Playing by the rules Bill Acker and Geoff Trickey on the use of power and how it affects banking regulation.
The banking world seems to have accepted that the financial crisis exposed an embarrassing lack of capacity for self-regulation and, perhaps more importantly, that public bail-out money comes with greater official regulatory oversight and scrutiny. Bankers, struggling with the cumulative effects of higher capital requirements, activity restrictions and increased compliance costs, have been hoping to see the light at the end of the regulatory tunnel. Ideally, this would take the form of a clear and relatively static set of ground rules. As such, this would be something they could come to terms with. It would allow them to begin to develop a banking system with the capacity to re-establish its relevance and value. However, bankers have found that regulators have warmed to their task and that the tunnel has only increased in length and complexity. A recent global survey (CSFI's Banking Banana Skins, FW, May 2014), for example, highlighted concerns about the warren of regulatory proposals. Of course, everything has its upside. Regulators and risk managers are in demand and they have discovered a territory rich in ambiguity and uncertainty - fertile and intellectually stimulating ground for anyone with a bent for decryption, codifying, classifying and organising. Further, unlike bankers, banking regulators and risk managers also enjoy public approval and support. However, while the advantages of being viewed as a force for redemption and public security are significant, they are not without a different sort of risk. In banking, as in any other arena, too much regulation can be as bad as too little. Think of banning running in the playground or forbidding games of conkers. The financial world is intrinsically uncertain. It exists to put a price on risk. If the balance between opportunity and risk could be neatly tidied away into a book of regulated processes and procedures, there would be no need for markets. What can psychology add to the complex and vitally important debate on regulating the regulators? The sine qua non of regulation and risk management is the exercise of power - that is the ability of the holders of power (regulators, risk managers and bank boards) to influence the behaviour of those working in banks. Much of the psychological analysis of power seems like common sense, but it has a distinguished pedigree and provides a useful lens to look at regulation and risk management in banks, including analysing an organisation's "risk culture". John R P French and Bertram Raven in the 1950s and 1960s identified five bases of power that individuals use to influence the behaviour of others. These are: Referent power - the personal power of the individual, his or her charisma and credibility that makes others accept their influence and alter their own behaviour.
Legitimate power - the position of authority that a person holds in an organisation that enables them to reward and punish others according to whether or not they do as they have been asked to do. Expert power - a person's knowledge or expertise that makes others follow their instructions. Coercive power - the ability of a person to punish others if they do not do as they have been asked to do. Reward power - the ability of a person to reward others for doing as they have been instructed. To these five, we can usefully add opportunity power. Is the power-holder present when decisions are taken? How do these psychological concepts apply to risk managers working within banks, to prudential regulators working in the Prudential Regulation Authority, or to conduct regulators working in the FCA? What makes these people able to exert power effectively? Coercive power and reward power depend upon those exercising them being able to know whether they have been obeyed. To do this, risk managers and regulators often try to use objective control measures. Surveillance of control measures has to be constant and accurate for them to work. Is this realistic when we look at something as nuanced as banking regulation and risk management? Also, the challenge is that those whose behaviour we wish to influence can, and do, hide non-compliance to earn rewards or to avoid punishment. Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, described this well in Goodhart's Law: "Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes." In other words, when a measure becomes a target, it ceases to be a good measure. This may be for quite innocent reasons. However, there can also be more sinister explanations. In particular, those regulated can try to "game" the measures and thwart the efforts of risk managers, the PRA, the FCA and also of boards to control their behaviour. In the case of prudential regulation, think of banks moving debt off-balance-sheet to appear less highly geared than they are, or think of traders being paid annually, although their deals can represent a threat to their institutions long after the bonus has been cashed and they may not even be working at the organisation. In conduct regulation, think of high-frequency traders who obtain pricing information milliseconds before it is available to the rest of the market. What we have is a game of cat and mouse between the regulators and those who obey the letter, but not the spirit of the rules. Another feature of coercive power is that we must believe we will be punished if we do not comply. The ultimate legitimate power of a bank is its board of directors. If the directors of a bank do not exercise this and govern their institution with prudence, and ensure it complies with regulations, they should be held accountable.
Those who are incompetent or negligent and know there will be little downside to inaction are apt to ignore or take lightly their duties of proper governance and compliance with banking regulations. Similarly, when bank regulators approve the appointment of incompetent directors in the banks they regulate, they should also be held to account. Legitimate power is effective only to the extent to which it is accountable. Reliance on expert power also presents a danger as banking regulation and internal risk management expand exponentially. The danger is that expertise develops in silos regulators and risk managers becoming very expert in regulation and risk, but less broadly experienced or developed as bankers. They know the rules but have never played the game. The most effective risk managers and regulators in banks have had extensive experience of banking before moving into risk management or regulation. These broadly experienced bankers have banking domain knowledge and expertise that enables them to understand and appreciate in depth the activities they regulate and the risks they manage. They can then acquire regulation and risk domain knowledge. As banking regulation and risk management expand as a discipline, there are simply not enough broadly experienced bankers to fill the new positions. Just as importantly, many of the strongest will not be attracted to risk management and regulation. A danger is that the new breed of "expert" risk managers and regulators will likely be low on referent power. That is they will not have the force of natural presence and natural authority, of credibility, that comes from broad banking experience. This, in turn, will mean that they could rely too heavily on objective control measures that savvy bankers can manipulate. Also, if regulators and risk managers are low in referent power, the bankers with whom they interact are less likely to treat them as equals or take them seriously. The extent to which regulators and risk managers lack referent power reduces their opportunity power. Except when explicitly mandated, risk managers and regulators low on referent power are simply not going to be there when decisions are taken. Referent power is also what a chief executive has and uses to set the values of an organisation, for good or ill. A CEO's stance on proper conduct is a crucial enabler for those managing or regulating risk within a financial organisation. If the CEO pushes profit at all costs, then it is difficult for those lower down to make ethical choices that entail reduced profit. Think of selling redundant card protection insurance that violates FCA standards. Individual differences or risk types matter. People by nature vary in their propensity to take risk - from highly adventurous to very cautious. Psychologists identify a spectrum of eight different risk types, and these are evenly distributed across the population. The implication is that whatever the regulatory regime - from speed limits to tax demands or property rights - a significant proportion will follow the rules and a significant proportion will buck against them. The global prison population of 9m is an extreme manifestation of people's struggle to discipline their impulses, but it illustrates a dynamic that influences everyone in one way or another. Banking is no different to any other enterprise in needing its risk-takers as much as it needs its reliable foot soldiers. The idea of taking strong positions as a trader is an elixir
for some and terrifying for others. Risk-takers appropriately deployed can be a greater asset than those who can only follow the rule book and have to be forced to look beyond it. Individual differences in risk appetite trigger important issues for banking regulation and risk management. 1. Analysing the appropriate attitude to risk for different banking roles can make fitting the person to the role more precise. It is not a case of low-risk appetite "good" and high-risk appetite "bad". It is more like Goldilocks's porridge - neither too much nor too little, but just right for the role. 2. Can regulators and risk managers be precise enough and clever enough to stay in front of those who wish to "game" them? Probably not, and it will inevitably be a case of catch-up. We wish to regulate and/or manage the risks bankers take to avoid another collapse. Can these bankers flourish and adapt to changing circumstances as we regulate their behaviour ever more closely? How much regulation and risk management is too much? The problem psychologists face is that when their ideas are explained in plain English, non-psychologists often say: "Ah well, that's just common sense" - which, of course, it is. There is, however, a Spanish expression that says it all - el sentido comĂşn es el menos comĂşn: common sense is the least common sense. Bill Acker lectures occasionally at the IAE Graduate School of Management at University of Aix-en-Provence and was managing partner of Acker Deboeck & Company, a corporate psychology consulting company in London and Brussels.
Geoff Trickey is the managing director of Psychological Consultancy Ltd and is an expert in individual differences in risk.