The various forms of misconduct impose direct costs such as fines, legal fees in investigating allegations and defending lawsuits, and internal monitoring costs that should matter to firms. In this view, a principal benefit to a financial firm of having a strong culture that builds trustworthiness is the avoidance of the bad behavior that can carry significant monetary costs and can inflict destructive damage to the organization’s reputation. Firms should have every incentive to manage and internalize those potential costs. More broadly, there may be additional adverse effects on other firms or the financial sector as a whole if there is a widespread lack of trust in financial services. Similarly, my colleague Michael Strine has argued that the financial industry exists, in part, to enhance the public good and thus faces a higher degree of social responsibility due to its role in supporting the broader economy.4 Both of these effects suggest a role for the public sector in facilitating appropriate behavior and conduct in the financial services industry. Supervision can contribute to this through support for the development of effective internal governance regimes, prudent risk management policies, and strong compliance and control structures, all within a framework of effective oversight from the Board of Directors. Conclusion To conclude, I’ve spoken today about the conceptual rationale for public sector intervention through supervision and some practical issues related to how we execute on our supervisory responsibilities at the Federal Reserve Bank of New York.
They can insist upon higher standards of financial reporting and transparency, facilitating better risk assessment of the counterparties and borrowers. And, on the more technical level, they can also ensure that the risks arising from the payments system infrastructure - especially the wholesale payments system - are minimised, reducing the danger that a failure of one institution will set off a chain reaction among other financial institutions that are its direct creditors. The importance of strengthening our defences in all these various ways against systemic financial disturbances can hardly be over-emphasised. Over the past 15 years something like 150 of the 180 or so member countries of the IMF have experienced significant banking sector distress, in many cases amounting to full-blown crises. Some Bank of England estimates of the costs of financial instability suggest that banking crises have over the past 25 years caused a cumulative loss of output of as much as 15-20% of GDP in the countries concerned. But finance is, as I say, inherently a risk business. And however much effort we put in to accident prevention - however vigilant we are - we have to recognise that accidents will occur. So we have to be prepared to limit the damage that they may cause.