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Markets need constructive debate, not scapegoats

20 March 2009

This is one in a series of articles exploring the theme of financial regulation and reform, written by Allen & Overy's legal experts.

Who would be in senior management of a bank today? The backlash from chastened regulators threatens to be extremely severe as they try to bring senior individuals to book for their institution's difficulties.

The pressure to find scapegoats for the past and examples for the future is strong, encouraged by current public sentiment. But is it the right approach simply to attack the bankers?

It is no doubt helpful to the politicians and regulators – deflecting criticism as it does from those responsible for setting economic and regulatory policy. Yet one need only look at the National Audit Office report into the handling of Northern Rock in the UK to see that few come out of this episode covered with glory.

On the one hand, you can see the regulators' point. Without a plausible threat of personal consequences, will senior management strive to make the right decisions about risk?

But the banks at the heart of our financial system are hugely complex, international organisations with overlapping legal and regulatory regimes and inter-related functions. They have to conduct business in global markets but answer to local regulators.

To suggest that an individual should be personally responsible for the failings of such a complex organisation is simplistic and unjust.

There may be some cases where personal culpability can be shown, and a few may well emerge as regulators sift through the debris of the past seven months. But cases where blame can be laid at the feet of one individual are likely to be few and far between. The effects of attempting to do so could, however, be very damaging.

Ultimately, a key question for regulators is how you attract the most talented and appropriate individuals to fill these most challenging of roles. Obviously they will have to be well remunerated or there will simply be a "brain drain". 
Regulators will not have served shareholders (which increasingly includes taxpayers) or customers well if they impoverish and diminish the role of senior management while simultaneously increasing the risk attached to the role. A number of things are happening at once in relation to banks' controls. 

In the UK, there is a review of corporate governance and the role of non-executive directors. That is sensible. Also, more rigour is to be applied by the regulator in assessing the skills of those in control functions. Again, that seems right.

However, the greater regulatory focus on personal liability for individual senior managers seems more problematic.

The suggestion that an individual in senior management should be intimately acquainted with all aspects of the bank's operations is misconceived. It is not only practically impossible but would risk key issues being lost in the noise of detail being fed up the chain.

Effective delegation is clearly crucial. Senior management must be able to rely on those to whom they have properly delegated risk management roles. They should always do so in good faith and in the belief that those individuals have the necessary knowledge and experience to identify risks to the business and report them upwards.

That does not, of course, permit unquestioning reliance, and an important issue for banks will be how they create a structure and environment that encourages appropriate, rigorous testing by senior management of what they are being told.

Senior management clearly have a fundamental role to play in deciding what level of risk-taking is acceptable, and what overall strategy should therefore be pursued.

The suggestion in the UK of more direct contact between senior risk management and Board risk committees seems a sensible mechanism for achieving this, and for impressing on the Board that it has ultimate responsibility to ensure that risk is properly managed.

In reality, much of the focus within banks needs to be at a lower level, aimed at ensuring that individual traders or heads of desks are not taking risks that the institution will come to regret. 

But how should that be effectively policed?

Most banks have already gone to great lengths to create sophisticated controls at that level, yet they are not always sufficient to stop excessive risk taking.  They may never be so. There will often be a mis-match in skills which can make detecting at least some risks extremely difficult.

Recent events show that some of those responsible for structuring, pricing and trading sophisticated products did not fully comprehend the risks of them.  What hope is there for others to do so? One solution is to have experienced former traders on the control side, and this happens to an extent in some banks already. But the likely pay differential will often make it unattractive to make the switch. A number of other models can be considered, but none of them is perfect.

These are extremely difficult issues. Senior management who have worked in the industry for years, and have a deeper understanding than any of how banks operate, have a great deal to contribute to the debate on how to address them.  They should be encouraged to join the debate, not ostracised.

Regulators are faced with a choice. They can engage with senior management of banks or they can draw the battle lines with them. It will be unfortunate if they choose confrontation as there are many within the industry that have a great deal to contribute to rebuilding a stable global financial market.

Calum Burnett