The following post comes to us from John M. Conley, William Rand Kenan Jr. Professor of Law at the University of North Carolina School of Law, and Cynthia A. Williams, Osler Chair in Business Law at Osgoode Hall Law School, York University. It is based on their recent paper, “The Social Reform of Banking,” which was published in the Journal of Corporation Law and is available here.

The financial crisis of 2008 led to global demands for reforms that would put the financial services industry on a more sustainable ethical, economic, and legal footing. Thus far, the response to these demands has been largely regulatory, as illustrated by the passage of the Dodd-Frank Act in the U.S. Recent developments in the banking world, including high-profile prosecutions for illegal activities, portend even further regulatory interventions on both sides of the Atlantic.

However, given market participants’ propensity to engage in regulatory arbitrage, one can feel pessimistic about the ability of regulation alone to wring excessive leverage, fragility or risk out of the system. For example, the New York Times has reported on a new fund—the Ovid Regulatory Capital Relief Fund—which is investing in “capital relief trades” or “regulatory capital trades” that  allow banks to shift assets off their books by buying credit default swaps being sold by the Fund. Even without regulatory arbitrage, the risk-adjusted capital adequacy requirements at the core of Basel II and III allow banks to make good faith determinations of the kinds of risks to which their loans give rise. A concern is that these determinations can be, and in some cases have been, manipulated.  Even if the banks do act in good faith, the leverage ratio of Basel III, requiring equity of at least three percent of total assets, will not come into effect until 2019, and has already been called “outrageously low” by prominent academic critics.

These developments suggest that, while traditional regulatory interventions may well be necessary, they are not likely to be sufficient. Because the structure of much banking regulation inevitably requires banks to make good faith determinations of the kinds of risks to which their loans and investments give rise, regulation can go only so far in insuring outcomes. At some point, almost all regulation must rely on the ethics of those within financial services organizations. Abundant empirical research has demonstrated that the culture of individual organizations is a vital factor influencing how crucial ethical decisions are made.

Against this background, in our recent paper, The Social Reform of Banking, we have examined the culture of financial institutions as a critical variable in predicting the success of regulatory regimes. We evaluate various specific regulatory interventions not simply from a normative legal perspective, but in terms of their capacity to affect and be affected by that culture. We give particular attention to the global entities that are explicitly or implicitly too-big-to-fail.  Our analysis concentrates on the realities of banking practice as revealed by the perspectives of anthropology, organizational and social psychology, and new governance regulatory theory.  We also draw on our own ethnographic and legal research on the Equator Principles, a voluntary initiative among global banks to implement social and environmental standards when lending for large infrastructure projects.

Our research has identified a number of influences within global, complex, “too big to fail” (TBTF) financial institutions that can normalize risky behavior. All are cultural in nature, or at least have a strong cultural component. First is the very notion of too big to fail, and the implicit and explicit government guarantees that notion implies. This can create a serious moral hazard: actors within TBTF entities may be encouraged to take on excessive risk, particularly by using high levels of leverage and relaxed credit standards, with the expectation of government bailouts. Second is the atmosphere of insecurity and market-driven churning among employees. As vividly chronicled by the anthropologist Karen Ho in Liquidated: An Ethnography of Wall Street, life within global TBTF financial institutions, particularly in investment banking and on trading floors, is characterized by employment volatility and the risk-taking that it can encourage. And third is the structure of compensation. There has been a shift in banking from an “originate-and-hold” approach to lending to an “originate-to-distribute” model that relies on securitization. In the latter approach, bank fees and bankers’ performance-based compensation are increased by the volume of transactions. The shift to this approach has increased the cumulative risk in the global financial system, because the distribution of credit risk via securitization has undermined the banks’ incentives to be as rigorous in credit evaluation as they would have been in the “boring” old world of originate-and-hold banking.

Weaving  strands of prior research together, we propose several specific suggestions for reform. Our suggestions involve both culture-sensitive regulation and voluntary, “soft law” initiatives.  In the first category, we emphasize structural reforms, accounting reforms (informed by ideas derived from both organizational psychology and transnational private regulation), and other regulatory approaches that might tap into the better elements of current banking cultures while simultaneously promoting a more ethical cultural environment. We argue that an innovative attention to culture can lead to reform that yields sustainable progress in the ethical, economic, and legal dimensions of banking practice.

In the latter category, our suggestions include closer examination of a project undertaken by the Australian Securities and Investments Commission (ASIC). In each of multiple industry sectors, ASIC employees work with the relevant professional organizations and self-regulatory bodies to develop regulatory standards of best practice. The professionals and their organizations are responsible for developing the standards initially, subject to ASIC’s oversight so that there is public input and accountability—soft law with the potential of hard-law intervention.  On paper, at least, such a structure has real potential to exploit the cultural power of industry self-regulation, with all its advantages (expertise, autonomy, engagement with the goals of standards ultimately developed), but with public oversight to ensure proper attention to broader societal interests.

Despite the promise of the cultural approach, we must acknowledge that we advocate for it with some trepidation. It is not clear at the outset how deeply firm cultures can be influenced by outside factors such as regulation. In addition, the commitment to change would have to be deep, going far beyond the currently fashionable corporate rhetoric about cultural reform.