Banks have even less room for error with bad behavior

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We are witnessing a sea change in risk. The emerging importance of conduct risk in financial services may appear out of proportion and perhaps temporary. But it’s neither.

It’s a global phenomenon — a passing glance at business headlines about big banks in the U.S., U.K. and Australia tells you as much. It is both permanent and likely to intensify. Understanding the phenomenon and dealing with it will become ever more central to running a regulated financial institution and keeping it out of regulatory crosshairs.

Failures to effectively manage conduct risk can lead to financial exposures and reputational damage that impairs a firm’s competitive position and how it is viewed by market participants as well as its own personnel.

Coupled with these high stakes, conduct risk is harder for institutions to monitor and manage for a number of reasons.

Size and complexity. Financial institutions are bigger and more global than ever before, and conduct risk information is scattered across them. It’s harder and more complicated for massive institutions to monitor the behavior of all their employees. And the increasing complexity of financial products plays into this as well.

Breadth and speed of spreading information. Social media and other modern means of communication allow for instant and broad public publication of individual information that wouldn’t have been possible even 25 years ago. Historically, an aggrieved customer might have talked with his or her neighbor, written a letter of complaint, and/or contacted a regulator. All of this was relatively contained. Today, a customer has multiple avenues to make information go viral. And when it does, it can result in media and political attention that is more active and lethal than ever before.

In this environment, if a firm is not on its toes, a smaller number of conduct errors can have an outsized impact on public and policy leader perception. If a widow or orphan, for example, is badly overcharged for a financial product, such a situation will be magnified with new information technologies, inflaming the political debate.

Short-term thinking. Due to the public and quarterly focus on earnings, there is more pressure and more economic incentive for employees to reach for short-term economic results, no matter the harm to the customer. Firms need to be especially vigilant about exactly what types of transactions their incentive compensation arrangements are incenting.

So how can a regulated institution deal with the risk of criticism over institutional conduct?

Traditional methods of response — better policies and procedures, employee training, better governance, tone from the top — can only be part of the answer.

But these methods alone won’t produce a result that’s granular enough in our social media age. Banks need a mindset shift. We have to deploy methods that minimize mistakes to a greater degree than had been feasible in the past.

The good news is firms can get on top of this problem. An effective approach is to combine the basic building blocks of sound risk management with advanced technology to identify conduct risk at an early state, minimizing potential damage. Some new technology enables a predictive approach for where conduct risk could be elevated. Machine learning and other cognitive techniques can help quickly and efficiently identify patterns that would otherwise be unearthed at a snail’s pace.

Of course, the cost of developing and employing these remedial systems won’t be trivial. At the same time, the cost in reputation and regulatory risk can be astronomical if regulated financial institutions can’t do a better job of managing misconduct. Enhanced technology can save money by catching issues early and reducing the need for expensive manual processes.

Preventing conduct risk issues requires a more granular understanding of how they spread and an acceptance that a combination of new and more traditional tools is necessary to fight them.

Eugene Ludwig

Eugene Ludwig is the founder and chief executive officer of Promontory Financial Group, an IBM Company. He was formerly comptroller of the currency under the Clinton administration.

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