The global financial system is experiencing a severe crisis of confidence that began during the onset of the crisis in 2007-2008 and has grown in scope since. The first convulsion occurred with the collapse of the housing market, triggered by the dangerous cocktail of irresponsible risk-taking mixed with irresponsible lending. And in just the last few months, investors, institutions and the general public have lost even more confidence in the private financial institutions that are the bedrock of an open, market-oriented economy.
To understand what can be done to restore our collective trust in a system that is intrinsic to our economy, we must first address a fundamental question: Why has this happened? Example after example dating back to the subprime debacle shows one of the root causes of this situation is a deterioration of culture and values in far too many financial firms.
Throughout 2012 we have seen a steady stream of news about mistakes in judgment (or worse) across the financial services sector, including (but not limited to) robo-signing, the collapse of MF Global, the failure of Peregrine Financial, alleged violations of money-laundering laws at HSBC, and now an ever-widening LIBOR scandal that has led to the departure of the entire senior executive team from what used to be one of the most respected banks in the world and threatens to extend to other players as well. Each of these incidents increases mistrust in the broad range of institutions and the many good people who through their work contribute to the proper functioning of the global financial system.
Trust is the lifeblood of our financial system. Anyone who has seen the film “It's a Wonderful Life” and listened to George Bailey describe the workings of Bailey Savings and Loan knows that without trust the connective tissue between savings and investment — between lender and borrower — is irrevocably torn. Yet it appears today that the behavior by some important players in the financial services industry is challenging the foundational belief that the system works for and serves the common best interests.
The long-term ramifications are profound and untenable: The loss of trust in our financial institutions creates the risk of alienating an entire generation of investors. There could be no worse time for this, just at the moment when the economy needs increased private savings and investment to help spur growth, innovation and economic prosperity. Underinvestment will increase the retirement savings gap as a large cohort of baby boomers struggle to reach financial security. At the same time, it will starve the economy of long-term risk capital that is so necessary to spark sustainable growth and meaningful job creation.
As we think about remedies we must recognize that finance is a means to an end. Unfortunately, sometime in the last decade the financial services industry lost sight of its core mission. Regardless of the type of financial services institution where we may work — bank, broker or investment manager — our function is that of an intermediary and services provider. While our specific roles may differ, our jobs are designed to facilitate the movement of capital from those who have it to those who need it. Certainly, finance should be rewarded for the service it provides, usually by way of an appropriate spread (or commission) or a stated fee. Since this often involves taking financial risk, we are also responsible for disclosing and managing those risks in an appropriate way.
Many stakeholders argue that the surest way to restore trust in the financial services sector is to increase regulation. Sound regulatory frameworks that enforce transparency and safeguard the system through the responsible use of bank risk capital are absolutely necessary, but they are not sufficient. Rather, the financial services industry is in need of a rediscovery of the importance of culture; institutions must embrace and live a set of core values that guide behaviors and ensure an unyielding focus on mission.
Culture has many definitions. At its essence, culture is a shared set of beliefs and common behaviors. Core values are an important element of that belief set. In combination, these communal values, beliefs and behaviors form a unique organizational identity or ethos that guides how the people within an enterprise perceive one another, which in turn heavily influences decision-making and extends to how firms interact with and engage their customers.
A strong culture is a corporate asset. Leading firms often self-describe culture as an essential success factor, ensuring a consistency of purpose and execution across an organization. Management can leverage a strong culture to operate a streamlined structure, speed decision-making and differentiate itself from competitors.
Conversely, “bad culture” can morph into a chimera that makes acceptable bad behavior that at best is unethical, or worse may be illegal. Just as many atrocities have been justified in the name of king or queen and country, a broken culture can be used to justify the most inappropriate behavior, purportedly for the betterment of the client or the shareholder.
Good culture within the financial services industry should comprise three important elements. First, the culture needs to be centered on its core purpose of serving a legitimate client need. Second, the practice of sound risk management should be an integrated component. Last and most important, the culture within the industry must rest on the foundation of stewardship and a sense of responsibility. The adoption of these principles fortifies trust, which ultimately contributes to positive business results.
Once again, the role of finance is to serve broader interests of society. It creates value not for itself, but on behalf of others. Hence, the culture of financial services organizations should reflect this purpose. Internal incentive and reward systems should be aligned to put the interests of the client ahead the firm, and the interests of the firm ahead of individual employees.
To be sure, finance involves taking risk. Financial risk-taking is intrinsic to a well-functioning capitalist economy. As financial intermediaries and managers of capital, rigorous risk assessment, appropriate risk transparency and responsible risk management are inherent to these roles.
We must never lose sight that our clients have entrusted us to guide and safeguard their savings and investments. We are charged with managing the financial well-being of real people. Our responsibility goes beyond the scope of any law or regulation. It rests on a foundation of trust by individuals and institutions that we have their best interests at heart and we will behave accordingly.
The financial services industry has a long way to travel before it re-earns the trust it has squandered. As a starting point, there are three steps the industry can take now to begin to repair its credibility.
- Culture speaks to leadership and leadership begins at the top. The leaders of the financial services industry, both firms and individuals, need to personify the values they espouse.
- Great organizations are built from the inside out. Their cultures are holistic, time-tested and extendable. Strong and sustained efforts should be made to reinforce the key elements of a service culture, including a re-examination of management objectives along with a realignment of incentives and rewards.
- We all make mistakes. But mistakes have consequences for which there should be accountability. Willful violations of the rules should not be tolerated. Firms should adopt a “culture of compliance” with increased training that ensures people know and follow the rules and that puts a stronger emphasis on ethics and integrity as the beacons that ultimately guide good behavior.
Financial trust, like any other trust, once lost is hard to restore. Yet if the financial industry can commit to recreating a culture centered on service and demonstrate its commitment through responsible action, then it can rebuild the trust that is so important to a well-functioning economy and a healthy society.
Douglas M. Hodge is chief operating officer of Pacific Investment Management Co., Newport Beach, Calif., and a managing director in the Newport Beach office. He also serves on PIMCO's executive committee and on the global executive committee for Allianz Asset Management.