The HKMA is addressing culture and conduct risk by learning from other markets, engaging with other regulators, and exploring new technology, say Jeff Kupfer and Stephen Scott at Starling Trust.
On 30 March, Starling released its annual Compendium, a report on global regulatory activities aimed at promoting improved culture and conduct in the banking sector.
In the first of a series of articles written in collaboration with Regulation Asia, we discussed how the UK’s Financial Conduct Authority (FCA) has been a definitive leader in driving the global supervisory agenda in relation to culture and conduct risk management. We then spotlighted Australia, where issues of banking culture and misconduct took centre stage during 2018, with implications that continue to shape the global dialogue around culture and conduct risk governance and supervision.
This article focuses on Hong Kong, where regulators are building on their previous efforts to address culture and conduct. The Hong Kong Monetary Authority (HKMA), for instance, is looking to learn from the Australian experience, by asking the financial institutions it oversees to indicate why similar issues would not be a risk domestically.
Bank Culture Reform Initiative
In December 2018, the HKMA announced a set of supervisory directives relating to bank culture. This followed its March 2017 guidance for developing and promoting a sound corporate culture, which focused on governance, incentive systems, and assessment and feedback as its three pillars.
The December directives required banks to conduct self-assessments to review and report on governance arrangements, policies and procedures in relation to corporate culture, and the implementation of culture-enhancing measures. The self-assessment exercise initially covers 30 banks – including all major retail banks and selected foreign bank branches with substantial operations in Hong Kong – and is expected to take approximately six months.
The HKMA has indicated that it will benchmark culture-related practices at banks through site visits and off-site reviews. It will also engage in dialogue with senior management and board members with an aim to draw together insights and lessons learnt through the self-assessment process.
The focus on boards builds on previous efforts by the HKMA to highlight their important role in promoting good conduct. As HKMA Chief Executive Officer Norman Chan remarked last October, regulation and supervision are more effective in proscribing bad conduct than they are in promoting good conduct: that is where the board must step in.
In January 2019, HKMA Executive Director for Banking Conduct Alan Au recapped the HKMA’s progress on culture initiatives, calling attention once again to the three pillars of a sound culture — governance, incentive systems, and assessment and feedback mechanisms.
While he noted that it was too early for broad conclusions, Au pointed to early successes such as the adoption of a higher weighting for non-financial metrics – such as those relating to culture and conduct – in the performance assessments at some institutions.
Au also applauded the development of a “Cultural Dashboard” at one firm, to support senior management in its board-level reporting on related matters. Still, he emphasised, the task was a long one and would require greater collaboration among industry participants and the regulator.
It is particularly noteworthy that the HKMA pointed to events offshore as being relevant for Hong Kong, asking that firms, when conducting their self-assessments, “make reference to the findings of major conduct or other serious misbehaviour incidents outside Hong Kong as they review and assess whether there are any potential similar issues” at play within their own firms.
“Recent examples include the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Australia and the Prudential Inquiry into the Commonwealth Bank of Australia by the Australian Prudential Regulation Authority [APRA],” the HKMA had said.
Moreover, the HKMA advises that the firms it oversees should “benchmark their culture and behavioural standards against community standards and expectations,” and report relevant findings to their boards. This reference to “community standards” is specifically contemplated in a cross-jurisdictional context: the HKMA is directing firms to learn from peer institutions in other markets.
Notably, this is something that the HKMA itself looks to achieve itself through engagement with peer regulators in other markets, seen most directly in its participation in the newly-announced Global Financial Innovation Network. The GFIN was originally conceived by 12 regulators, including the HKMA and regulators from the UK, Australia, and Singapore. When formally launched in January this year, the GFIN had grown to include 35 regulators and other interested organisations.
GFIN members have committed to increase cross-border collaboration, to support innovation and knowledge-sharing, and to provide a sandbox-like environment within which to conduct cross-border trials of RegTech solutions. The GFIN invited applications from interested RegTech firms in February this year, and received nearly 50 applications covering all participating jurisdictions.
Starling recently learned that it had been named among only eight companies to have passed the initial screening to join the GFIN’s inaugural cohort. We are the only firm among that group to focus on culture and conduct risk, and we were pleased to learn that the HKMA had joined the FCA, ASIC (Australian Securities and Investments Commission), and the DFSA (Dubai Financial Services Authority) in looking to engage in a trial of our tools.
Metrics No Longer Sufficient
The GFIN initiative reflects what we perceive to be an emergent “ecosystem approach” to the challenge of improving culture and conduct risk governance and supervision. There is now a global dialogue regarding these issues – one that has widened in the last two years to include regulators, standard setting bodies, investors, industry associations and firms.
Moreover, in 2018, concern for culture and conduct risk issues seems to have melded into a previous dialogue regarding ESG concerns, and we now see increasing attention to culture and conduct risk from the world’s largest investors as a principal corporate governance interest.
As noted in the Preamble to our Compendium, intangible assets now make up some 80 percent of the total value of the S&P 500’s market capitalisation, and over 70 percent of the S&P Europe 350 index. With culture now regarded as a valuable if intangible asset, there is a need for better measures of such, and an ability to capture the “off balance sheet costs” that may be present when culture is seen to be impaired.
“Measuring culture and conduct risk remains a challenge for firms, with a combination of compliance monitoring results, staff opinion surveys, complaints analysis and internal audit results all being widely used as metrics,” Thomson Reuters reported in 2018, following its fifth annual survey on the topic, canvassing over 600 global financial institutions.
However well-intentioned, this approach has not generated desired outcomes and regulators no longer view such methods as sufficient. Over the course of the last year, we have heard distinct calls for improved metrics. “As we continue to see the impact of technology and big data in other parts of financial services, one interesting question is how innovation and enhanced technology will support the measurement and management of culture,” New York Fed head of bank supervision Kevin Stiroh notes.
New Tools in Behavioural Science
The HKMA clearly shares the growing interest in RegTech. “We believe the time is right for closer collaboration among the banking industry, technology community and the HKMA to give a push to the adoption of RegTech in Hong Kong,” HKMA Deputy Chief Arthur Yuen commented late last year.
Earlier this year, Yuen added that, “The future success of financial firms will depend very much on how accurate they are in predicting or driving behavioral change. For that to happen, you have to understand human behaviour.”
Research repeatedly demonstrates that individual behaviour is directly influenced by the witnessed (mis-) behaviour of peers and that, within firms, employees are demonstrably likely to engage in what sociologists refer to as “conditional dishonesty.”
The IMF (International Monetary Fund) has studied how behavioural science is relevant for banking supervision and regulation. In a working paper published in August 2018, it acknowledged that regulators have not yet realised the full potential of tools informed by behavioural science and identified areas for further study.
As we will discuss in more detail in a future piece, the HKMA is again acting consistently with peer regulators elsewhere in placing this emphasis on predicting and driving behavioural change.
For instance, in a speech made at the San Francisco Federal Reserve Bank last summer, Ravi Menon, Managing Director of MAS (Monetary Authority of Singapore), spoke of the “enhanced supervision” that he anticipates will characterise the next decade. He envisions regulators collaborating to establish common frameworks for culture and conduct supervision, drawing specifically on the tools of behavioural psychology.
As noted in its 2018 Annual Report, the HKMA organised “thematic seminars” to help independent non-executive directors keep updated on issues facing the banking sector. We were very pleased to have been invited to conduct one such seminar, in partnership with the Hong Kong Institute of Bankers, in November 2018.
The HKMA’s election to work with Starling further, through the GFIN, suggests a continuing interest in applying behavioural science in the supervisory context.
We will continue our series of articles further discussing some of key themes and findings from the Compendium, a full copy of which is available here.
Jeffrey Kupfer and Stephen Scott are co-founders of US-based RegTech firm Starling Trust Sciences. Starling has been invited to present its ideas and capabilities at the SEACEN Policy Summit for APAC Central Bank and Monetary Authority Leadership (Kuala Lumpur, 13-14 June) and at the SEACEN/Financial Stability Institute High Level Meeting for regional Directors of Bank Supervision (Hanoi, 26-27 June).