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17 May 2017

Culture and the impact of regulation - a help or a hindrance?

What is culture?

Most business leaders recognise both the existence of culture within organisations and its critical role in shaping behaviour.

It is much more difficult to define what a good or bad culture is and to work out how it influences patterns of behaviour. Bad culture tends to manifest itself by problems arising which retrospectively can be traced back to systemic poor behaviour within organisations.

In financial services firms the raft of misselling claims can be seen with hindsight as representing a poor culture because the interests of the institutions were seen to be subordinated to the interests of customers. We are all aware of the reputational damage these claims have caused.

One of the problems with culture as a concept is that it is often overcomplicated and overanalysed. The essence of culture within businesses lies in the creation of a shared awareness and understanding to provide a basis for alignment of purpose and action across the workforce. A good or bad culture can then be measured by the outcomes for the business. A good culture is aligned with serving customers in a professional and enlightened manner and in their best interests, so enhancing the prospects both of repeat business and enduring profitability.

Particularly in the financial services sector a poor culture tends to reveal itself in rule breaches, problems with regulators and poor customer outcomes. Culture, good or bad, emerges in an ethereal manner from structural and operational features of a business.

How rigorous are corporate governance and supporting management structures? Are roles clearly defined and understood? Is there a proportionate sense of personal responsibility and accountability? Is there a genuine sharing and implementation of corporate beliefs and values? Are staff incentivised in a way that reflects positive values and avoids excessive risk taking and a silo culture?

Why culture is particularly important in financial services firms

From a customer perspective financial services are a vital part of day to day living and long term financial planning and security. From banking and lending to financial advice and asset management financial services impact on nearly everyone. Paradoxically, for many people there is the potential for “information asymmetry” (as described by the Financial Conduct Authority (FCA)), between providers and consumers. Financial products and services,their  pricing and value can be opaque making it difficult even for sophisticated investors to understand their suitability and the value being provided.

As a result of recent regulatory change, financial advice is becoming more expensive which is in turn leading to an increasing number of consumers who do not wish to pay higher (or any) fees for financial advice and are relying on their own judgement and using online platforms which provide access to financial products but not advice. This can lead to them being more exposed. Against this background a positive, customer focused culture in financial services firms is critical to good customer outcomes. As a result, “culture” is under increasing scrutiny from regulators.

The “regulation” of culture

Is it possible for the Prudential Regulation Authority (PRA) or the Financial Conduct Authority to regulate culture?

The regulators are quite clear on this and Andrew Bailey (currently CEO of the PRA but from July 2016 CEO of the FCA) in a recent speech said: “As regulators, we are not able, and should not try, to determine the culture of firms. We cannot write a regulatory rule that settles culture. Rather, it is the product of many things which regulators can influence but much more directly which firms themselves can shape.”

What the regulators can do, and have done, is to create rules that provide a framework in which good rather than poor cultures are encouraged.

Regulatory rules designed to encourage a good culture

There are three major areas in which the regulators have made rules designed to have a favourable effect on culture, as follows:

The Senior Managers Regime (SMR)

The UK’s much discussed Senior Managers Regime and Certification Regime came into force in March 2016. The regime initially applies to deposit takers, PRA designated  investment firms and UK branches of overseas banks and (through a parallel regime) to insurers and reinsurers. Over the next two years though the regime will be rolled out to cover most regulated businesses.

The SMR applies to individuals performing a senior management function within the organisation (executive directors, compliance oversight, anti-money laundering and overall responsibility functions).

Firms are required to produce a statement of responsibility for each senior manager to set out clearly the areas of a firm’s regulated activities that each senior manager will be responsible for. They will also be required to ensure that each senior manager is fit and proper to carry out their allocated role. Each senior manager has a “duty of responsibility”, meaning that a senior manager will be guilty of misconduct if there is a regulatory breach by the firm and if they did not take responsible steps to avoid the contravention occurring or continuing. The SMR is a classic example of a regulatory initiative intended to create a framework or environment which encourages a good culture.

At a conceptual level the SMR creates a process under which senior managers are allocated express responsibilities and accept personal accountability for those responsibilities. The positive aspect of this is that the stringent corporate governance principles underlying the SMR will help focus the minds of senior managers and avoid
responsibility lines becoming confused and opaque.

Combined with an understanding of the needs of a firm's particular client base the SMR should encourage a culture focused on good outcomes for customers. The FCA has said (as an example) that with the misselling practices of the past it has been difficult to identify particular individuals with responsibility for ensuring that services provided fit the needs of customers and are transparent and fair. The obligations and responsibilities have been diffuse and difficult to pin down. The allocation of a duty of responsibility will back up the framework provided by the SMR with effective regulatory penalties for default. One of the challenges is to reconcile individual accountability with collective responsibility within a culture that is supportive of individuals who, on a personal level, are now more demonstrably in the regulator’s spotlight.

Remuneration policies

There have in recent years been a large number of regulatory initiatives setting out standards and policies that financial services firms are required to meet when setting pay and bonus awards for staff and there are a number of remuneration codes that apply, depending upon the classification of each firm. The purpose of the initiatives in strategic terms has been to:

  • ensure greater alignment between risk and individual reward
  • discourage excessive risk taking and short termism
  • encourage more effective risk management, and
  • support positive behaviours and a strong and appropriate conduct culture within firms.

Detailed rules require bonuses to be deferred over significant time periods and require part of bonuses to be paid in shares, share linked instruments or equivalent non-cash instruments. Senior management are charged with ensuring that staff performance is assessed with respect to financial and non-financial factors and is based on the performance of the individual, business unit concerned and the overall results of the firm.

The rules also require that variable remuneration is paid or vests only if it is suitable according to the financial position of the firm as a whole, and justified on the basis of the performance of the firm, the business unit and the individual concerned. The requirement to limit the extent to which relevant individuals can be remunerated through variable pay, as a ratio to fixed pay, has also caused much debate both within the industry and on the global political stage.

This is because remuneration is a key constituent of culture. Human nature being what it is, people will tend to shape their behaviour to what they are incentivised to do. It is also worth bearing in mind that “incentives” cover not just monetary rewards, but also status and recognition and procedures for promotion. The various regulatory rules on
remuneration are designed to help create a culture where incentives do not encourage risk taking and look to the wider interests of the firm and its customers. Again though, the rules are a framework and leave to senior management the determination of policy and procedures and allocation of incentives within the framework.

Treating customers fairly

The ‘treating customers fairly’ (TCF) doctrine has long been enshrined as a major principle of regulation of UK regulated financial services firms.

What is the relationship between treating customers fairly and “culture”?

There has been a longstanding perception that there is a conceptual disconnect between many financial services firms and their customer base. As a generalisation this has tended to be more of a problem for major financial services institutions where many of those within an organisation may have little or no direct customer contact.
The sensible application of TCF is of vital importance in creating a culture which encourages good not poor outcomes for customers. Applying the doctrine in an effective and proportionate way involves an in-depth analysis of the services provided by the firm, their suitability and appropriateness for the client and whether the services achieve the outcome reasonably required by the customer. “Customer” in this sense means not just those with whom the firm has a contractual client relationship but where relevant the ultimate consumer of the product or service.

For example, a major institutional fund manager may act for pension funds and not those investing in pension funds. Effective TCF procedures would involve detailed  consideration and monitoring of outcomes for the ultimate consumer. Effective application of the TCF doctrine is likely to encourage a positive culture concentrating on the achievement of good outcomes for customers. It is a source of some incredulity in business circles outside the financial services sector that the customer is not always at the centre of strategy within financial business. It is instructive for example that one of the high profile “challenger” banks is heavily focusing on a customer oriented service strategy which it feels is not currently represented in the retail banking market.

Some reflections

Is a good culture consistent with profitability?

A good culture helps lead to good outcomes for customers, building long term relationships and a basis for growth and enduring profitability.

Is a good culture consistent with an entrepreneurial spirit?

A good culture does not mean excessive control of risk and a stifling of new ideas. A good culture will provide a supportive and protective environment for innovation. This is a particularly important point in an era where financial technology is leading to a reshaping of parts of the financial services sector.

The way forward

Culture is becoming of increasing importance and likely to attract far more regulatory scrutiny than before. Regulators can at best only provide a framework under which good cultures are encouraged and investigate when the results of a bad culture (i.e. bad outcomes for customers) become known. It is a matter for the leadership within each firm to inculcate a positive culture throughout the firm, to monitor its impact on outcomes for customers, and to do so in the right way for that firm, its business and the customers it serves.


This article was written by Jonathan Bayliss. For more information please contact Jonathan on jonathan.bayliss@crsblaw.com or at +44 (0)20 7203 5025.

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