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Can Bankers behave after 2008? Despite small fines, Morgan Stanley tries

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What reward do bankers bestow on ethical business practices? Apparently, very little, if anything, is paid to rank and file banking employees for obeying their conscience and always acting in an ethical manner. Continuing scandals and countless studies have established that senior executives condone a culture of corruption by refusing to make substantive internal changes since the financial crisis of 2008. Billions in dollars of fines have been assessed to our largest and most well known financial institutions, but their only responses have been carefully prepared press releases that reek more of symbolic gestures, than the necessary structural changes expected to regain the public’s trust.

Despite ample warnings from central bankers, economists, and some of the best minds around the planet, very little has penetrated the thick skins of senior banking executives. Christine Lagarde, the managing director of the International Monetary Fund (IMF), has also been quite vocal on the topic, especially after the recent interest rate and foreign exchange rate fixing scandals came to light. “While some changes in behavior are taking place, these are not deep or broad enough,” she said. “The industry still prizes short-term profit over long-term prudence, today’s bonus over tomorrow’s relationship. Some prominent firms have even been mired in scandals that violate the most-basic ethical norms.”

When the likes of the Swiss banking giant UBS, Citicorp, JPMorgan Chase, London-based Barclays, and Royal Bank of Scotland acknowledge that “their traders rigged foreign exchange prices of U.S. dollars and Euros from Dec. 2007 to Jan. 2013”, then we have a global banking phenomenon that defies the imagination. When the CEO of each entity apologizes publicly, states that this behavior is not representative of the high ideals of the bank, but does nothing to rock the boat in his own establishment, then it is time to get worried.

What could happen if these executives try to stall their way through this crisis with nothing more than a few paltry words to dismiss the severity of their misconduct? The solution may come from central bankers that are sickened by the overt hubris of these banksters. If the words of William Dudley, the president of the Federal Reserve Bank of New York, are to be taken at face value, then change may be forced upon these institutions.

In a private conference last October, Dudley warned that, “If those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial-stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.”

Is there at least one major bank that is attempting a culture transformation?

The answer is “Yes” — Morgan Stanley Smith Barney, LLC (Morgan Stanley). This Wall Street firm has been on both sides of the behavior line over the past few decades, first attempting to change, then returning to a swashbuckling style, and then, only after eating a $9 billion loss from the antics of a rogue trader, decided to take the bull by the horns and radically convert the institution to a new religion, one of higher ethical standards.

The road has not been an easy one, but their stoic CEO, James Gorman, began his new mission in 2010 and has made every effort necessary to steer his firm away from excessive and, in most cases, unnecessary risk taking. Gorman approached his goals with a religious fervor that frightened his competitors. What if he was right? What if every firm had to follow his lead? What if stonewalling Dodd-Frank and the regulatory community did result in being ripped apart into smaller entities? As these brazen types hold their collective breaths, their overly paid executives and traders are openly hoping that Morgan Stanley fails, their gravy train continues, and possible jail time evaporates.

When the average executive and trader makes upward of $1 million and more, who would not want to join the ranks of these highly paid thieves? The simple fact is that incentive structures are way off balance. There are far too many individuals and firms trying to grab the golden ring, a situation that demands that more arcane investment products (even more ridiculous than mortgage-backed securities and counterparty-risk swaps) must be created every year and then sold to an uninformed and often manipulated public set of consumers, both foreign and domestic.

One Morgan Stanley banker was particularly moved by Gorman’s new tact. In 2012, Gorman had highlighted the issue, and this loyal executive summarized his words as,  “Bankers just get into the habit of complaining about compensation and sort of thinking that they’re entitled to be paid 50 times what a firefighter that runs into a burning building to save a little baby gets paid. That entitlement is sort of endemic within banking. He said what a lot of people actually felt, and to be honest with you it was kind of refreshing.”

What exactly did Morgan Stanley and its evangelistic CEO do to stem the tide?

Ruth Porat, Morgan Stanley’s former chief financial officer (who has now left the firm to join Google), helped implement many of the new directives handed down by Gorman and their board. Her take on the proceedings were that, “When bankers become disconnected from their ultimate clients … they have no direct view of the value of their work. That makes unethical behavior easier. We’re in the risk-taking business. Just no outsized risks. You can’t do that to an institution. It’s irresponsible.”

Here is a list of a few of the key changes that were undertaken at Morgan Stanley:

  • Cut back senior pay, increased deferred compensation, instituted bonus “clawbacks” when malfeasance was determined, and limited the cash component of annual bonuses to $125,000 per person;
  • Focus on wealth-building activities for clients that produces predictable annual service fees by doubling the size of that business line within the firm;
  • De-emphasize the “swashbuckling, risk-taking bravado” of the firm and dispense with its proprietary trading activities and commodity business lines;
  • Limits have also been instituted that restrict the amount of capital that any one trader can have at his disposal (This edict specifically addressed the Howie Hubler incident in 2007, when his incompetence led to a $9 billion trading loss and almost forced the firm into bankruptcy);
  • Morgan Stanley also tripled the size of its internal audit staff and opened more internal doors to outside regulators, more so than at other firms, in order to promote transparency;
  • Promotion policies have been revamped by, as one analyst put it, “placing a higher value on collegiality and effective management than on star power and rainmaking.”

Have these changes brought success to the firm of Morgan Stanley? According to its latest annual report, “At the end of 2014, Morgan Stanley employed more than 16,000 brokers and managed more than $2 trillion in assets, making it one of the largest wealth-management firms in the world.” These results took a few years to realize, due to the staggered acquisition of Citi’s Smith Barney business, completed in 2013. Profits for 2014 were $6.2 billion, and the company’s stock price appreciated some 24%, placing it in the Top Tier of Wall Street performing banks for the year. When shareholders are happy, you must be doing something right.

Not all, however, is peaches and cream. Many traders, who were particularly offended by the new cash limits on bonuses, quickly exited stage left for other companies where compensation policies followed the “status quo”. Gorman actually addressed these types in a Bloomberg interview, by saying, “The world has changed. You’re naive. Read the newspaper, number one. Number two, if you put your compensation in a one-year context to define your overall level of happiness, you’ve got a problem which is much bigger than the job. And number three, if you are really unhappy, just leave. I mean, life’s too short.”

Concluding Remarks

Changing corporate culture is not an easy task, nor is it one that can be accomplished in a short period of time. Morgan Stanley has been at it since 2007, for example. Vikram Pandit, the former CEO of Citigroup, who served both during and after the Great Recession, made a valiant attempt to modify the culture at his bank. “Culture does make a difference,” Pandit recently said to a banking colleague. “On the other hand, building a culture takes years. I think we made a big difference at Citi, but we certainly weren’t even close to getting it done in the five years that I was there.”

Will the changes at Morgan Stanley stick or just fade away when a new CEO takes the helm? The bank had already undergone a similar process fifteen years back. Philip Purcell, another former McKinsey consultant like Gorman, followed a similar playbook at the turn of the millennium. He orchestrated the merger with Dean Witter, Discover & Co., reduced risk taking, and expanded the wealth-building portion of the firm’s revenue streams. He restored the health of the firm’s finances, but his actions so offended the Old Guard that he was ousted during a palace coup.

The usurper was John Mack, an old-timer with the firm, who had jumped ship and gone to Credit Suisse during the Purcell years. He returned in 2005 and was known more for his “gregariousness and devil-may-care attitude.” He brought in Gorman in 2006, but the Howie Hubler incident and events leading up to the financial crisis in 2008 made him change his tune. The firm lost 80% of its market value during the crisis, but was rescued by a capital infusion from Japanese sources.

Mack retired at the end of 2011, and Gorman then had free rein over the culture aspects of the firm. Open transparency with the regulators has led to more fines, but these are insignificant when compared to the billions that have been assessed to other banks during the recent scandals. Will Gorman’s changes endure or will events dictate another overhaul? Only time will tell, but at least this is one bank that has chosen to embrace an ethical ideal that is higher than its piers. Let us hope that others choose to follow.