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Part III The Conduct Crisis, 12 Ethics and Standards

Roger Mccormick, Chris Stears

From: Legal and Conduct Risk in the Financial Markets (3rd Edition)

Roger McCormick, Chris Stears

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2021. All Rights Reserved. Subscriber: null; date: 15 April 2021

Subject(s):
Banking — Regulators

(p. 233) 12  Ethics and Standards

… work to establish a professional body should begin immediately as a demonstration that commitment to high standards is expected throughout banking and that individuals are expected to abide by higher standards than those that can be enforced through regulation alone … A unified professional body for banking should have no need of public subsidy, either directly or indirectly. We would expect such a body to be funded by participating banks and individual qualified members. However, it would also need to establish independence from the outset, through its forms of governance, its disciplinary procedures and through personnel at senior levels. The body must never allow itself to become a cosy sinecure for retired bank chairmen and City grandees. Just as importantly, it must eschew from the outset and by dint of its constitution any role in advocacy for the interests of banks individually or collectively.1

Our mission is simple: to identify the grey areas where wholesale market practice is unclear, formal regulation can't help and market users are vulnerable—and to develop and publish Standards which lay out exactly how markets should function in these areas in order to deliver the best outcomes for all users.2

(p. 234) A.  Introduction

12.01  The first epigraph, taken from a major report by the PCBS published in June 2013, summarizes the PCBS’ conclusion that, in response to the issues that came to light as a result of the Crises, some kind of ‘professional body’ for banks should be established and that this body should promote better standards of behaviour in banking. Perhaps the most prominent, game-changing result of the LIBOR scandal and the deliberations of the PCBS was that ethics and the morality of individuals’ behaviour (and the accountability of individuals) now had to receive comparable attention to that given to the ‘usual’ risks in the financial system. The conclusion, importantly, recognized that conventional regulation, by itself, would not be enough to cause behaviour (or ‘conduct’) to improve. Following the onset of the Conduct Crisis, and reflecting the deliberations of the PCBS, the calls for ‘standards’ to be adopted in the finance sector became more pressing. To some extent they were part of a desire to see bankers behave more like a profession and be more ethical but they also stemmed from a recognition that conventional regulation had left a number of ‘grey areas’ regarding market activity, where the ‘right answer’ to a conduct dilemma was not clear merely from the language of law or regulation and nor was it entirely obvious from an everyday understanding of what was honest or dishonest, right or wrong.3 Typical grey areas would arise in situations where a market participant would infringe no regulatory, contractual or other requirement in pursuing the most profitable course of action but where, nevertheless, such a course of action might be seen as immoral or unethical and expose the institution or individual to reputational and, possibly, legal risk. In this context, the publication of a standard could both improve market behaviour and also act as a risk control tool. Standards also have at least the potential to operate on an international basis, unlike conventional law and regulation.

B.  The Banking Standards Board

12.02  In response to the recommendation of the PCBS that a ‘professional body’ be set up, and following a consultation exercise (the Banking Standards Review, conducted by Sir Richard Lambert) the Banking Standards Board (BSB) was eventually established (commencing work in January 2016). As at the time of writing, the BSB has twenty-two member banks and building societies. As is stated in its Chief Executive’s Report in its Annual Review for 2016/17,

(p. 235)

The BSB does not exist to encourage trust in the banking sector, but to help to raise the trustworthiness of the sector; a very different proposition.

12.03  The Lambert consultation had reported in May 2014, recommending the formation of a ‘Banking Standards Review Council’ (which, in the event, became the BSB). Lambert recommended that, ‘the objective of [the BSRC] will be to contribute to a continuous improvement in the behaviour and competence of all banks and building societies doing business in the UK.’ It was to achieve its objectives by:

  • •  Requiring participating banks and building societies to commit to a programme of continuous improvement under the headings of culture, competence and customer outcomes, and to report back on their performance to the public every year.

  • •  Setting standards of good practice.4 That means identifying activities where voluntary standards would serve the public interest, and working with practitioners and relevant stakeholder groups to come up with agreed procedures. Examples could include whistleblowing protocols, the approach to retail sales incentives, banks’ processes for handling small businesses in distress, or the management of high-frequency trading.

  • •  Publishing an annual report setting out where progress is being made both by the sector and by individual banks and building societies, and where more needs to be done.

  • •  Having a meeting once a year with non-executive directors or, in their absence, risk or reputation committee chairs of the larger banks and building societies to discuss the institution’s progress relative to the previous year and to its peers.

  • •  Working with the industry and its stakeholders to develop a single principles-based code of practice in alignment with the high levels principles now being considered by the regulators.

  • •  Identifying and encouraging good practice in learning, development and leadership, with a particular focus on behaviour and ethics.

  • •  Helping the banks to meet the obligations being placed on them by new legislation, such as the Certified Persons regime.5

  • •  Working with the professional bodies already active in the banking industry to increase the value placed on professional qualifications.

12.04  The authors, as directors of CCP Research Foundation, participated (in February 2014) in the consultation process of the Lambert Review. The Foundation responded to questions focused on: (i) the role and scope of the proposed organization; (ii) ethics; (iii) professional standards of behaviour; (iv) benchmarking; (p. 236) (v) discipline; and (vi) banking as a profession. Extracts from the Foundation’s response to the consultation paper are set out below.6

(1)  Role and scope of the new organisation

12.05  The Review asked: ‘Do you agree with the proposed role of the new organisation to set standards of behaviour and competence for banks and building societies, and to define metrics against which they could benchmark?’

12.06  The Foundation’s response was:

Yes. The importance of any new organisation (‘the Organisation’) achieving cohesion and co-operation with policy-makers, regulators, industry associations, banks, other professional bodies and civil society groups cannot be overstated.

This requires strategically embedding the new organisation into the fabric of the industry.

It is essential to the long-term success of the Organisation that it develops the operational means by which to achieve its goals. This includes establishing close relationships with stakeholders.

It will also be beneficial (not least in terms of assessing conduct and benchmarking) to consider the means by which the Organisation can avoid the potential disclosure gap between the regulator and the Organisation in matters of ‘conduct’ concern that might arise by virtue of s.348 FSMA 20007. The banks, regulators and the Organisation alike should be permitted to disclose conduct costs and other conduct performance metrics that are collated and/or otherwise received without falling foul of any ‘selective’ or improper disclosure laws. In short, such information should be the subject of specific [public interest] disclosure obligations … and be deemed non-confidential. This may, of course, require legislation or new regulations but it is important that the general bank oversight infrastructure cuts back at least some of the omnipresent ‘confidentiality’ requirements to the extent they continue to justify unnecessary secrecy and behaviour on ‘transparency’ that falls far short of the fine words one hears on the subject.

We agree that its independence will be crucial to its credibility. It must not be (or look like) the ‘same old, same old’ dressed in new clothes. This goes to its place in the overall social/political/industry structure and also to the composition of its governing body and relevant committees. It should be fiercely independent, sceptical of tradition and able (and feel encouraged) to ask awkward questions, not just of banks but also of regulators, politicians and others who may influence or be affected by bank conduct and behaviour.

This leads us to the conclusion that the organisation should not report to the FCA, the PRA or any body of politicians (such as a Parliamentary Committee). It has to report to someone, however. We would tentatively suggest it reports to the Governor of the Bank of England. Although the Governor is, of course, part of the regulatory structure, we feel that there is more public confidence in his/her (p. 237) independence and freedom from ‘regulatory capture’ threat and political agendas than is the case with the alternatives.

We do, however, see the importance of the organisation having strong links with regulators. Subject to our comments below, we suggest that the organisation seek a Memorandum of Understanding with the regulator(s) covering matters such as mutual assistance and exchange of information. The organisation might also benefit from establishing a ‘Regulatory Liaison Committee’ charged within overseeing the MoU and maintaining a synergy between the organisation’s objectives and the regulatory system.

12.07  In relation to the scope of its membership, the Review asked whether the new organisation should include all British banks and building societies, and foreign banks doing business in the UK. The Foundation did not disagree, but emphasized the importance of there being representation from ‘challenger banks’ in the organisation as well as more established commercial/retail banking.

(2)  Ethics

12.08  On the subject of ethics in banking, the Review asked: ‘In the section titled ‘Ethics’, a case is made for a more pro-active approach to managing ethical issues. Do you agree with this, and if so how should it be done?’

12.09  The Foundation’s view was:

Yes. We view ethics as being a core function within the decision-making equation. Ethical issues are not merely for discussion at lofty, philosophical levels. They can arise with surprising frequency in the course of an ordinary working day. Managing ethical issues should sit alongside managing risk, specifically legal and conduct risk.

Whilst any standards adopted by a bank must of course be in conformity with what regulators require, we feel that the organisation should see such regulatory requirements as a minimum and steer away from an approach that relies too heavily on ‘reverse engineering’ what regulators have laid down into a bank’s own organisational structure and deeming that to be sufficient.

Banks should be encouraged to start afresh, notionally, with a ‘tabula rasa’ when devising ‘ethical’ rules for how they wish their staff to behave in the light of the experiences they have had. They should then, when they have developed some substance to such rules, check back against what is required by regulation and ensure that no regulatory requirements have been omitted. The difference in approach is important. One approach involves a mindset that poses, as a first question: what are the regulators making us do? The other poses the first question: what do we think is right? The banks’ ‘restore trust agenda’ (which should be more about deserving trust than simply regaining it) is not about an ongoing struggle to get the compliance function to work effectively. It is about re-thinking, for each person in the bank, why he/she goes to work every day and what makes him/her proud of a job well done.

It follows from the above that we would encourage banks to surpass the standards of regulators not merely to ‘meet or surpass’ them. We agree that the organisation should benchmark the banks’ efforts in this area against good practice. We see the (p. 238) organisation’s role in the cross-pollination of ideas that lead to good practice as crucial.

Training

Whilst training in conduct matters is, undeniably, a ‘good thing’, staff should not need to be trained in order to understand the importance of honesty—if they do, the bank really does have a problem. Sadly, however, it is want of honesty that seems to have given rise to some of the most prominent scandals of recent times.

Notwithstanding the above paragraph, we do think that all concerned in the industry (including regulators) need to develop a better common understanding (which they should share with the organisation and the public) of where some of the boundaries lie in relation to, for example, ‘manipulation’ and taking advantage of another’s ignorance or error (leaving aside consumers, who are a special case). To use a celebrated example of language from a recent scandal, is it ever appropriate to regard a counterparty as a ‘muppet’ and milk him for what you can get? There is a danger that we set up training programmes for the sake of appearance and overlook some of the fundamental right vs. wrong judgement issues, which still require a more substantive debate in the industry—a debate that might include the continued efficacy and modifying the application of parts of COBS in regard to eligible counterparties.

The extent of the need for training in banks should, one would think, depend on how well the staff of any given bank understand (a) what honesty means and how it affects decisions and behaviour in their work and (b) how decisions should be taken in the inevitable ‘grey areas’. A ‘programme’ of training designed for all banks may, by its nature, be somewhat crude (looking as though it has been devised in a ‘one size fits all’ workshop) and, as a result, not taken very seriously. We do not believe it is being suggested that all banks have the same training programme but we would caution that the idea of assessment of training by the organisation should not lead to this result.

Training needs to address the potential confusion for staff that can arise when there is a sharp change in values and the bank’s judgement on right and wrong behaviour. What was OK yesterday, even encouraged, may not be today. And vice versa. No one criticised generous bonuses in years leading up to the Crisis and much of the now-condemned ‘excessive’ and aggressive behaviour was well known and not regarded as a sign of serious moral decay or reputationally problematic for banks (or something to which regulators should respond). Now things are different. And the changes in culture that post-Crisis scrutiny of banks will require is not yet a closed list. The implications for conduct are fundamental.

We believe that on-line training should be discouraged (because it is unlikely to be effective) and face-to-face training encouraged.

We would suggest that training initiatives should include off-site ‘schools’ where staff from different banks can compare experiences and seminars and workshops are arranged at which examples of best practice, ‘lessons learned’ etc. can be openly discussed. Confidentiality of a bank’s sensitive information needs to be respected but it is a characteristic of a ‘profession’ (if that is what we are trying to set up) that fellow-professionals meet each other and talk about matters of shared professional interest (especially questions of professional ethics) reasonably regularly. (NB These occasions should not be arranged so as to be marketing opportunities for outside advisers).’

(p. 239) (3)  Professional standards: Behaviour

12.10  Aspects of the Review’s concerns over professional standards in banking included the interaction of best practice with the regulatory principles and guidance. The Foundation’s position on this reflected the broader issue that best practice standards tied to regulatory principles (and/or conduct-related obligations) would not be an optimal approach. While market participants would rightly want to know how best practice standards are viewed by the regulator in order to manage related legal and conduct risk issues, this should be in the context of developing standards that engender an ethics-centric outcome. As the Foundation remarked:

The new, more interventionist regulatory approach, focusing on forward-looking judgements and on appropriate ‘outcomes’, coupled with the product of a treating customers fairly mantra, ought to align expectation and standards in the minds of banks, customers and regulators—and this is a positive development. However, in our view the issue is with the use of the word ‘appropriate’. It is becoming increasingly routine to scope conduct risk by reference to the regulator’s outlook and priorities and what it considers ‘appropriate’ behaviour and outcomes. This, we think, largely misses the point and can in fact lead to an unconstructive preoccupation with regulatory expectation. It promotes a focus on pre-empting the next thematic review, product intervention or enforcement action. It results in management information and risk management output fit for ‘compliance-purpose’, rather than fit for ‘client-purpose’: it can lead to ‘regulatory neurosis’.

We see the Organisation’s role in promoting best practice that has at its core an appropriate balance of incentives for good behaviour (distinct from deterrence of bad behaviour, which ought to remain within the concern of the regulators), but that gives equal attention to the cultivation of ethical practice in banking. Banks should ‘want’ to achieve the best outcome for clients, not merely feel that they are ‘compelled’ (or ‘incentivised’) to do so—for fear of the ramifications. Furthermore, banks should ‘want’ to avoid disproportionate damage to counterparties relative to its benefit in a transaction. It ought not be right that when faced with asymmetric information, an imbalance of bargaining power, or simply because the other party is objectively experienced and well resourced, that a bank can simply rely on the principle of ‘caveat emptor’ to prevail in a transaction at any cost. Although we would resist imposing general good faith obligations as a matter of contract law, some generally accepted standard of fair, honourable conduct has now become essential to the protection and enhancement of market integrity and productive competition. And this starts with appropriate behaviour. The Organisation can play an important role in promoting the ‘motivation’ for good behaviour through professional standards. But first, the banks must ask the question—and do so from the right perspective.

12.11  Moving from principles-based practice to codes of conduct, the Review was concerned as to how the implementation of any such codes might be assessed over time. The Foundation’s response was to emphasize the need to identify concrete indicators, ‘like conduct costs’ and the importance of holding the Senior Independent Director responsible to the board and the Organization for overseeing:

(p. 240)

  • •  The production of a code of conduct that is demonstrably tailored to the bank;

  • •  The supervision and enforcement of the Code;

  • •  Regular training and awareness assessments, at all levels, on not only the content or ‘form’ of the Code but its spirit or ‘substance’. Including oversight of the appropriateness of ‘grey area’ case studies used within training and competence assessments.

  • •  The bank’s responses to conduct costs;

  • •  An effective whistleblower mechanism and related counselling procedure for employees at all levels who feel that something is amiss.

  • •  It is acknowledged that this question carries all the usual problems of ‘proving a negative’ (ie demonstrating that nothing needs fixing).

(4)  Benchmarking

12.12  The Review asked the pointed question: ‘Do you think a benchmarking exercise, to help banks identify areas for improvement, would be of value?’. The Foundation agreed but went further suggesting that ‘the organisation should place banks under a good practice obligation to record instances of conduct failure within a database accessible by the Board, Board Committees, Legal, Risk & Compliance and Sustainability & CSR. The organisation should work to promulgate a minimum level of detail (metrics) to be recorded in relation to a particular conduct failure.’ The Foundation’s response underlined the importance of ‘devising a system of regular reporting by banks on matters that relate to their conduct (such as the level of conduct costs experienced) and requiring the reporting to be done in a manner that enables comparisons to be made (even a “league table” to be drawn up)’.8 The Foundation went further, stating that:

We would like to suggest the following guiding principles in this area:

  • •  ‘Concrete’ indicators are always preferable;

  • •  Behaviour counts for more than words;

  • •  Facts count for more than opinions;

  • •  Hard evidence of actual experience counts for more than surveys; and

  • •  ‘Anecdotal’ evidence is unreliable.

It follows from the above that we would not place as much reliance on surveys, interviews, codes of conduct and internal reports (or reports commissioned by bank management) as the [Consultation] Paper appears to be suggesting. As will be apparent, we place rather more emphasis on the ‘story’ told by conduct cost history for each bank and are pleased to see that such costs would be part of the benchmarking exercise.

A definition of conduct costs will be essential.

(p. 241) 12.13  In relation to metrics and staff surveys, the Foundation offered the addition of a ‘conduct costs’ metric, although it cautioned against placing too much reliance on survey data, observing that:

… there is some merit in conducting surveys of employees where this facilitates inter-bank comparison and identification of conduct trends/issues. However, we have reservations regarding the usefulness of surveys compared to other indicators of ‘actual’ experience and certainly about standardisation of questions. The concern is that standardisation, if not properly implemented, can lead to box-ticking and semi-automaticity. Interviewing staff members may provide more qualitative results but employees would need to feel able to give honest and open answers, without fear of reprisal. Individual, but not departmental etc. anonymity is fundamental to promoting candour in this respect.

12.14  The issue of performance reporting was also raised in the Review. In the context of whether self-reporting was appropriate, the Foundation responded:

Reporting of ‘conduct costs’ and other conduct benchmarks should be mandatory and verified by auditors. We would be concerned to avoid a similar practice to that adopted by banks in regard to their Sustainability (or CSR) Reports, where only so-called ‘limited assurance’ by auditors is obtained. It is very limited indeed, in terms of its basis and its scope. Moreover, it provides no substantive check on the conduct disclosure practices of the banks, despite specific indicators emphasising the materiality of these indicators.

We are therefore of the view that the banks should be under an obligation to record instances of [mis]conduct and to report these in a clear and transparent way. The Organisation should work to hold the banks to account in this regard.

We would like to see the organisation encourage a much greater degree of transparency, from regulators and banks themselves, about how and why conduct costs are incurred and what measures banks are taking in order to avoid recurrence of the problems that lead to them. It is, in our view, unacceptable for a major UK bank (for example) to announce that it has incurred several hundred million pounds worth of new ‘legal costs’ but ‘decline to comment’ on what they are for. We accept that where a bank makes provision for an as yet unsettled, but nevertheless anticipated, conduct cost, there is a sound commercial necessity for the particulars of that provision to remain confidential. However, as soon as the cost crystallises (the bank settles), the bank should disclose and report on the settlement—irrespective of its balance sheet ‘materiality’. We do not consider the ‘flood gates’ argument to be a sound basis for the opacity in Bank conduct cost disclosure.

In connection with transparency, we would make the technical point that traditional accounting requirements as to materiality as a test for disclosure should be disregarded in relation to the disclosure requirements to be imposed by the organisation. Because the major banks are so big, many important costs (even, in theory, a record FCA fine) tend to be, or could be, aggregated into larger, more opaque disclosures than is in the public interest—because they are not considered ‘material’ enough to the balance sheet to warrant specific disclosure. All instances of misconduct should be recorded and reported to the organisation and within the banks’ public disclosures.(p. 242)

We would suggest that the Organisation should review the adequacy of bank reporting of conduct-related matters within their sustainability reports. We have observed that despite purportedly reporting pursuant to the Global Reporting Initiative Index, banks, in relation to the ‘core conduct indicators’ of EN28, SO8 and PR9, either i) do not report or ii) simply cross-refer to the annual report and accounts. Our various interviews with banks have not produced any credible defence of the excessive secrecy in this area and the lack of frankness on this topic in a document such as a Sustainability Report seems to us to work against the very image (of being a responsible corporate citizen) that banks are trying to project in that document.

We would suggest a code of practice for conduct costs disclosure and reporting, at least similar to that previously provided to the organisation.

Our experience suggests that much of the information on conduct costs is not currently easily found in the public domain and that banks will have to be required, in clear terms, to produce that information (which they are currently reluctant to do) if a comprehensive picture is to be produced for any one bank or the industry as a whole.

(5)  Discipline

12.15  With regard to discipline and the suggestion by the Review that there might be a role for kite-marking, the Foundation discussed the virtues of presenting league tables. Their response suggested that a kite-marking system could be too simplistic, although, when derived from a standardized code of conduct, it could be of limited use where it positively incentivises/motivates banks to behave appropriately and where it forms both the obligation for on-going conduct review and the benchmark against which bank conduct is externally audited. League tables, on the other hand, were preferred by the Foundation as they inherently pitch banks against each other and serve to engender a ‘race to the top’. They also catch the media’s attention. Publicity (and banks’ fear of the negative kind) is an important tool in making the Organisation effective.

(6)  Banking as a profession

12.16  With many a call for the banking sector to become a profession—in some sense of the word—it was important to nail down what exactly is meant by this. For the Review, the question focused the discussion on, among other aspects relating to qualifications and the relationship with existing bodies, whether individuals (not just institutions) should become members of the organization, by virtue of which ‘they take responsibility for their own professional ethos’.9 The Foundation agreed, but suggested that the organization needs to set out a reasonably clear vision of what ‘profession’ means. The Foundation goes on to state that:

(p. 243)

For example, the legal profession circa 1975 was quite different to that which we have today. There are many occupations that call themselves a ‘profession’ (not just medicine, accountancy, law) and the traditional professions operate more and more like ordinary businesses. So, we believe that the Organisation needs to spell out some ‘hallmarks’ of profession in the context of banking. We think that mutual discussion of, and agreement on, ‘what an ethical banker should and should not do’ is one such hallmark. This requires cross-industry consensus and a continuous programme of dialogue to achieve and maintain that consensus. One beneficial effect of this is that the industry will have its own strong motivation to discipline those who break the rules (because they are cheating those who, at a financial cost, observe them and because they bring the whole activity into disrepute).

12.17  The BSB published its second Annual Review (for 2016/17) in March 2017. Shortly before that, the BSB also published its most substantive work to date, a ‘Statement of Good Practice’ on assessing fitness and propriety under the new Certification Regime.10

12.18  The Annual Review contains the results of the BSB’s ‘Survey’ for 2016, which links into the general findings of its 2016 ‘Assessment’,11 intended to gauge how its twenty-two member firms perform in relation to the nine characteristics of honesty, respect, openness, accountability, competence, reliability, responsiveness, personal and organizational resilience, and shared purpose. Each firm gets the results of its own survey with information enabling it to judge (on a no-names basis) how it stands in relation to its peers The BSB does not, however, publish individual firms’ Assessment reports. Instead, the Annual Review gives an indication of how the twenty-two member firms ‘performed’ as a group and summaries of responses to the more interesting questions in the questionnaires. (For example, 42 per cent of those asked ‘strongly agreed’ that: ‘my organisation’s purpose and values are meaningful to me’.)

12.19  As at the time of writing, the BSB has not published any standards ‘of good practice’ of the kind envisaged by the Lambert Review (for example, on how to deal with small businesses in financial distress or whistleblowing protocols) or of the kind published by the FICC Markets Standards Board,12 although it could be argued that its Statement of Good Practice in relation to the Certification Regime is akin to a ‘standard’.13 It remains to be seen whether it will do more work on such matters in the future. The current indication seems to be that it prefers to (p. 244) approach standards of this kind through encouraging more ‘engagement’ from existing professional bodies in the sector.14

C.  The FICC Markets Standards Board

12.20  The FICC Markets Standards Board (‘FMSB’), at the time of writing, has fifty members drawn from the wholesale financial markets. It was set up in 2015 ‘as a private sector response to the Conduct problems revealed in global wholesale Fixed Income Currencies and Commodities (‘FICC’) markets after the financial crisis’.15 The establishment of the FMSB, like that of the BSB, followed a consultation process, the Fair and Effective Markets Review (‘FEMR’), that was initiated by the Chancellor of the Exchequer in June 2014 ‘to conduct a comprehensive and forward-looking assessment of the way wholesale financial markets operate, help to restore trust in those markets in the wake of a number of recent high profile abuses, and influence the international debate on trading practices’.16 The FEMR was comprised of individuals from HM Treasury, the Bank of England, and the FCA and had a separate market practitioner panel. Its consultation document was published in October 2014 and its Final Report was published in June 2015. Its recommendations included that:

There should be a set of common standards for trading practices in FICC markets, written in language that can be readily understood, and which will be consistently upheld; and

There should be a new ‘FICC Market Standards Board’ to ‘give guidance on expected minimum standards of training and qualifications for FICC market personnel in the United Kingdom, including a requirement for continuing professional development.17

12.21  The FEMR Final Report noted the difficulties market participants tended to have in deciding on the right course of action where a situation was not clearly covered by either of the ‘two extremes’ of a regulator’s ‘high level principles’ or ‘detailed rules’. High level principles, although usefully flexible, may ‘require judgement’ as to their application and thus create uncertainty. Detailed rules, on the other hand, whilst more precise, ‘may hinder innovation, may need to be regularly updated to address new developments in markets, and can incentivize ‘gaming’ behaviour.’18 The conclusion of the FEMR was that ‘there is a strong case for (p. 245) drawing up a common set of standards, designed to articulate the core objectives of the principles and rules in practical terms that individual traders in wholesale markets should uphold in their interactions with clients and counterparties. These high level standards should be drafted in a concise self-standing form, in language that can be readily understood.’19

12.22  As at the time of writing, the FMSB has published three standards. The topics are: (i) Reference Price Transactions for the Fixed Income Markets; (ii) Binary Options for the Commodities Markets; and (iii) New Issue Process for the Fixed Income Markets. The standards essentially are in two parts. The first part sets out the market context. The second part sets out the substantive body of the standard, which consists of a number of ‘core principles’, many of which are accompanied by explanatory notes. For example, the standard for the New Issue Process for Fixed Income Markets, which is particularly concerned with transparency of process, states, in Core Principle 1:

Lead banks should have policies on the selection of investors for market soundings and investor roadshows. These policies, or a summary of such policies, should be publicly available to all market participants and should take account of issuer preferences.

12.23  This principle helps to address the following question posed by Mark Yallop, the Chair of the FMSB:

Who should get to decide how the bonds being issued will be allocated between different investors? Pro-rata based on potentially inflated demand? Preferentially, to those favoured buy-side accounts of the lead manager who pay big commissions on other business? Preferentially, to the investors that the issuer favours? Some mix of the above?’20

12.24  As with the other ‘core principles’ and standards published by the FMSB, the principle sets out to fill the ‘gap’ left by high-level principles and low-level detailed rules and provide a statement of what the industry regards as acceptable market practice in what has become something of a ‘grey area’.

D.  The Relationship Between Standards, Ethics, and Culture

12.25  Conduct, ethics, and ‘culture’ issues remain vexed questions for many financial institutions. Despite an apparent falling-off in conduct cost levels,21 serious (p. 246) dilemmas remain as to what is regarded, in the post-Financial Crisis world, as ‘acceptable behaviour’ for a financial institution. Mere compliance with the law is no longer enough. But what is enough? If this question cannot be answered with any confidence there is every possibility that banks with simply ‘de-risk’, ie close down the business lines that are perceived to be too ‘risky’ rather than carry on and risk business- and reputation-threatening conduct costs. This may be the ‘right answer’ in some cases but, in others, it may result in unforeseen adverse consequences for not only banks but for their many stakeholders as well. Can the question of ‘what is the right thing to do?’ be answered more clearly than at present? The publication of standards, by bodies such as the BSB and the FMSB, can only assist. Such initiatives neatly combine the practicality of risk management and improvement of the market’s trustworthiness and reputation with the promotion of greater ethical awareness (understanding what is right and what is wrong and, importantly, why the line is drawn where it is). Whether or not banking deserves to be considered as a profession, this behaviour is consistent with how a well-organized profession would respond to the issues that the Crises have presented.

12.26  The FEMR Final Report called for ‘near-term’ actions to improve conduct standards. One of the principles underlying these actions is that ‘firms active in FICC markets should take greater collective responsibility for developing and adhering to clear, widely understood and practical standards of market practice, in regular dialogue with the authorities’. The logic behind such a principle is compelling and, most evident, in so-called ‘grey areas’, ie areas where it is not immediately obvious what course of action by a financial market participant is compliant, not just with law and regulation but also with society’s expectations. By fostering high standards of conduct in grey areas, firms can actively rebuild public trust, becoming ‘trust-worthy’ and reducing the risk of over-regulation and associated legal risk. On this view, the FEMR Final Report made it clear that if market participants failed to take the opportunity for collaboration ‘more restrictive regulation is inevitable’. The aim should be to avoid a more restrictive environment by introducing conduct standards which keep pace with market innovation and with changing perceptions of what constitutes acceptable behaviour in a business setting.

12.27  A number of respondents to the FEMR consultation document believed the industry should develop its own standards rather than rely on regulation. Respondents desired greater certainty and doubted that conventional regulation would provide this. Since no regulator can provide a detailed rule for every eventuality, conventional regulation leaves ‘gaps’ that have to be filled by judgement on ‘right’ and ‘wrong’ behaviour. The answers to the questions posed by these gaps are not always obvious; ‘grey areas’ thus result. To borrow the words of the FEMR consultation document, market participants must be in a position to judge appropriate conduct across a broad range of potential situations.

(p. 247) 12.28  Principles-based regulation, operating, as it must, at a very ‘high level’ only takes us so far—and in many cases, the absence of more detailed rules (and regulatory guidance) is a source of frustration (and risk) for market participants. For the regulator, reliance on high-level principles is politically attractive (since such principles are difficult to ‘game’). Conversely, there is a backlash when the regulator seeks retrospectively to apply high-level principles to incidents and behaviours that practitioners did not regard as wrong at the time they occurred. The identification of what ought to be defensible conduct in a given scenario is essential to firms’ efforts to manage, not only their legal and conduct risk, but also their reputational risk, which entails rebuilding and sustaining trust. All such efforts support the interests of the broader stakeholder class, most notably owners and customers.

12.29  The logic of the FEMR (and now the FMSB) in promoting standards as a ‘half-way house’ between high and low-level regulation, filling the ‘conduct void’, is surely correct. This logic also applies, in our view, to areas of financial market activity beyond the wholesale markets, the terrain now occupied by the BSB. The implications for risk management are considered in Chapter 32.(p. 248)

Footnotes:

1  From the Report of the PCBS, ‘Changing Banking for Good’ Vol. 1, Summary, and Conclusions and Recommendations (paras 94 and 96).

2  From a speech by Mark Yallop, the Chair of the FICC Markets Standards Board (see para 12.20 et seq.), given to the FT Banking Standards Conference on 27 April 2017.

3  For consideration of ‘grey areas’ in the context of legal and conduct risk management, see Ch 32.

4  See para 15.07 below.

5  See Ch 15.

6  The Foundation’s response was in two parts. Where appropriate, comments from these two parts have been merged in these extracts.

7  The Financial Services and Markets Act 2000.

8  Later in 2014 (October), the FEMR consultation document suggested (at para 5.5.2 4 (a) (ii)) that ‘A single, objective, industry-wide definition of costs arising from misconduct and its transparent disclosure in firms’ annual (and/or corporate responsibility) reports could … be explored as a way of incentivising improved ethical behaviour across the FICC markets.’ (see para 12.04). It also suggested that the work of the Conduct Costs Project and the CCP Research Foundation could provide a framework for further development in relation to industry-wide performance measures related to conduct.

9  Lambert, ‘ Banking Standards Review’ (19 May 2014), p 12.

10  See Ch 15 and para 12.19.

11  The five parts of the Assessment in 2016 were (i) a questionnaire for employees, (ii) a questionnaire for board members, (iii) interviews with non-executive directors, (iv) interviews with senior employees, and (v) 104 ‘focus group’ discussions.

12  See Section C of this chapter.

13  The BSB regards this document as a summary of  ‘what ‘good’ looks like.’ It sets out ‘fitness and propriety assessment principles’ with the intention of helping firms implement the Certification Regime effectively and is accompanied by ‘Supporting Guidance’. As to the Certification Regime generally, see Ch 15.

14  See, for example, Part III of the 2016/17 Annual Review (‘Policy Work in 2016’) at p 25 and the proposed ‘Professionalism Forum’.

15  From the website of the FICC Markets Standards Board (‘What We Do’). The abbreviations adopted in the quoted passage (‘FMSB’ and ‘FICC’) are henceforth used in this text.

16  From the FEMR section of the Bank of England website.

17  From p 12 of the Final Report.

18  In a speech given to the FT Banking Standards Conference (27 April 2017), Mark Yallop, the Chair of the FMSB commented that, ‘High level regulations—the guiding principles of the sort the FCA publishes—have to be set out in such general terms—“act with due skill care and diligence”—that they can’t tell those in markets how to act in ambiguous circumstances. Low level regulations—the rule books that the FCA and others publish—are very operational and don’t describe how to resolve tricky conflicts that arise every day in markets.’ Between the two ‘levels’ Yallop argues there is a risk of a ‘conduct void’, where acceptable market practice is not clear. There is also a tendency, in his view for ‘conduct anxiety’ to develop, with a chilling effect on market activity.

19  All the quoted passages in this paragraph are from para 4.3.1 of the FEMR Final Report.

20  In the speech of 27 April 2017 (n 18).

21  See Ch 10.