. In conjunction with evidence from the financial crisis these reasons strongly indicate that there is the need for self-restraint and self-regulation within the industry.

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Chapter 3: Regulation from the industry The 2009 Turner Review, as the first official examination by the UK government into the causes of the financial crisis, presented evidence that financial and regulatory failures were due in part to human misconduct (FSA, 2009). Scholars such as Austill claim that unethical behaviour by bankers, which ignored moral and ethical obligations, was a key driving force behind the crisis (Austill, 2011). This highlighted that the tendency towards misconduct by the industry outweighs legal and regulatory constraints imposed upon them. The PCBS, however, emphasises the limitations of relying solely on government regulation in order to achieve effective reform of banking culture, which leads to such misbehaviour (PCBS, 2013, p.33). The Archbishop of Canterbury reiterates this problem, noting that; “if we think that by changing the law we have solved the problems revealed by the crisis, we are profoundly mistaken” (Welby, 2013, p.2). Consequently, it is necessary to acknowledge alternative ways of changing the culture in the banking industry without a total reliance on government regulation. Some form of self-regulation within the industry can thus be put forward to address and reform present problems. Such regulation is often present in the legal or medical industry. Reynolds and Newell argue that where business practices are of public interest and there is a public will to regulate, change in behaviour can sometimes be brought about most effectively by internal regulation (Reynolds and Newell, 2011, p.19). This appears to be the case in the banking industry, implying that an industry self-regulator, who guides and promotes ethical behaviour by the means of soft law and punishment, has the potential to solve present problems and encourage trust. The following chapter highlights how developments within the UK financial industry are aiming to transform the culture and behaviour of bankers. Before examining recent processes one must outline the theoretical rationale for self- regulation. Following such scrutiny, the chapter will focus on a practical application of the theory in line with a self- appointed standard setter - the Banking Standards Review Council. A critical investigation of this new institution is necessary in order to consider its potential in delivering the entrenchment of trust within the banking industry. 3.1 The rationale behind self- regulation within the industry Due to the global complexity of the banking industry, scholars such as Omarova suggest that a regulatory approach based on pure unilateral command and control, as exercised by government regulators, will lead to fundamental problems and will intensify the never-ending spiral of rulemaking and rule evading (Omarova, 2011, p.416). Likewise, Steare highlights the importance of a move towards a more sophisticated understanding of ethics in industry. He advocates an interpretation of ethics that goes beyond the simple notion of an obedience culture defined by what is legally right and wrong. Instead, he encourages a focus on the ethics of reason and care (Steare, 2006). Additionally one must note that too much government regulation often fails to achieve what it intended. For example, despite guidance produced by the FSA increasing by 27 percent during 2005- 2008, this period marked the

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peak of misbehaviour and failure of the industry (Wheatly, 2014). This evidence is in line with Brennan’s work that emphasises Albert Einstein’s famous words; “Not everything that counts can be counted. Not everything that can be counted counts” (Brennan, 2013, p.7). Here the scholar tries to highlight the need to move away from a simple reliance on a box ticking approach from the government regulator. Furthermore, even if individuals act in accordance with the law, their behaviour might still not be ethically right and thus can be counted legally but not morally. In turn this also means that individuals whose performance is based on ethical underpinnings might not act explicitly in accordance with a specific law. Therefore, law can be interpreted as outlining a bankers’ rights in terms of what they can do whereas ethics directs the individual in terms of what is right thing to do. Industry self-regulation has the potential to encourage morally right behaviour, by embedding ethical conduct in the industry. Scholars such as Gunningham and Reese advocate self-regulating bodies in the financial industry, which can be an effective and efficient means of social control that has been often ignored by many economists (Gunningham and Rees, 1997, p.371). This establishes the clear need for alternative non-red tape institutions to guide the banking industry and its individuals in their decisions of what is right and wrong behaviour. Incorporating elements of self-regulation has been acknowledged for its flexibility and quick responsiveness to changes in a highly technologically driven environment. Schultz and Held have highlighted these advantages with an emphasis on the speed of adaptability when operating self-regulation in the telecommunication industry (Schulz and Held, 2004). This industry provides a good comparison as both are highly influenced by technological changes. Likewise, Johnson underlines the advantages of self-regulatory organisations, in particular in areas such as regulating credit default swaps (Johnson, 2011, p.101). One must note that these scholars perceive the concept of self- regulation as a proxy for complete freedom of any government regulation. Yet in the present analysis self- regulation is defined as rules and supervision made and exercised by the industry alongside and simultaneous to government-imposed regulation. Moreover, the type of self- regulation anticipated by the UK banking industry incorporates elements of soft law, quasi regulation or some form of voluntarism. This is because it mirrors voluntary participation as well as non-legal agreements within the organisation. As Black highlights, self- regulation may be analysed at several levels, varying from firm-specific to industry-wide regulation (Black, 2001 p.119). A regulatory industry-wide body of bankers in the UK would therefore aim to address the problem on an industry-wide scale, yet simultaneously encourage firm-level self-regulation. Therefore it is important to note that when addressing the UK industry self-regulator in this examination, what is essentially meant is a body which acts as a self-appointed standards setter based on soft law without legal powers but can also dovetail with the government regulator. From this follows that self-regulation may take many forms, yet offering a one size fits all definition can be seen as insufficient (Gunningham and Rees, 1997, p.52). This is in accordance with Coglianese and Mendelson’s view that the field of regulation lacks an overarching standard and defined terminology (Coglianese and Mendelson, 2010, p.3).

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Having considered the rationale for self-regulation and its potential to change behaviour in the banking industry, one must highlight the efforts made by the UK in establishing such a system. The most recent financial crisis provides an opportunity for an increase in regulatory governance of the financial sector to be perceived as reflecting socio-political dimensions of public interest (Andenas and Chiu, 2014, p.68). This public interest mirrored efforts of the UK’s biggest banks and buildings societies who have supported the creation of a tougher professional standards body for the financial sector. There exists a desire for the format of this organisation to coincide with similar institutions such as the General Medical Council in the health sector (Thompson, Jenkins and Schäfer, 2014). The following analysis will consider this organisation – the BSRC- as an attempt to satisfy the demand for an industry self- regulator. 3. 2 Incorporating self- regulation in the UK banking industry 3.2.1 Establishing the Banking Standards Review Council Aforementioned evidence has strongly indicated that there is a need for self-restraint and self-regulation within the industry. In his book “On Liberty”, the founding father of liberalism, John Stuart Mill, argues that democracy cannot be forced upon people; instead it must be nurtured from within the people themselves (Mill, 1859). The same reasoning can be applied to the banking industry. A real transformation of banking culture and behaviour must be desired from within the industry itself in order to be most effective. The application of this notion to the UK banking industry translates into a similar concept espoused by Sir Richard Lambert, the appointed leader of the BSRC. He claims that “you can regulate against bad behaviour - that is what the FCA is there for… but it is not possible to regulate for good behaviour - that is where we come in” (Richard Lambert, 2013). The task of setting up the Council was initiated by many sources. Most notably, the evidence received and collected by the PCBS formed the substance of the body (PCBS, 2013). Likewise, inquiries such as the Walker Review and the Salz Review encouraged the establishment of such organisations. They advocate a body that emboldens ethical requirements, professional qualifications and more general industry self-regulation based upon principles anchored in a code of conduct (Salz Review, 2013). The Consultation Paper by Sir Richard Lambert provides a skeletal framework of this industry self-regulator and outlines the organisation’s strategy (Lambert, 2014). A critical first step on the path to industry self- regulation is the development of an industry wide normative framework, which defines conduct, moral restraints and aspirations (Gunningham and Reese, 1997, p.376). This aims to establish an industry morality that can guide, as well as challenge, decisions and situations an individual might face in the banking sector. In order to deliver these changes the institution will identify good practices of conduct and encourage banks to pursue them. The regulator should act as a standard setter of baseline ethics, which banks can then use as minimum standards (Fell, 2014). The Council will measure the bank’s commitment to change via several factors such as the frequency of

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whistleblowing, pay metrics and the level of competence. The institution therefore aims to encourage banks to self-regulate for good behaviour (Jenkings and Goff, 2014). These measures will be evaluated via a league table of bank’s ethical behaviour and staff qualifications operated by the Council. Such a system implies that the Council will rely on public naming and shaming of banks that fail to improve their conduct and standards (Black and Anderson, 2013, p.5). Most notably this would not require altering the law and could be exercised at a low real cost. The body aims to provide the right encouragement for banks to change direction and embark on a race to the top, in which integrity and exemplary behaviour are seen as providing a powerful competitive advantage (Lambert, 2014c, p.8). It targets collective effort by the banking industry to raise conduct standards and requires participating banks to commit to a programme of continuous improvement, under the heading of culture and competence. This means that banks that proactively follow set self-regulatory standards set by the BSRC will demonstrate their efforts to regain public trust (Woodhouse, 2014, p.3). Rather than replacing the FCA and the PRA as day-to-day regulators, the BSRC will review the progress that banks make in improving their culture and competence. Such progress is evaluated via the publishing of annual reports regarding the performance of individual banks and their alignment with set standards. Dolan suggests that this provides the Council with the potential to make a difference to banking standards over time, if the opportunities it has to offers are taken up by the banking industry (Dolan, 2014). Additionally, the BSRC is aiming to work with the government regulators by helping banks to meet new legislation requirements, most notably the ones outlined in the Banking Reform Act (Goff and Fleming, 2014). 3.2.2. Reactions towards the Banking Standards Review Council The banking industry does not operate in a vacuum and therefore its external environment also influences desired change in culture and behaviour. It is necessary to examine the responses other participants in the financial sector have made in regards to the BSRC. Such responses have outlined the potential influence the Council has on the top down structure of the industry. Burrows accentuates this by noting that; “The right tone from the top is a vital ingredient in making high standards of competence and behaviour part of corporate DNA” (Burrowes, 2014). Encouraging ethical behaviour and standards from the top to trickle down to the very bottom of the organisation is hence deemed as essential to deliver lasting change in the industry. Moreover, this will contribute towards a reduction in the occurrence of conduct spending, which has cost the industry a significant amount of money and reputational capital. Bryant argues that the only way to prevent the increase of such conduct costs is to improve conduct morally. A banking industry, which operates in line with what is lawful and morally right, would leave no more room for moral arbitrage (Bryant, 2014). This provides a stronger rationale why the Council is targeting ethics in particular. Similarly, Mark Carney has highlighted that; “A meaningful change in the culture of banking will require a true commitment from the industry” (Carney, 2014, p.3). One can consequently argue that the BSRC tries to demonstrate such a commitment. Moreover, this commitment is likely to provide a competitive advantage for the UK’s banking industry. The UK banking industry

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has the potential to position itself as the leader in an international race to the top. These suggestions are supported from a range of industry bodies (Chartered Banker Institute, 2014, p.3; Malenczuk, 2014, p.4) and therefore build a core objective of the new BSRC. Ingram and Lifschitz highlight that the performance of organisations depends partly on the reputations of their industries. This has led to the industries being referred to as intangible commons, as organisations and industries share both rewards and penalties with each other. This notion should be part of the driving force behind industry self- regulation as it promotes the interest of mutual welfare within the industry (Ingram and Lifschitz, 2006). Bartley, who highlights that industry reputation is common in the domain of corporate social responsibility, puts a similar argument forward (Bartley, 2007, p. 233). Such a collective notion is underlined by John Donne’s famous words of; “No man is an island” (Donne, 1988). This concept can be replicated in a context of the banking industry suggesting, that banks do not operate in isolation to each other, and therefore the actions of one bank affects the sector as a whole. Thus a collective effort to combat their bad image and change behaviour in the banking industry is more likely to be effective. Helping the industry can redefine its moral responsibilities and proactively increase the social good. Joyner and Payne highlight this by providing the example of community participation yielding communal spirit (Joyer and Payne, 2002, p.301). This indicates that if the banking industry fosters a community spirit based on ethical behaviour, social good is enhanced overall. So far, the participants of the BSRC are the seven biggest banks and building societies in the UK. Yet the body itself, and many respondents to the consultation paper advocate a collective approach, with widespread membership across the banking industry (Woodhouse, 2014; Browne, 2014; CBI, 2014). This suggestion is in line with concerns raised by the PCBS, outlining the need for the BSRC to aim for a comprehensive coverage of all banks in UK, while simultaneously being independent from them (PCBS, 2013, p.16). Furthermore, only partial participation might harm the competence of the body itself (De Montille, 2014, p.2). Thus increased participation is likely to enhance the credibility and success of the body. This provides the reasoning behind a collective industry self- regulator. An important feature of this collective notion is that the BSRC will not replace already existing professional bodies; such as the Chartered Institute for Securities and Investment. Instead it must align its work with industry wide key objectives and act as an oversight body for other training programmes (Jenkings, 2014). Developing an effective liaison with professional bodies in the industry is highly important to the success of the institution. An effective cooperation with other professional bodies and participation by as many UK banks as possible is an essential contributor towards the institution’s effectiveness. The BSRC in itself provides a measurement of how committed the industry is to real change in its behaviour. Success of this institution is probable to mirror successful change in the industry. Having outlined how the self- regulator is likely to operate and its potential influence on the banking industry, one must nevertheless recognise the limitations of such an approach.

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3.2.3 Evaluating self- regulation in the UK Despite a general welcoming of an industry self-regulator, there remain doubts about the impact of such regulation in delivering real change in the banking industry. A common criticism is raised when considering the time it will take for the culture and behaviour of banks to change fundamentally. To put it in the words of Andrew Tyrie, the leader of the PCBS, when he addressed Sir Richard Lambert as leader of the BSRC; “You are too old. You will be dead by the time anything changes. You are like Moses - you will never get to the Promised Land” (Jenkins and Goff, 2014). This quote reflects the crucial concern about timing in the process and the limits to the power that regulation has in delivering change in the behaviour of the industry. From this review it follows that the BSRC must be strong enough to restore trust and address a fundamental crisis of ethics in the industry. It might be a challenge for the Council to keep the banks on board while maintaining credible independence. Even though the BSRC claims that it will be independent and not lobby on behalf of banks (Lambert, 2014), this commitment might be questioned as the Council receives its main source of funding from banks. Thus Brown calls for total independence of the BSRC from the banking industry, in order to avoid the heavy influence of lobbying on the Council (Browne, 2014). Striking a balance between the reliance on financial support from the banks, whilst staying independent, will therefore be a key challenge the BSRC has to deal with. Furthermore, one must note that communal effort is key to foster change within an industry as a whole, yet the attitude of individual banks and people within it and their desire for change is also of crucial importance. Indeed, banks do operate with each other and therefore cannot be seen as individual islands, importantly is the notion that they may justify the motivation for a change in ethics with the stance of everyone else is doing it. This necessitates, however, a true understanding of the underlying need behind it. The BSRC can support banks for better ethics and a change in their culture but ultimately only banks themselves can embed the desired culture in their operations. Therefore it is important to note that the body’s powers should not simply be used as shifting the responsibility of ethics away. Both Carney and Lambert have actively acknowledged the limits of regulation. Lambert outlines this by noting that; “one can write rules to punish the bad guys but it is difficult to legislate for the kind of environment in which the good guys flourish” (Lambert, 2014b, p.4). Essentially this suggests that acting in an ethical way based on integrity cannot always be regulated or bought. A body like the BSRC, which uses collective initiative by the banking industry itself to raise standards driven by voluntary participation, has the potential to deliver lasting change in areas which government regulation might not be able to address. Yet one must highlight the importance of holding banks and individuals accountable on the basis of conduct and competence, as outlined in the Banking Reform Act. Stears notes it is essential that this mission dovetails with the objectives of the regulator, making regulatory synergy essential to the process (Stears, 2014). The following chapter will therefore highlight how

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both regulatory approaches have the potential to work together in order for regulation to maximise its potential in influencing change in the banking industry.

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Chapter 4: Towards a nexus between both types of regulation

The problem when making an ethically based decision is, that although it may be easy to choose the right answer on paper when educating and training bankers, it is significantly harder to guarantee this would be emulated at the frontline of day-to-day business operations. Gupta argues a key question that must be addressed is whether bankers should follow the rulebooks, which might be out-dated, or pursue their own ethical judgments, which are often not clearly defined nor standardised (Gupta, 2014). Establishing a well-functioning cooperation between government regulation and industry self-regulation is essential to erode such problems. It could contribute to keeping rulebooks more up to date and offer greater guidance in making ethical judgements, by providing clearer definitions of the correct business behaviour desired from both outside and within the industry. When examining different types of regulation, a balance needs to be struck in order to avoid an over- paternalistic regulator or a case in which regulatory capture occurs. Thus it is necessary to investigate how a nexus of optimal synthesis between government and industry regulation could be incorporated. This chapter will therefore outline the rationale for operating both types of regulation in conjunction with one another. In order to demonstrate the necessity for such an approach, the influence of meta-regulation is critically assessed. From this follows an evaluation of the how the BSRC and the government regulators can foster an improvement in banking standards, by effective cooperation with each other. The final paragraph outlines the limits of regulation by questioning the outcomes that a cooperating regulatory approach can have on changing the culture and behaviour in the banking industry.

4.1 The rationale behind operating both types of regulation 4.1.1 The influence of meta- regulation When reviewing how self-regulation and government regulation should optimally operate in order to improve banking standards one might consider the role of meta-regulation in this process. Meta-regulation is a type of regulation that enhances the capacity of firms and industries to self- regulate, via connecting the private justice of internal management systems with the public justice of accountability (Parker, 2000, p.247). It refers to the methods that government regulators use to induce the regulated to develop their own self-regulatory responses to public problems. Such directions can be made via threatening firms with sanctions or encouraging them via rewards (Coglianese and Mendelson, 2010, p.14). Some scholars have suggested that meta-regulation best addresses the interactions between government regulation and self-regulation. This is illustrated by Parker, who defines meta-regulation as interactions between different regulatory actors or levels of regulation (Parker, 2010, p.16). Meta- regulation therefore focuses on outside regulators, but also incorporates the insight from self-regulation (Coglianese and Mendelson, 2010, p. 5), making it of relevance and interest to the present analysis.

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Common perceptions of this concept often highlight the impact meta-regulation had on regulatory failure during the financial crisis (Akinbami, 2013), indicating that the concept is either wrongly exercised by its actors or in need of reform. The present analysis thus considers a different approach towards utilising meta-regulation. This is necessary in order to apply the concept to the relationship of the BSRC and the government regulator. Meta-regulation has often concerned the regulator identifying a problem and leaving the industry with the discretion to solve it. In this case, the industry has clearly had an influence in defining the problem itself, which is evident in the initial desire to set up the BSRC. Moreover, the Council will not set out an entirely new set of goals but adopt parts of the already existing standards provided by the FCA and PRA. The government regulator and the BSRC could also use a checks and balances system in order to take advantage of the vital features of meta-regulation. Meta-regulation can be seen as a half-way house between conventional government regulation and self-regulation, striking a balance between the extremes of total government control and unconstrained freedom of firms. The approach therefore seeks to address the drawbacks of a purely self-regulatory method whilst enhancing the advantages of its hybrid nature. Andenas and Chiu note that a key advantage of meta-regulation in the UK is that it accepts that government regulators deal with uncertainty. This accommodates a flexible environment whereby value is placed on an experimental and learning-based approach adopted by many firms (Andenas and Chiu, 101). By working closely with the BSRC, the government regulator can use this flexibility to its advantage. The Council, with its close ties to the banking industry, has the ability to encourage the adoption of ethics and moral values, and with its benchmarking features it is able to measure this learning process. Such type of meta-regulation leaves firms with the discretion of choosing an optimal framework suitable to their business structure when trying to voluntarily implement the standards set by the Council. Yet the government regulator will not implicitly punish banks that fail to adopt these ethical standards. Instead, the BSRC will use its soft powers of benchmarking. Failing to position oneself in the upper echelons of these benchmarks is likely to increase the banks’ reputational risk and might even erode their competitiveness. The fear of this outcome may encourage them to adopt certain standards and provoke a race to the top. It is important to note that a total reliance of a meta-regulatory approach is not advisable; instead what is desired is operating simultaneously within the confines of both traditional government regulation and self-regulation. Black highlights that an overreliance on meta-regulation has negative implications and, moreover, can lead to the development of a utopian version of responsibility, mutuality and trust (Black, 2008). An additional disadvantage is that compliance systems often run parallel to the organisation’s core operation (Black, 2011, p.7). However, adopting an approach as advocated in this analysis, involving a symbiosis of government regulation and self-regulation, aims to make ethical compliance an integral part of the firms procedures. Therefore, it can be seen as having the potential to overcome the disadvantages outlined by Black. Furthermore, combining the clear hard law features of the government regulator and the soft law power from an industry self-regulator has the potential to optimise prior approaches to change banking standards. Yet it is important to stress that

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both institutions must stay independent from each other by nature but complement their work in terms of what objectives they try to achieve. This is because the institutions must stay independently accountable but also avoid duplication of work in order to most effectively improve conduct in the industry. 4.1.2 The relationship between the regulators in practice The establishment of an industry self-regulator and the introduction of tougher laws to encourage more ethical standards into banking provide evidence for the fundamental and far-reaching improvements both actors have undergone since the financial crisis (O’Connor, Cadman and Goff, 2014). Yet in order to maximise the impact regulation can have in achieving a change in banking culture, it is necessary for different types of regulation to effectively cooperate. The reasoning behind an approach advocating cooperation between the government and industry regulator is derived from multiple sources. As Reynolds and Newell argue, a simple reliance on self- regulation is not enough as the industry is, by its nature, driven by competition and might not have a strong enough incentive to deliver a race to the top in terms of ethics. Consequently, determination from the industry as a whole, which take ethics seriously, should be fostered, as well as the establishment of outside intervention to create an environment where ethics can flourish (Reynolds and Newell, 2011, p.145). Furthermore, appropriate external regulation by the industry might not be able to be ethical in the long run, yet a sole reliance on government regulation has major shortcomings, such as the speed of market innovation (Reynolds and Newell, 2011, p.31). Stears claims that; “an appropriate culture can have an influence but it is without teeth unless individuals fear the cost of misconduct more than they stand to gain from the potential benefit” (Stears, 2014). This suggests that an industry self-regulator must be backed up by government regulation. The punishment for reckless misconduct by individuals in the banking industry as outlined in section 36-38 of the Banking Reform Act provides such teeth. This notion is in line with Hobbes philosophy, which asserts that moral values were completely ineffective if they were not enforced and reaffirmed by hard law (Moller, 2012, p.27). This indicates the necessity for government regulation and industry self-regulation to effectively work together and complement each other in order to achieve a transformation in banking culture. In response to the consultation paper put forward by the BSRC, a variety of concerns were raised, particularly with regard to the relationship of the body with the regulators. Lambert summarises these by noting that one of the biggest problems facing its implementation was the lack of a detailed description of the relationship between statutory regulators and the new body (Lambert, 2014c, p.14). From an early stage, the BSRC stressed that it seeks to align its activities with regulators, starting with building its guiding principles on the FCA’s Principles of Business (FCA, 2014). Thus it is necessary to have a successful dialogue between the BSRC and the government regulator. This could be exercised via Memorandum of Understanding, covering matters such as mutual assistance and exchange of information. Scholars such as McCormick put forward the idea of establishing a Regulatory Liaison

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Committee charged with overseeing such MoU. (McCormick, Stears and Duarte, 2014b, p.10). The fact that the Governor of the Bank of England is playing a key part in the appointment of key figures of the BSRC provides evidence for the desire of the new self-regulator to strive for an effective relationship with the government regulators. However, a key difference between the two regulatory approaches is that the BSRC will set voluntary standards in areas where it claims that statutory regulation is unlikely to work effectively. Wheatly highlights that trying to change behaviour and culture in the industry with a sole reliance on the government regulatory mechanism is too static and it often encourages the behaviour it seeks to stamp out (Wheatly, 2013b). Likewise, Dutta underlines that the BSRC needs to complement such a transformation in banking culture with the full support and collaboration of the regulators (Dutta, 2014, p.18). The BSRC must work in symbiosis with the regulators and an optimal nexus between these institutions must be found in order to most effectively influence and change behaviour in the banking industry. 4.2 The limits of regulation Embedding ethical behaviour into the banking industry is evidently a difficult task and some might question whether any type of regulation can ever achieve this (Black and Anderson, 2013, p. 6). Scholars such as Schein question the effect regulatory governance can have on the values and culture of the banking industry as a whole (Schein, 2004, p.42). Reynolds and Newell advance this perspective and inquire whether an increased focus on ethics will deliver the behaviour desired. They conclude that a greater awareness of ethics has the potential to provide such change, at least to some extent, yet it is important that the desire for such change remains focused and determined (Reynolds and Newell, 2011, p.145). Nonetheless, ethical duties have already existed since the 1980s in the legal and regulatory realm but have not prevented the behaviour seen during the financial crisis. This indicates that the industry has failed to understand and implement these principles (Black and Anderson, 2013, p.5). It is unclear if recent attempts to regulate will be successful in improving this understanding, in order to prevent future misconduct in the industry. Whilst Black and Anderson also acknowledge the role of regulation in deterring unethical conduct and promoting appropriate behaviour, they simultaneously highlight that the ultimate responsibility in achieving change lies with the banks themselves. Consequently, banks need to focus on fostering a structure that sets out clear practical guides on how compliance is achieved, and provide rewards for such behaviour (Black and Anderson, 2013, p.6). Coglianese and Mendelson’s findings support such claims, as they emphasise that the effectiveness of regulation and compliance are heavily dependent upon incentives and rewards (Coglianese and Mendelson, 2010). This argument is supported by Plender, who claims that as long as incentives are at odds with ethics, common decency will be a minority pursuit (Plender, 2014). Changing the incentive structure for banks has recently been considered by the PRA and the BoE but is still to be translated into law (BoE, 2014). Yet, Authers suggests that it is not just the incentive structure that must be changed in order to

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increase standards in the industry, but also training towards ethical values must be initiated early on in an individual’s career. Thus he proposes the incorporation of ethical lessons in universities or business schools (Authers, 2014). This is cemented by the view that compliance in achieving cultural change in the industry is likely to be more effective if the people who enter the industry already have existing knowledge about the ethics desired. From this follows that the current attitude and efforts of the government and the industry regulators, are potentially limited in their ability to change banking standards. Moreover, Whittaker questions whether the changing of the current banking culture, even if desirable, would be legitimate. He highlights the costs and risks involved when trying to implement such change, particularly criticising the lack of democratic spirit in the attempts of the industry and the government regulators to change banker’s behaviour (Whittaker, 2010, p.159). However, the most recent public outcry from outside and within the industry suggests that there is high popular demand for changes, and the government regulator does have the implicit approval by the democratically elected party in power. Following this analysis it is clear that using regulation to influence and foster standards and good conduct in the banking industry is a difficult task. O’Connor, Cadman and Goff highlight Carney’s cautioning words warning that, ultimately, integrity can neither be bought nor regulated. This suggests that even with the best possible frameworks of codes and principles, financiers must constantly challenge themselves to the standards they uphold (O’Connor, Cadman and Goff, 2014). One can thus conclude that even though regulation is a powerful tool in influencing behaviour in the banking industry, which works most effectively when there is a successful communication between different types of regulation, its triumph in terms of changing behaviour and culture in the banking industry is by no means guaranteed.

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Conclusion

The present analysis has provided an insight into the extent to which regulation has the potential to change the behaviour and culture of the banking industry. Bearing in mind the critical analysis regarding the nature of this change in chapter one, the subsequent chapters demonstrated different approaches in terms of how this change can be achieved.

Banks are the gatekeepers of the financial system and of core importance to the financial intermediation process and the smooth functioning of the economy as a whole. This means society must take close care of how they are behaving. Even though the banking industry has recognised the need for a behavioural shift in its culture following the financial crisis, recent scandals have suggested that the industry perpetually experiences difficulties when implementing any reform. This indicates that embedding cultural changes throughout organisations will be an on-going process.

As Dutta highlights, the banking sector is on a journey towards fundamental change but embedding and implementing a wholly different culture will take time and serious will power and determination (Dutta, 2014, p.18). Furthermore, ideological changes need long periods of gestation, reflection and political will (Andenas and Chiu, 2014, p.11). This suggests that change in the banking industry will certainly be difficult to achieve but nevertheless remains essential to the flourishing of the industry. It might be a rocky road, which lies ahead but the potential of increasing standards and thereby economic sustainability is a worthy outcome. Ultimately, regulation of any type can provide incentives, yet it is up to the banking industry as a whole and the individuals within it to meet this challenge.

Despite criticism about the effectiveness of regulation, it can already be seen that regulation has profoundly influenced the post- financial crisis agenda. Nonetheless, I believe that in order to ensure compliance with the law it is necessary to understand the law. Thus it is of crucial importance to increase the understanding and clarification of ethical values in the banking industry, by both the government regulator and the industry self- regulator. The BSRC has great potential to play a key role in supervising and clarifying standards without replacing or duplicating the position of the government regulator. The present analysis therefore concludes that the most effective way to deliver a successful cultural and behavioural overhaul will demand mutually beneficial cooperation between industry self- regulation and government regulation.

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