Responsible finance, wind tunnel and radiotherapy. Notes from the conference “Market failures, market solutions” by the ICAEW Financial Services Faculty

December 3, 2012

If you thought responsible finance was just another word for responsible investment, here is an eye opener: many practitioners stress that it is just as much about good customer service

It was very intriguing to hear this as a key message at an Accounting conference, and not for example at a Bank Marketing event. The importance of customer service came up at the conference organized by the Institute for Chartered Accountants of England and Wales, a key professional accounting body, last month in London. The high-profile discussion on making finance responsible — from within the industry — featured talks around two panel discussions “Can responsible finance pay?” and “Have we forgotten the fundamentals of finance?” Link to the program here.

What prompted the event is the desire to restore trust in the financial sector after the crisis is. The ICAEW FS’s new paper framed the subsequent discussion, by providing a set
of expectations for finance and some examples: Prudential after the 1906 San Francisco earthquake; and more conventional “responsible investment” initiatives, such as the Finance Innovation Lab partly run by the ICAEW and the WWF, which develops environmentally friendly financial solutions. Leaders of “sustainable banks” such as Triodos were also speaking at the event.

Three things stood out to me at the conference:

– the diverse and intermingled notions of “responsible finance” that exist empirically

– the desire to “reintroduce judgment” into banking, and

– the widespread reference to “ethics” and even more so, to “culture”.

More about each below.

1) “Financial services is a service business. This is forgotten” emphasized Iain Coke, Head of the Financial Services (FS) Faculty of ICAEW in his opening address. Coke said everyone talks about financial products but finance is not about product manufacturing. Rather, the key to restoring trust and responsible providers was in maintaining long-term “sustainable” relationships with customers

In this vein, the conference identified a central aim of finance in making products that
customers understand, and making consumers understand the products.

The panelists talked at length about the virtues of having simple products (this is a frequent
preferred alternative in consumer protection debates worldwide). Others argued for products that may remain complex internally but deliver “what it says on the tin.” Jonathan Bloomer of Lucida presented a clear image: we need to get back to products that do what they need to do. He used the analogy of a small car with a concealed engine that the owner cannot access—its makers deemed it too complex for users. But the car does what the user expects it to do, which is to get from point A to point B. For Bloomer, the key issue is that the manufacturer understands the complexity behind the product, to make sure that the product does what it says it will do, in all circumstances. 

The discussion implicitly shifted between, and worked with, ideas about engineering the right properties of financial products (such as simple vs complex; reliable/knowable; transparent/opaque), or not touching the properties but communicating better information about them (such as more details; less details but clearer; delivered in an understandable or personal format).

John Griffith-Jones, Chairman-designate of the UK’s new Financial Conduct Authority said that transparency about the “wind tunnel test” of products by providers is especially important. In fact, the idea to label financial products briefly came up, likened to food labels.

A further dimension was added to the debate by Griffith-Jones, who emphasized less the
generic reliability of products and more their personal suitability to a given client: finance must be delivering the right products to the right people. Customers should only be offered products that are good for them. His analogy with medicine: radiotherapy is not good for everyone but may help someone with specific types of cancer. (See my very brief comparison between the UK’s distinctive personalized approach and planned US consumer financial protection policy.)

Some of the panelists therefore saw transparency as the pretext for responsibility, so that
under transparent circumstances, both financial providers and consumers should be held
responsible for their decisions (such as in an example of interest-only mortgages). There was less debate about what this transparency of financial products and services entails, how to ensure it, and what it means to understand a financial product, either by makers or users.

However, the LSE’s Paul Woolley cautioned against the knowability of finance and
pointed to the inherent uncertainty in financial products/services: finance is a different sort of product, and you do not find out whether the financial provider was good until you have
already retained their services. (Basically explaining what economists call “expert” goods
and “experiential” goods.) Based on this observation, he argued that the Principal-Agent
problem is the correct model for financial markets instead of the Efficient Markets Hypothesis, since investors rarely invest directly into these markets but rather through an intermediary such as a bank, broker or even the exchanges. Since the interests of Principal and Agent are not aligned by default, this gives rise to exploitation by Agent.

Woolley came close to arguing performativity when he explained that he is writing the Agency problem into asset pricing theory and this should matter to practitioners. He pointed out that the rulebooks of financial markets were written based on asset pricing theory, so in essence, to change the markets we need to change theory first.

Finally, the soon-to-be Deputy Chief Executive of the new Prudential Regulation Authority, Bank of England Executive Director Andrew Bailey pointed out that we miss a broader “political economy” debate: how does the financial industry fits into the bigger picture? He brought the case of endowment policy mis-selling in the UK several decades ago. This has to be placed as part of the shift from a higher inflation regime to a lower inflation regime. That, in turn, should be related to a societal shift in relation to inflation. We do not talk about it, Bailey said, referring presumably to public discussion, regulation and the financial services industry.

2) In terms of financial decision-making, reintroducing judgment and local power
was mentioned both for lending and for regulation.

First, large UK banks are reconsidering the role of the bank manager in lending, as CEOs
question the virtues of their centralized credit decision-making functions. Kevin Burrowes of PwC said banks are asking if they should get away from “faceless credit” and give more power back to the bank manager, who is sitting in the middle of the community, and can be part of its prosperity. Others added that relationship managers should get proper training whereas turnover is high.

Not only that, Burrowes said that banks become increasingly involved: since large UK banks find they cannot lend to small businesses based on credit criteria, they increasingly decide to provide equity and essentially become venture capitalist banks.

Second, Bank of Engalnd’s Andrew Bailey said the financial regulator’s plan is to
reintroduce “judgment” in assessing capital adequacy, instead of a risk-weighted calculation which he suggested is too mechanical. IN the same spirit, he added that Accounting as a profession “needs to remember assurance and opinion in audit”. 

While the discussions often did not specify investment banking or commercial/retail banking, Bailey stressed that he sees a big difference because commercial banking is defined by a fiduciary duty to customers, while investment banking is about dealing with counterparties. Therefore they should be treated separately.

3) Finally, the two major concepts of the day were “ethics” and “culture”, running through all of the topics. The panelists grappled with the difficulty of pinning down responsible organizational culture and how to engender it. The “tone at the top” (board) and a permeating ethical culture were often mentioned as solutions. Alternatively, Iain Coke highlighted “integrity” and “competence” as the central features of a financial sector that people can trust again. But these come from various practices, including redesign of performance measurement and incentive structures, as well as relying more on professionalism. In short, the participants often decomposed culture into practical incentives.

For some, ethics came as a necessary substitute for regulation-by-knowledge, because we will never understand the details of what the industry is doing, as UK Member of Parliament David Mowat said, who acts as Parliamentary Private Secretary to the new Financial Secretary to the Treasury

On the matter of regulation-by-knowledge, Mowat also asked, how do we manage global risk and global entities? In his closing address, the Conservative politician ho is involved in the new financial services bill, reiterated that the City depends on being the center of finance in Europe, but the UK is trying to regulate nationally what is a global financial system, where company risk management means that the UK is treated as just one part of a far-reaching corporate portfolio. He added that Eurozone financial regulation currently bypasses the UK, yet it obviously has great effects on UK-global banks. 

What can we take away from all this as sociologists/anthropologists of finance? There are many many points here and I want to start off with these three:

– A customer-oriented definition of responsible finance: what does this mean in the grand scheme of financial reform? Are mainstream banks trying to solve a new problem with an old tool? How does this discourse relate to the socially-environmentally responsible investment movement?   

– There was a relative lack of discussion of systemic properties in finance. Culture of organizations or the profession, and personal ethics were the main frame of discussion, and some speakers acknowledged that failures will be inevitable, so the key is how to respond to that, and that is where customers came in. 

– The reported initiative in the banking industry to turn to personal “judgment”, culture and ethics, as solutions to the problems of what we may call a technical expert system. I wonder how some of these ideas will take shape and if they will change mainstream banking. For example, how would banks bring back the bank manager and dismantle centralized credit decision-making systems, which seem to be so cemented into the financial infrastructure?

One clear conclusion is that practitioners and regulators are becoming attentive to “social” factors such as ethics, culture, or judgment as key to banking reform. But these are very difficult and complex concepts in social science; no wonder that their practical use (“how to have a better banking culture”) remains hard to envision. Financial practice is really entering the realm of sociology and anthropology here. A public discussion might be in order.


6 Responses to “Responsible finance, wind tunnel and radiotherapy. Notes from the conference “Market failures, market solutions” by the ICAEW Financial Services Faculty”

  1. danielbeunza Says:

    Thanks Zsuzsi. Fascinating workshop (and post). The debate on responsible personal finance needs to grow louder. Two comments.

    The turn to judgement will have to grapple with the reasons why banks turned to algorithms in the first place: less minority discrimination (See work by Martha Poon on this.) Any thoughts? Maybe a combination of banker-algo in the spirit of your Hungarian CRM?

    Regarding Woolley’s point, but did he say what is he suggesting, aside from index funds? (By the way, there’s nothing simple about these very abstract animals…)

  2. zsuzsannavargha Says:

    Hi Daniel, on the “turn to judgment” that’s exactly it, they need to trace back the history and rationale of the systems they now see as too “mechanical” and impersonal.

    There were no details at the conference but it would be hard to imagine that the whole credit modeling kit goes out the window. As you say, if anything, the new personal touch would probably mean a combination of designated human “judger”, bank manager, backed by a centralized information or scoring system.

    At first sight the CRM site is similar to such a combination in that there is some official discretion granted to the bank representative to decide what to use from the CRM product recommendations. They can make the final call on what to sell.

    But a difference could be that for CRM, what happens in the interaction with the client has consequences because it enters the tracking system — actions recorded will recalculate the customer profile. For a loan application, however, my understanding is that currently, the interaction of bank rep and client itself is not “data” for the system; what they discuss does not feed into the credit approval process, and does not by default change the outcome of the lending decision — or does it? If it does not, then the combination of centralized system and local decisions might not work. The models would have to include the manager’s local “knowledge”.

    Woolley I’m not sure if he suggested specific strategies but they have many working papers:

    So, index funds are brought as an example of an agency theory-based model of markets?

  3. danielbeunza Says:

    Hi Zsuzsi, you hit it on the nail. The key to the system is indeed whether it records your actions.

    In the case of loan application in the UK, I don’t know.

    But in the case of UK mortgage applications the system does record your actions, and in a way that is not transparent. Specifically, when you apply for a mortgage, the bank decides based on an automated system. So for instance, if your name is misspelt in the voter’s roll (and even if you tell them so) the system counts you as “non permanent resident.” If the bank decides to deny you the mortgage, the denial is “printed” in some document that all banks see. So when you go to the next bank, you are perceived as a riskier applicant. What’s peculiar is that the banks are not forthcoming about this, and the document is not public. Seems to me this system can be much improved.

  4. Rex Desorcy Says:

    Banks are notorious for shady behavior. Since the beginning it’s been shall we say a “Covert Operation”. I won’t be wating for improvement!

  5. Thank you for taking the time to create this content. Lots of useful posts here!


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