Wholesale Conduct Risk

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Speech by Tracey McDermott, director of supervision, investment, wholesale and specialists, at the Financial Conduct Authority (FCA), delivered at the British Bankers’ Association Conference ‘Wholesale Markets and Risk: FEMR and beyond’, London. This is the text of the speech as drafted, which may differ from the delivered version.

This conference has the title of Wholesale Markets and Risk: FEMR and beyond. And, of course, the management of risk is, and always has been, a key driver for the existence of wholesale markets. 

Innovative, vibrant, competitive markets enable individuals and companies in the wider economy to take risks and to manage them. They enable others to participate in that risk taking and in the rewards that may follow.

And this takes a myriad of forms, whether through traditional insurance; through enabling a large multinational to hedge its currency risks; providing capital for a start-up entrepreneur or, increasingly importantly, to help manage the assets of individuals as they plan for their financial future.

Against that backdrop you will I am sure agree that it is difficult to overstate the role the wholesale markets to the global financial system, and their importance to the UK. London is a leading global financial centre, and I could pick any number of statistics to demonstrate this. 

More international banking activity is booked in London than anywhere else; 41% of all foreign exchange trading takes place here; London is the leading centre for international bond trading and this position is not an accident. 

It has been hard won over many years and is a testament to a long history in the UK of fair, efficient and effective markets which evolve and adapt to meet changing demands.

We want London to remain a success. The effective functioning of our financial markets matters not just to financial services professionals or the regulator but to [the competitiveness of] our economy as a whole.

But, unfortunately, in recent years wholesale markets in London and worldwide have tended to be known as much for the wrong things as the right ones. 

This started with the financial crisis; the impacts of which continue to be felt across the global economy and which rocked our confidence in the ability of markets to find appropriate solutions and to effectively manage risks. And as society was still reeling from this and still feeling the impact, we have had the further destruction of trust and confidence caused by of what feels like wave after wave of misconduct being brought to light.

The findings published by regulators around the world since 2012 regarding LIBOR and more recently FX confirmed the suspicions of many – the system was being abused by some within it at the expense of those it was supposed to be there to serve.

The emails and messages between traders seemed to sum up a culture where the primary objective of those within the markets was to protect their own interests, and those of their mates, with the interests of clients and of the wider market coming a long way down the priority list. If, indeed, they featured at all.

Libor triggered a wave of change – regulatory, legislative and within firms. It forced the industry – and indeed regulators – to challenge our orthodoxies about what mattered; about what could and could not be manipulated; about where loyalties lay; about the importance of culture and about whether and how these risks can be effectively controlled and managed.

It is no exaggeration to say that an unprecedented amount of resources – both monetary and human – have been ploughed into trying to put things right. But FX was a timely reminder that we are not there yet. 

Very significant progress has been made but unless we, collectively, remain focussed on the end outcome we will risk throwing away those billions of hours and pounds of effort and allowing ourselves to slip back to a place we do not want to return to.

Be in no doubt, misconduct of this nature affects not only the individuals directly involved, but the reputations of all those operating in the wholesale markets, and the integrity of the markets themselves. It, as the Governor of the Bank of England has said, undermines the licence of institutions to operate. And if that was not enough – look at the impact on the bottom line. 

The fines paid by large global banks in the past 7 years top some $235bn. Compensation paid out in relation to IRHP mis-selling approaches £2bn. That in relation to PPI is approaching £20bn. We need to get better at this.

So against that backdrop I am pleased to be here to speak to you about not just why the FCA thinks conduct matters but why you – as a business – should be treating conduct risk as seriously as any other risk on your balance sheet, and managing it accordingly.

I should stress that while my focus today is conduct we are also the prudential regulator for many of the firms in the wholesale markets. And as recent global and market events demonstrate, managing these risks remains critical.

Good conduct is not about preventing innovation or growth. To the contrary I would argue that it is essential to allow innovation and growth.

But, as I said, today’s focus is conduct and the lessons of the last few years illustrate clearly that firms need to take proactive steps to improve conduct. Without a firm foundation in identifying the conduct risks inherent in your businesses, it will be hard to manage conduct, let alone show us and others that it is being managed.

We know that most firms now understand the value in getting it right and not simply the cost of getting it wrong, and the benefit of good conduct in terms of building customer trust and analyst confidence. However, there is a long way to go, and it will not happen by regulatory osmosis. Firms and individuals need to take responsibility for their own actions.

As a host of people have said, good conduct is not about preventing innovation or growth. To the contrary I would argue that it is essential to allow innovation and growth. Trust is, and always has been, at the heart of financial markets and we need to ensure that it is restored and renewed. And this was of course a major theme of the Fair and Effective Markets Review that Charles spoke about earlier.  

As FEMR recognised solving these issues in a sustainable way which is practical and allows markets to continue to evolve cannot be a job for the authorities alone. But the authorities clearly have a role. So I will talk today about what we think the FCA’s role is and what we expect of firms? I will highlight three areas.

First, how we need to work with the industry on solutions to rebuild reputation and embed cultural change.

Second, how we get firms to ask themselves some hard questions about how they identify and manage conduct risks.

And third, how we create a system in which individuals, as well as firms, can be held accountable for their actions.  

I will take these one by one.

Regulators and the industry

Effective and proportionate regulation is a considerable strength of the UK economy. To steal an analogy from a colleague of mine – a good regulator should be like a good referee – constantly on the pitch, keeping up with what is going on, respected, firm, consistent and fair – and tough when required – but not interrupting the flow unnecessarily and being largely invisible to the spectators most of the time.

We treat conduct risk like any other risk, and with a risk this big, you need to give us a very good reason why you are not taking proactive steps to manage it.

So that is what we aspire to – but we cannot get there on our own. Being an effective referee requires there to be clear rules of the game and a basic buy in to following those.

We have a clear statutory objective to make markets work well. There will, in that, inevitably be winners and losers - making profit is not a problem – in fact it is a key element of the UK having a thriving investment banking industry. But that must be achieved fairly with everyone playing by the same rules.

Some good examples do exist. FEMR showed the authorities and the industry working together to identify the problems in a vital market, and to start to come up with ways to fix them.

And it’s important to note that these ‘solutions’ are not all about rules and regulations. Many of them will be industry-led, with Elizabeth Corley chairing the new FICC Market Standards Board. 

This Board, as Charles mentioned earlier, will work with the authorities to spot trends and risks to the market. It will help market participants understand what good looks like and think about how that changes as markets evolve and practices develop. We hope, and expect, it to be a driver for ever improving standards – over and above regulatory minima.

There is, of course, always more we can do to work together, and this relationship goes both ways. One of the key aspects of the FCA’s new strategy is about how we make the most effective use of our resources.

Recognising that the way we have carried out business model analysis in the wholesale sector is resource intensive both for us and for firms, our supervisors have been looking at how to get more ‘real-time’ quantitative analysis of the revenues of the sector, while streamlining the process. 

They have developed a monthly P&L scorecard across a number of major firms, which uses firms’ existing P&L reports – data firms already produce for themselves. The expectation is that this will lead to more efficient (for us and for firms), current, consistent and comparable data analysis of the largest firms in the sector.  

It may surprise you to know that our working assumption is that 95% of the time the interests of the regulator and regulated are aligned. Neither of us have an interest in misconduct happening on our watch. It is as bad for us as it is for you. It shows the market is not working well.

Think about it like this. The risks arising from misconduct is one of the largest contingent risks on a firm’s balance sheet. It rarely matures, can’t be sold or hedged using normal market instruments. Any other risk this large, with these characteristics, would be managed and mitigated to within an inch of its life. Yet stick the word ‘conduct’ in front of it and suddenly it is not. 

We treat conduct risk like any other risk, and with a risk this big, you need to give us a very good reason why you are not taking proactive steps to manage it.

Five conduct questions

Which leads me to my second point: getting you to ask yourselves the hard questions. And in this case we think there are five. The five conduct questions, which some of you may be familiar with already, are something we see as a mechanism for helping you ask yourselves the hard questions that are needed, and to give you a sense of what good looks like.

First, how do you identify the conduct risks inherent within your business?

As with any risk, you cannot hope to mitigate something you don’t know exists.

The root causes of much that goes wrong in wholesale markets are constant - risks exist in managing information flows, conflicts of interest and trader controls. However, time and again we see firms failing to identify where these might crystallise and manage these appropriately. The investigation into FX manipulation found many of the same failings as in LIBOR.

This suggests that the connection between the high level definitions and the potential on-the-ground impact were not made. I, in this and my previous role, have said a number of times that it is a concern to me that firms are not reading across the root causes of misconduct and ensuring that the same issues don’t exist in another area. 

This does require a bit of creativity and effort being put into understanding of the root cause rather than an assumption that it couldn’t happen here or that one rogue is responsible. But I believe that this would be time and energy well spent.  

Second, who is responsible for managing the conduct of your business? We expect firms to be asking themselves how they are encouraging their employees to be and feel responsible for actually managing the conduct of their business.

There are, even with the growing size of compliance teams, many more people in the front line. They understand their business better than anyone else; they know where the risks are and they should – if we get the incentives right – have the greatest interest in long term, sustainable good business practices. They need to understand that is part of their job and be helped to do it well.

Third, what support mechanisms do you have to enable people to improve the conduct of their business or function? Naturally there are a large number of answers to this question, and we have seen some good examples already. However, there is no golden metric. For many firms, it will be a combination of practices that create the environment we want to see.

For example, are new product and new business approval committees robust and appropriately represented by the control functions? Do training and induction programmes lay out a firm’s expectations of its staff? Do firms provide management information for supervisors that is useful, timely and genuinely helps them supervise their staff?

Ultimately this is also about creating what we sometimes call a culture of appropriate escalation, where people can speak up when they observe poor behaviour or are unsure about what to do. Too often people are unwilling to do this, or are penalised if they do. 

Again I return to the point that conduct risk is an inherent risk to your balance sheet. If it is viewed like this, speaking up when people see or suspect something is wrong, it is no longer snitching or grassing on your colleagues, but is about mitigating risk to your firm. It is important for people at all levels to understand this.

The fourth question is about how the board and executive committees gain oversight of the conduct of the organisation. At a basic level, this is about what information the board and executive see, and how they take it into account in their decision-making. 

While we’ve certainly made progress in getting conduct issues onto board agendas, we still have some way to go in getting them to take conduct implications into account in every strategic decision and recognise that their decisions can have just as big an impact on the way business is conducted as the behaviour and decisions of those who report to them.

The fifth and final question is almost a ‘catch-all’ question – we are regulators after all. It is whether firms have any perverse incentives or other activities that may undermine any strategies put in place to answer the first four questions. As an example, most employees of any firm will never – or rarely – see the CEO. 

Their role models are not board members. Their role models are the top trader, the desk head. If they see a colleague rewarded and promoted, even if their behaviour is not consistent with the values of the firm, this does not send a clear message that such behaviour is not tolerated.  

So they are the five questions. They are not here to catch you out – but this framework allows us to compare and contrast, collaborate and share best practice. This last part is important. In the industry people move between firms and positions all the time. The only way for conduct standards to rise, and to stay high, is for everyone to rise together.  

Individual accountability

Which leads me to my last point: the importance of individual accountability. Individual responsibility for behaviour was notably lacking during the financial crisis and beyond – bringing with it, as Martin Wheatley spoke about earlier this year, the ‘Murder on the Orient Express’ defence – yet it underpins everything I’ve said above.

Before you can explain the value and utility of what you do to others, you must be able to explain the same thing to your own staff and colleagues.

The Senior Managers Regime, final rules for which were published last week, should reintroduce and reinforce professional accountability to the industry. This should not only help rebuild the reputation of the industry; it also makes commercial sense.

Most banks here will be familiar enough with the plans already: each firm building a responsibilities map, setting out its allocation of responsibilities between individuals; and statements of responsibility, setting out in detail the individual areas each senior leader will be accountable for. One of the recommendations of FEMR is to extend the regime across all those active in FICC markets, so more and more people in the wholesale markets will become familiar with its aims and, hopefully, change their behaviours accordingly.

One thing that the introduction of the Senior Managers Regime will do is hard-wire responsibility for good conduct into the firm’s governance.  It is important to stress that SMR and individual accountability does not replace other forms of governance. It does not mean you cannot delegate. It does not mean you have to be followed around by an army of compliance professionals to tell you what to do. What it does mean is that you must run your business well. 

You must take responsibility for understanding and managing the risks in your business, you cannot delegate and forget, and you cannot hide in labyrinthine structures where it is all too easy for everyone to say it was not me.

And it is increasingly evident that culture and conduct are two sides of the same coin. Good conduct – hedging that conduct risk – relies on cultural change, and can’t happen without it.

Senior leaders have responsibility for espousing the correct culture and behaviours. While we’ve seen encouraging signs, and certainly lots of commitments, it needs to be about changing outcomes.

We are seeing progress in particular both in the top layer and at the bottom, through better training and induction procedures, as well as the nature of people now joining the industry. To become an investment banker now, for example, with all its pressures, commitment and public scrutiny, you have to really want to become an investment banker!

Where the most progress has still to be made is in the middle layer – to borrow another analogy from a colleague, the ‘permafrost in the middle’. Many of these middle-ranking individuals entered the industry in a different time, when the perception of what was acceptable may have been different.

Expectations have now been raised, and people have to adjust their behaviour accordingly. We should not underestimate how difficult this is going to be to do. We are asking people to re-examine the behaviours that in many cases made them successful, and led to reward and promotion. This can’t be anything but a challenge, but it must be done, and firms need to support these people to do it.

This industry does some great things but it is often very bad at explaining what it does to those outside it. These failure to explain what you do also means that you don’t make the connection to the impact of your behaviour on others, and by this I don’t just mean your counterparties (although obviously that is important) but also on society.

Cultural programmes should help connect the dots – it is about seeing what you do in context, creating the right narrative about your purpose. And before you can explain the value and utility of what you do to others, you must be able to explain the same thing to your own staff and colleagues.


So to conclude, the cost of failing to identify risks to clients, market integrity or fair competition is material. It makes good commercial sense – indeed I would say there is a commercial imperative – to manage these risks as effectively as any other risk on your balance sheet.

Responsibility for this starts at the top, with the board taking account of the consequences of conduct risk in all its strategic decision-making. The last few years have shown the cost to both individual firms, and the industry as a whole, when they don’t.

Regulators of course play an important role, and will continue to do so, even where market discipline is already strong. It is our responsibility to encourage you and help share best practice, and to evaluate what you do, calling out the worst behaviours, showing the occasional red card. As market discipline and standards increase, we hope we should have to do less of the latter.

It will never be possible, nor is it desirable, for the FCA to take responsibility for conduct by itself, and so we need to continue sharing and talking about the changes taking place, looking at what is working and what isn’t.

As I said at the beginning of my speech, wholesale markets are of huge importance to the UK economy. And they need to work well for everyone. They can only do that if everyone working in them feels responsible for their own behaviour, and importantly, the consequences of that behaviour for everyone else.

I look forward to working with you all to do that.