Weekend Reading: A New Era of Market Discipline

By: Stephen J. Scott , Founder & CEO of Starling

This piece first appeared in Starling Insights' newsletter on March 22, 2024. If you are interested in receiving our thrice-weekly newsletter, among many other benefits, please consider signing up as a Member of Starling Insights.

Since the Global Financial Crisis, regulators have imposed hundreds of billions of dollars in punitive fines, penalties, and customer remuneration costs on banks for misconduct issues and lapses in non-financial risk management. In addition to targeting firms, a number of regulatory bodies have gone further by implementing senior managers accountability regimes whereby individual executives are held personally liable for misconduct that occurs on their watch. These regimes have resulted in individual fines and bans from working in the industry.

With this as background, we note with great interest that Norges Bank Investment Management (NBIM), Norway's $1.5 trillion sovereign wealth fund, is co-leading a?class action lawsuit related to the collapse of Silicon Valley Bank (SVB). The lawsuit, filed alongside the Swedish pension fund Sjunde AP-fonden, AP7 , serves as a signal that banks may be facing increased pressure from yet another stakeholder: their owners.

While Norges is not unfamiliar with shareholder lawsuits, this marks the first time it is taking a leadership role in seeking to recover substantial investment losses incurred by the fund and other SVB investors. "We manage money on behalf of all Norwegians," said Nicolai Tangen , CEO of Norges. "I see it as our duty to take legal action to both maximise our recoveries after the SVB collapse and to signal that this is not acceptable market behaviour."

Notably, the lawsuit focuses not only on SVB and its executives, but also on the bank's auditor and the Wall Street advisors who helped it raise money. The investors?named?accounting firm KPMG and four Wall Street banks — 高盛 , 美国银行 , KBW , and 摩根士丹利 — as defendants, alleging all had "utterly failed in their role as gatekeepers."

It has been widely acknowledged that SVB's collapse was rooted in failures of governance, risk management, and supervision. Despite clear and identifiable deficiencies in these matters, Norges argued, SVB and the "gatekeepers" misrepresented the bank's financial position and risk management capabilities to investors. As a co-lead plaintiff, NBIM aims to maximize recoveries for all investors while addressing broader concerns about market integrity, the governance of financial institutions, and investor community interests.

"It is important for us to take legal action where the alleged conduct raises significant concerns about market integrity," said? Carine Smith Ihenacho , Norges' Chief Governance and Compliance Officer. "We have clear expectations towards the companies we are invested in and see this as a part of being a responsible investor."

In this direction, Norges has temporarily?relocated?Ihenacho to New York City and announced that it would be expanding the stewardship team in its New York Office. As almost half of the fund's equity investments are in the US Markets, Norges is looking to adopt a more active stewardship role toward its holdings in the country.

While Norges is one of the loudest voices in the room regarding the importance of sound culture and good governance on account of its sheer size, it is not alone. Globally, there are indications that both institutional investors and the public at large are becoming increasingly skeptical of pious statements of intent that go unmatched with genuine action.

Most firms today are signaling that they have become more proactive around culture, governance, and risk management. Much of the evidence they point to centers on risk management frameworks, new training programs, organization-wide surveys, and statements emphasizing responsible growth, diversity and inclusion, and positive societal impact. Therefore, when a firm's publicly reported values are revealed to conflict with the reality of how things are actually done, trust is damaged and investors are demonstrating a willingness to take action.

If institutional investors are indeed stepping in to enforce market discipline, firms would be wise to look for meaningful ways to manage these non-financial risk matters and to evidence such, as they have real financial consequences. In a?report?published late last year, Fidelity International identified workplace misconduct as a financial risk with systemic implications. The report coined the term 'culture-based financial risks' to define how culture can impact shareholder value.

Therein, Fidelity implored companies to improve their management of culture and employee conduct and to enhance disclosures of such information so investors can utilize it in decision-making and corporate engagement. These responsibilities may extend to supervisors, auditors, and the other "gatekeepers" — as Norges terms them — who have long struggled to assess these 'culture-based financial risks' at the firms they oversee.

None of these organizations must go it alone, however. In fact, a truly effective solution is unlikely without joint engagement from management and relevant stakeholders. Instead, as the former Vice Chair for Supervision of the US Federal Reserve,? Randal Quarles , argued in an?interview?for our 2023?Compendium, we need global collaboration on developing new tools and techniques that enable firm leadership?and?their supervisors to assess organizational culture and non-financial risks more effectively and proactively.?

Orchestrating such collective action will demand determined leadership. And, so, we ask you: where should we look for such?