Weekend Reading: Tolerable Failures & the Price of Growth

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

This piece first appeared in Starling Insights' newsletter on January 26, 2025. If you are interested in receiving our thrice-weekly newsletter, among many other benefits, please consider signing up as a Member of Starling Insights.

Over the past several months, we have explored how shifting political winds are reshaping financial sector regulatory policy priorities globally. The post-Financial Crisis mantra of "safety and stability" has given way to increasingly urgent demands for "growth and competitiveness," and this transition presents regulators with a profound functional challenge: how best to promote economic vitality while maintaining system stability in an increasingly uncertain world.

Moreover, this functional challenge is paired with an equally thorny political challenge when efforts to meet the imperative of safety and stability are perceived to conflict with the imperative of growth and competitiveness.

As we discussed in a Weekend Reading late last year, 2024 witnessed a comprehensive drubbing of incumbent governments worldwide, with economic malaise proving decisive in what has been called "the biggest election year in history." From Washington to Westminster, Berlin to Brasília, voters have issued a clear mandate: deliver economic growth or out with you.

Perhaps nowhere is this in starker evidence than in the UK. Since taking office in July, Prime Minister Keir Starmer has made economic revitalization his government's primary mission. With October's controversial tax hikes damaging his Labour party's popularity, stagnant GDP figures, falling retail sales, and rising borrowing costs, demand for demonstrable economic growth and progress has only intensified.?

These pressures were thrown into sharp relief last week when, in a closed-door meeting reported by Bloomberg, Chancellor of the Exchequer Rachel Reeves criticized regulators for stifling economic growth. Going forward, the Chancellor insisted that regulators must "tear down regulatory barriers" and embrace a more pro-growth mindset.

Reeves' insistence reflects mounting political pressure. The post-Financial Crisis regulatory framework was erected upon the premise that system stability must take precedence over all other considerations, and that capital buffers must be broad enough to contain losses when firms fail so that "contagion effects" would not propagate throughout the system. Now, however, regulators are being asked to promote growth and innovation by freeing up capital and cutting red tape — without imperiling the system safeguards deemed essential after 2007-08.

How to strike that delicate balance?

The Accountability Paradox

In a letter delivered to the Prime Minister last week, Financial Conduct Authority (FCA) Chief Executive Nikhil Rathi stated clearly that, if the regulator is to satisfy political demands that it work to promote growth, this will necessarily imply that political leaders — and the public — be ready to accept greater instances of firm failures and consumer harm. "We will not stop all harm when making risk-based choices about the cases and intelligence we pursue," Rathi wrote, challenging political leaders to acknowledge this uncomfortable reality.

This represents a significant shift in policymaking discourse. Rather than simply acquiescing to political demands for growth-oriented reforms, the FCA is insisting that parameters around "tolerable failures" be clearly defined, and that metrics by which to judge the regulator's performance against those parameters be established.

While Rathi insists that he stands ready to implement "deep reforms" that aim to promote economic growth, he argued that effecting these changes will require "enduring acceptance" that the FCA will need to reprioritize deployment of limited resources and that, as an assured consequence, "there will be failures."

By taking this argument public, Rathi forces political leaders to state publicly just how much failure they are willing to tolerate, deftly shifting accountability for future failures away from regulators bending to the political will and implementing policy set by others: voters and opposition party leaders take note.

FCA Chair Ashley Alder expanded on this theme in an opinion piece published by City AM last week. "At the FCA we have long recognised effective regulation can be a powerful enabler of growth," Alder wrote, emphasizing how the regulator's primary objectives of protecting consumers, maintaining market integrity, and promoting competition all contribute to building the trust and confidence that undergird sustainable growth.

Alder further asserted that fulfilling a "secondary objective" to facilitate competitiveness and support growth would "require a bolder approach," insisting that this would demand "decisive trade-offs" and an increased risk appetite.

These dynamics point to a deeper challenge in regulatory reform. Recent history demonstrates that, when financial failures occur, political leaders readily attribute blame to regulators accused of lax oversight. The FCA, having weathered significant such criticism in recent years, appears understandably circumspect of loosening guardrails, should doing so mean that it will be held accountable when inevitable failures occur.

Regulators are confronted by what might be termed an "accountability paradox." While understandably insisting upon clear guidance as to the risk levels they should tolerate in their efforts to implement growth-oriented reforms, political leaders — mindful that they will face public judgment for any subsequent failures — are reluctant to set concrete risk tolerances.

Heads I win, tails you lose

The regulators' current quest for clarity ironically parallels longstanding industry frustrations.

For over a decade, financial institutions have sought similar specificity regarding regulatory expectations for culture risk governance. The consistent response from supervisory bodies has been to emphasize that it is a firm's responsibility to establish and demonstrate effective measures. Perhaps because they are unsure what to insist upon, supervisors have failed to provide direction as to how desired culture risk governance is either to be effected or evidenced.

Identifying firm culture as a key driver of potential misconduct, in 2016 the Financial Stability Board (FSB) established a Working Group on Governance Frameworks, chaired by Jeremy Rudin, at the time the Head of the Office of the Superintendent of Financial Institutions Canada (OSFI). The FSB Working Group set out "to explore the use of firms' governance frameworks to mitigate misconduct risk with a view to potentially developing a toolkit for firms and supervisors."

In 2018 the Working Group delivered its Toolkit. "It is for firms and authorities to determine how best to address conduct issues in their jurisdictions," the Toolkit demurely opens. "Therefore, rather than creating an international standard or adopting a prescriptive approach, the FSB is offering this toolkit as a set of options based on the shared experience and diversity of perspective of FSB members in dealing with misconduct issues."

Thus having rendered itself largely immaterial, the Toolkit swiftly goes on to assure that financial sector overseers are clearly off the hook when misconduct scandals erupt. "While authorities can take steps to promote strong internal practices at firms, these do not replace the actions that firms should take to promote appropriate conduct within their organisations."

Fair enough: the FSB believes that firms should be responsible for the misconduct they may exhibit. And in this connection, the Toolkit emphasized work done by the FSB to address "cultural drivers of misconduct" as these were viewed as "particularly important for mitigating misconduct risk from a financial stability perspective."

"A firm's culture plays an important role in influencing the actions and decisions taken by employees within the firm and in shaping the firm's attitude toward its stakeholders, including supervisors and regulators," the FSB Toolkit insists. "It also may allow or encourage misconduct by individuals, or large numbers of employees, particularly if instances of misconduct are overlooked."

Given such significance, what guidance does the FSB offer leaders responsible for addressing cultural drivers of misconduct risk within their firms?

Well, it doesn't. "The tools do not constitute guidance and are not a recommendation for any particular approach," the Toolkit reminds. In sum, the 19 "tools" identified by FSB offer little more than suggested hygiene.

Tool #1? Firms are advised that senior leaders should "articulate desired cultural features that mitigate the risk of misconduct." Tool #2? Firm leaders should seek to "identify significant cultural drivers of misconduct by reviewing a broad set of information and using multidisciplinary techniques." And Tool #3? Leaders should "Act to shift behavioural norms to mitigate cultural drivers of misconduct."

This is a bit like the International Civil Aviation Organization — the global standard-setting body for aviation safety — suggesting that Boeing executives should seek to implement a safety culture which emphasizes the desirability of assuring that the doors on its planes don't blow out mid-flight. As advice, it's hard to argue against. But it is risible to suggest that this is operationally instructive.

Dear CEO…

As the FSB's work reflects, discussions of "culture problems" have tended to emphasize culture as a driver of misconduct. But bad outcomes do not flow from misconduct only.

Indeed, it is far more often the case that well-intentioned professionals, making best efforts to operate soundly, fall short nevertheless.

At Starling, we saw this in repeated non-financial risk management failures across HSBC's Three Lines of Defense risk framework. Through the application of Predictive Behavioral Analytics, we were able to demonstrate that these risk management failures flowed from cultural drivers that shaped staff behavior in ways that could be anticipated. An ability to discern leading indicators?of such risk management failures equips leaders with the ability to course-correct?proactively.

In addition to driving bad behavior, culture may serve to undermine good behavior.

Last week, the UK's Prudential Regulation Authority (PRA)?recognized this explicitly.?In a "Dear CEO" Letter addressed to the leaders of international banks, the PRA suggested that "Boards should also consider where risk culture may be the root cause of material weaknesses in their firm's control environment."

This marks a significant step forward in discussions of culture as a supervisory concern, but it nevertheless reflects persistent limitations in regulatory guidance.

While the Dear CEO Letter takes the important step of explicitly identifying risk culture as a matter for boards to consider, and while it rightly suggests that culture may sit among the root causes of material weaknesses in control environments, it stops short of providing remedial guidance.

As we recently argued, this muddled messaging reflects the fact that, like firms, supervisors too seem unsure what?must be done to ensure that cultures support good performance outcomes — whether those that firms hope to achieve or those that we expect of supervisors themselves.

The parallel challenges faced by regulators and regulated entities alike in defining acceptable parameters for matters of culture risk governance point to a fundamental truth: we cannot effectively govern what we cannot measure.?

As we have long argued, resolving these "wicked problems" requires moving beyond simplistic discussions of culture to develop a more sophisticated understanding of how organizational culture dynamics drive outcomes.

Clearing the Log-Jam

Approaches to culture risk governance typically focus on organizational inputs that can be recorded (policies and processes) and the outputs that are subsequently in evidence (performance and problems). That is, they focus on tangible?inputs and?observable?outputs.?

But this ignores the cultural dynamics?that actually determine those outcomes. When problems emerge (outputs), the reflexive response is to revisit policies or processes (inputs), leaving the critical intermediary factors — "throughputs" — unrecognized and unexplored.?This is perhaps understandable: how are such throughputs to be examined?

Discussing the?"somewhat elusive nature"?of?these?challenges in a 2017 speech, Andrew Bailey — then heading up the FCA and now Governor of the Bank of England — described culture as "everywhere but nowhere." His speech went on to highlight precisely the thinking outlined above: "There is an active, sometimes passionate, debate on the meaning of culture," Bailey observed. "One form of this debate is to ask whether culture is an input to institutional behaviour, or is it a summary outcome?"

"I see culture as an outcome more than an input," Bailey explained.?His speech hints at?the significance of what I’m calling "throughputs" but doesn’t go far enough. "Cultural outcomes are the product of a wide range of contributory forces," Bailey allows. Among these are "the structure and effectiveness of management and governance" — things that can be observed — as well as the proverbial "tone from the top" and the incentives it creates — things that can be recorded and studied.

Bailey also points to?squishier elements like the greater degrees of "public interest influences" that are found to be at work in firms and "the willingness of people throughout the organisation to enthusiastically adopt and adhere to the tone from the top." He allows that "culture is characterised by a pattern of behaviours" but Bailey emphasizes "more structural determinants" of those patterns over "a more purely behavioural approach."?

This is sensible. "It is essential that the leadership of firms identify what drives their culture," Bailey insists. But rather than target culture directly, we must seek to "act on the many things that determine it." For Bailey — and no doubt for many others, myself among them, it is important that we focus on things that lend themselves to practical analysis and that can be rendered tractable. Culture, as often discussed, is some wooly thing that does not lend itself to practical measure.

Bailey neatly sums up where this past approach has left us: "You can't take institutional culture down from a shelf and seek to change it in some mechanical way." This view is prevalent and entirely understandable.

And it is this view that I am expressly seeking to challenge here with my emphasis on?structural "throughputs." These represent the living tissue of organizational culture, the medium through which formal governance structures and informal behavioral influences interact to produce observed conduct and performance outcomes.?

In our own culture risk governance work, we emphasize three critical dimensions:

1. People — Beyond formal organizational hierarchies, we must understand the informal networks through which work actually gets done. These social structures often prove more influential in shaping behavior than official reporting lines. "Tone from the Top" is of some value, perhaps, but it is woefully feeble when contrasted with the behavior-shaping power of peer influence.
2. Presumptions?— The unspoken assumptions and beliefs that guide decision-making frequently matter more than written policies or established processes. Understanding these operative mental models is essential for effective governance.?When policies and processes run counter to the way people?believe?they?should act, policies and processes fail, and leaders are regularly astonished to learn that people believe differently than any "Tone from the Top" emphasizes.
3. Practices?— Day-to-day behaviors often diverge significantly from formal processes, creating gaps between intention and execution.?Invariably, those gaps are glaringly obvious?in hindsight.?The trick is to render them visible with foresight so that remedial measures may be implemented proactively.

This diagnostic framework offers practical benefits for both regulators and regulated entities?alike.?Firms are made better able to drive desired culture risk governance outcomes?and?to anticipate such outcomes so they can engage in proactive remedial measures.?And supervisors are enabled to achieve a more fulsome?understanding of how these throughput dimensions determine performance outcomes,?thus enabling?more targeted and effective oversight.

It is?among these throughputs?that?those responsible for culture risk governance and supervision?will find the "root causes" of intentional misconduct and?control failures?alike.?

The adoption of this diagnostic approach, and the Predictive Behavioral Analytics tools that enliven it, would improve risk governance outcomes at reduced cost and regulatory burden, and advance supervisory capabilities without increased red tape, thus promoting growth and competitiveness while maintaining safety and stability.?The further cultivation and broad adoption of such capabilities has become an immediate political priority.