During the last few weeks, when I can find the time, I’ve been reading chapters of former Fed Chairman Ben Bernanke’s recent book on the financial crisis. It’s a sobering experience. What’s most striking to me as a fraud examiner and auditor is how apparently flawed the corporate cultures of the banking and insurance firms involved in the crisis were. But tone at the top and culture weren’t problems for banks and insurance companies alone, as the book makes clear. Time and again, boards across America apparently decided what the tone in their organizations should be, but seemed to fail to communicate it to people lower down the chain. Perhaps their audience didn’t understand the message. Perhaps staff members just decided to ignore it. Other times the message was completely clear, and adhered to by everyone, just completely wrong ethically, and that individual business, along with so many others, simply sailed ahead on a fixed collision course with the whirlwind.
The Chairman makes clear that the challenge is not only to set the right tone at the top, but also to ensure that it’s in harmony with what he calls the ‘tune in the middle’ – the unwritten real world rules that describe how people further down the organization should behave and work. For a business to thrive – or to simply survive – everyone in the organization needs to sing from the same piece of ethical sheet music. On page after page of Bernanke’s book, as the unfolding of the crisis was described, it occurred to me again and again that there’s a lot CFE’s and other control assurance professionals can do to assist our clients to fore-stall the risk of any future, similar crisis.
I think the first time I saw the term ‘tone at the top’ was in a 1987 report on fraudulent financial reporting from the Treadway Commission, which paved the way for the commission’s Committee of Sponsoring Organizations’ (COSO’s) Internal Control-Integrated Framework. As I recall the framework said, and still says, the CEO has to take ownership of the organization’s control system. Part of the CEO’s responsibility is to set a tone at the top that will enable a positive control environment. That includes providing direction to senior managers and checking how they’re controlling the business. Senior managers, in turn, assign responsibility for more specific internal control policies and procedures to their subordinates. The idea is that the right tone will cascade all the way down through the organization, from top to bottom. But the CEO isn’t the only person responsible for setting the tone. COSO says the full board and audit committee (if there is one) have an important role, as well. Eventually, further COSO guidance, published for small public companies, fleshed out what a good tone at the top might sound like. And in its most recent guidance on monitoring controls, COSO puts even more emphasis on tone at the top. All COSO publications stress the importance of establishing a culture in which managers are aware of the risks in their part of the business, monitor the controls designed to mitigate them, and take action if those controls aren’t working.
There’s no shortage of guidance on what a good tone at the top should look and sound like, yet this remains, for Bernanke, an issue that many organizations, to this day, still get badly wrong. The banking and insurance sectors are just one example. Official reports like the Chairman’s into the causes of the credit crunch, and such as the one published years ago by the Financial Stability Forum, a group of central bankers, criticize banks for their poor risk management, and point to organizational cultures that failed to recognize the importance of risk management and internal control functions. Many of the banks that failed literally “dis-empowered” their risk functions.
A lack of support for the value of risk and control functions wasn’t the only indicator that tone at the top in the financial industry had gone generally awry. Another significant one is the controversy over executive pay in the sector. According to Bernanke, the size of bankers’ pay awards and bonuses, the apparent failure to link rewards to performance, and the refusal to forgo or repay bonuses led to the current global political drive to reintroduce a degree of control over pay. Directors’ pay is the litmus test of tone at the top, because pay is the most significant issue over which the interests of shareholders can directly conflict with those of boards of directors. The former want pay levels set in the company’s best long-term interests, while the directors must fight the temptation to line their pockets with short term rewards. Any company with a chief executive who has pay that is considered offensive by colleagues, owners, or the wider society has failed that fundamental test.
And the nature of the financial crisis, according to the Chairman, also tells us something else generally about tone at the top in the financial services industry. While the rocket scientists inside banks and insurance companies were inventing increasingly complicated financial products, their boards failed to ask the intellectually naive but important questions that might have told them that trouble was brewing. These would have been simple questions, such as “Do housing prices always go up?” and “Can we always trust the opinions of rating agencies?” In failing to ask such questions, boards set a tone of what Bernanke styles “mindless compliance” – and it’s this tone that cascaded down the organization. That meant that the tune in the middle was not right. Middle managers weren’t applying their minds, only singing into the storm. For banks, this failure of middle management’s tune was as damaging as the poor board-level tone. Clearly, culture isn’t just a question of what board directors say and do; there are leaders throughout every part of the organization. They range from heads of departments, business unit directors, and project team managers, to shop floor supervisors and shift leaders. Every one of them sets an example, for good or bad. Wherever there is someone in a leadership role, there is an opportunity for a gap to emerge between the stated aspirations of the board and what actually happens.
Tone at the top is often categorized as an issue of business ethics (we’ve repeatedly so categorized it in this blog), but the example of the banking and insurance industries during the crisis, demonstrates that it’s clearly about more than just that. Ethics are universal, applying to all companies; don’t steal, act honestly, and don’t mislead the board. Tone at the top includes how the company should relate to all of its stakeholders, such as its employees, shareholders, suppliers, customers, and the wider community. So tone at the top symbolizes what the leadership of the business believes the ethical priorities are for that business at this point in time. It’s a question of how senior people expect the organization to be run and organized. That would include the kind of ethical conduct that Bernanke describes, but also the reputational risk appetite associated with every individual project and product sale.
To my mind, Ben Bernanke’s book is the very best on the financial crisis for financially literate readers. I whole-heartedly recommend it as must reading for all practicing fraud prevention and control assurance professionals.