Academic journal article Federal Reserve Bank of New York Economic Policy Review

Corporate Culture in Banking

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Corporate Culture in Banking

Article excerpt

1. INTRODUCTION

Culture can be a very complex issue as it involves behaviours and attitudes. But efforts should be made by financial institutions and by supervisors to understand an institution's culture and how it affects safety and soundness. While various definitions of culture exist, supervisors are focusing on the institution's norms, attitudes, and behaviours related to risk awareness, risk taking, and risk management or the institution's risk culture. (Financial Stability Board 2014)

The issue of corporate culture in banking has surfaced in recent discussions as a topic of pivotal significance for addressing two concerns: restoring public trust in the banking system and enhancing financial stability. (1) With more than $100 billion in fines imposed on the largest financial institutions since the financial crisis, there is now a growing suspicion that ethical lapses in banking are not just the outcome of a few "bad apples"--such as rogue traders--but rather a reflection of systematic weaknesses. The lack of confidence in banking engendered by such mistrust may invite more intrusive regulation, which could reduce risk but may also restrict lending. Given how essential banks are for economic growth and their complementarity with financial markets for channeling capital from savers to investors, this issue is of broad economic interest. (2)

In this dialogue, considerable attention has been paid to executive compensation in banking, with the prevailing view being that improperly structured pay was one of the culprits in the recent financial crisis (see, for example, Curry [2014]). This issue was addressed in the Dodd-Frank Act, which requires regulatory agencies to implement appropriate incentive-based compensation rules covering institutions with assets of $1 billion or more. The Office of the Comptroller of the Currency, for example, published a proposed rule in 2011 that is based on three principles: (1) incentive-based compensation should balance risk and reward, and should include deferred compensation and other mechanisms to reduce the sensitivity of compensation to short-term results; (2) compensation plans should be compatible with effective controls and risk management; and (3) incentive-based compensation should be supported by strong corporate governance.

Focus on compensation is a useful first step. But as important as pay is for driving employee behavior, it is but one piece of the puzzle, and excessive reliance on compensation may actually distract attention from other important determinants of the decisions banks make. I am heartened by the growing recognition of bank regulators in the United States and Europe that organizational culture in banking is a crucially important factor in generating positive observable outcomes in banking. Culture not only determines the efficacy of compensation in influencing employee behavior, but it can also induce employees to work in a manner consistent with the stated values of the organization, particularly when achieving this outcome via formal contracts may be either costly--owing to bargaining, asymmetric information, and imperfect state observability--or infeasible (see Kreps [1990] and Song and Thakor [2016]). Cultural difference means that the same incentive-based compensation scheme can produce different behavioral outcomes in two banks.

It is easy to see, however, why culture has not been a big part of banking regulation. Variables like capital ratios and compensation are tangible and visible, so it is easy to target them in the formulation of regulations. Culture, by contrast, is a nebulous concept that often means different things to different people. Because it is fuzzy, culture tends to be overlooked. Moreover, we have a vast body of research on capital requirements and incentive-based compensation, but precious little on culture, at least in economics. This omission too adds to the reasons why culture has received relatively scant attention until recently in regulatory discourse. …

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