The Blind Dance of RegulationBOXWOOD PERFORMANCE SERIES:

The Blind Dance of Regulation

The need to change the culture of banking has been highlighted by the parliamentary committee on banking standards, the FCA and leaders in the industry. But it is not just the banks that need to change - there is a need for system-wide reform.

Those in the system need to confront and change their underlying beliefs and assumptions. For example, the belief that incentives drive high-performance when research shows the opposite effect; or the belief that increased regulation will lead to reduced risk. These beliefs underpin the Blind Dance of Regulation.

Cover graphic: Word cloud of a speech by Patrick Spens, Head of Market Monitoring at the FSA on January 31st 2013.The size of a word indicates its relative frequency.

Paul Sweeney © Boxwood Ltd. 2013. All rights reserved

Several years ago, Daniel Goleman excited the world of leadership with his work on emotional intelligence. In the world of banking and banking regulation, there’s another “intelligence” or capability that appears to be lacking. This is what we refer to as systems intelligence - the ability to think and behave intelligently in complex systems.

Banking operates in a complex system. Key players in the system include the regulators, the banks, and the end customers. They are all in a dance together. The moves of one party have consequences for all the others. Unfortunately, despite good intentions, there is little evidence that of any of the players can actually see the dance they are part of - they only see their own perspective and react accordingly. They are essentially blind to the impact on the whole system.

This short paper explores the themes of the blind dance of regulation. It starts with the flaws in the regulatory paradigm, and discusses the reactions of banks and customers to the regulator’s moves.

Our view is that the blind dance of regulation we currently observe will lead to poor outcomes for all - regulators, bank employees, bank shareholders, bank customers and society in general. The blind dance of regulation is in danger of becoming locked into a downward spiral. We hope it is not too late to change it.

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“Unfortunately, given the linear thinking that predominates in most organisations, interventions usually focus on symptomatic quick fixes. This results in only temporary relief and it tends to create still more pressures later on for further, low-leverage interventions”

- Peter Senge

Introduction

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Stung by criticism and determined to be more “effective”, regulators are becoming more intrusive, more aggressive, more crusader-like. Nobody can deny that banks have behaved badly, and that regulation has a role in protecting consumers and businesses. However, we believe that the regulatory “paradigm” that has emerged may ultimately lead to worse outcomes for all. The paradigm looks something like this:

• Banks, and the people that work in them, are inherently untrustworthy

• Behaviour can be managed by more process, more compliance, more penalties

• Customers lack the intelligence to make informed decisions on financial matters

• Banks, and not customers, are responsible for poor customer decisions

Rather than becoming an agent of change, the regulator has become the parent to the wayward bank child. Enforcement notices criticise but don’t help address root causes.

The FCA claims to be true to principles that include efficiency and proportionality. The reality is ever-expanding bureaucracy and a seeming blindness to the eventual consequences for the entire system. The regulators may lead the dance, but they can’t seem to see the whole picture of consequences unfolding.

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KEY POINTS

1. The current regulatory paradigm appears to be based on the tenets that:

• Banks are inherently untrustworthy

• Behaviour can be managed though controls

• Customers lack intelligence

• Banks are responsible for poor customer decisions

2. This flawed paradigm will lead to worse outcomes for everybody

The Regulator

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Many banks are stuck in reactive mode, as more and more regulatory demands impact. The anxiety of the leadership is compounded by the continued political and media assault. Banks have developed a matching paradigm that governs their responses to regulation:

• We will let the regulator define “doing the right thing” for us

• We can’t trust our employees, we must “manage” their behaviour

• Regulation must be turned into a set of rules that need to be followed, checked, and locked into process

• Compliance spend trumps investment in our people, customer experience and innovation

Costs of the paradigm are high. Expensive risk and compliance functions balloon - despite delivering little of value to customers. Autonomy and intelligence are “designed out” of front-line roles - creating disengagement, poor interactions and an inward-looking mindset. Decisions go through multiple hoops, burdened with scripts, checklists and other audit requirements. Nobody seems to be asking the interesting question - how can we rebuild customer trust when we don’t even trust our own people? Banks wait for regulator’s next move, not seeing the deeper consequences of the dance.

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KEY POINTS

1. Banks are stuck in reactive mode

2. They have developed a matching paradigm:

• We will let the regulator define “doing the right thing”

• We can’t trust our people

• Regulation must be turned into process

• Compliance trumps value-adding investment

3. Employees and customers will suffer a self-reinforcing cycle of disengagement

The Banks

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Customers have largely been detached observers of the dance, believing the regulatory paradigm that customers bear no responsibility for the system. But they buy that argument without seeing the real price of doing so:

• Customers are already finding it more difficult to obtain advice. The Retail Distribution Review has effectively left the most financially vulnerable without affordable advice options

• The shift towards a compensation culture will continue. Customers will increasingly see little value in service and relationship and will buy on price - taking no responsibility to engage in making the system better for all. This, combined with a heavy regulatory burden, will discourage new entrants

• Huge swathes of customers are already failing to either buy products they need or plan effectively for the future. This behaviour is unlikely to change until underlying assumptions about banks’ value propositions change. Combine this with the rapidly aging UK population and you have a major issue for the future

• Costs of banking and of obtaining finance will rapidly increase as the withdrawal of funding-for-lending schemes exposes the new costs of regulation being built into banking business models. In the end, the customer always pays

Is this really what customers want from regulation?

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KEY POINTS

1. Regulation has left the most vulnerable without financial advice

2. The shift towards a compensation culture will accelerate

3. Distrust means the value banks could add to people’s financial future is lost

4. Regulatory costs being built into bank business models will be paid for by the customer in the end

The Customers

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To move forward we need to change the current paradigms. The first step in changing the dance is to help the participants see where the dance is leading.

All the participants in the dance have some interesting questions to answer. For the regulator these include:

• Are we really being true to our purpose?

• Why assume that people working in banks are untrustworthy, rather than trying to see the systemic issues at play?

• Are we considering the systemic impacts of our actions in key areas such as employee engagement, customer experience, and sustainability?

• How can we find a way to experiment and learn to achieve a better outcome for all?

For banks the questions include:

• Why do we exist?

• How do we rebuild trust with our employees?

• How can we have a more constructive dialogue with regulators and consumer bodies?

• How can we engage our people in experimenting with a different approach to answering the regulator’s concerns?

Consumers and consumer bodies also need to explore the direction of this dance and ask some questions:

• How can we help customers to educate themselves and take responsibility for their actions?

• How can we help all parties to understand the eventual costs of the dance to customers and to society?

Unless these prevailing paradigms change, there will be poor outcomes for all - shareholders, bank employees, customers, regulators and society.

We hope this short paper will help to ignite some of the required conversations.

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The Way Forward

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Boxwood Ltd. 15 Old Bailey London EC4M 7EF | www.boxwood.com

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Boxwood Financial Services Team

Matt Malone (matt.malone@boxwood.com)mob +44 (0) 7889 078742 | tel +44 (0) 20 3170 7240

Paul Sweeney (paul.sweeney@boxwood.com)mob +44 (0) 7525 991533 | tel +44 (0) 20 3170 7240

Colin Wilson (colin.wilson@boxwood.com)mob +44 (0) 7802 151273 | tel +44 (0) 203 170 5668

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Boxwood Ltd. 15 Old Bailey London EC4M 7EF | www.boxwood.com

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