Two stern warnings regarding bank compliance efforts were issued by two Federal Reserve officials this week. The message from William Dudley, president of the Federal Reserve Bank of New York: if financial institutions don’t fix their culture problem, they risk being downsized and broken-apart. Meanwhile, Fed Governor Daniel Tarullo blasted banks that take a “check-the-box” approach to compliance.
Dudley, speaking at a conference on “Reforming Culture and Behavior in the Financial Services Industry” held by the Federal Reserve, said senior leadership and boards must take an active role in improving a firm’s culture or they risk having regulators step in to break them apart into more manageable entities, he said.
Since 2008, fines imposed on the nation’s largest banks have exceeded $100 billion. “I reject the narrative that the current state of affairs is simply the result of the actions of isolated rogue traders or a few bad actors within these firms,” Dudley said. “The problems originate from the culture of the firms, and this culture is largely shaped by the firms’ leadership.”
Dudley posed the question of whether the size, complexity and global scope of large financial firms have made them “too big to manage.” Also affecting culture, he proposed, is a shift in the prevailing business model away from commercial and investment banking activities to trading. “Clients became counterparties—the other side of a trade—rather than partners in a long-term business relationship,” he said. “Interactions became more depersonalized, making it easier to rationalize away bad behavior.”
Pay incentives that are linked to short-term profits have also contributed to a lessening of firm loyalty—and, sometimes, to a disregard for the law, Dudley added, offering a plan for how compensation policies could be redesigned to reduce excessive risk-taking. He wants more compensation to be deferred, for longer periods, accompanied by a shift away from equity and to debt. A deferral period might be five years, with uniform vesting over an additional five years to provide sufficient time for any illegal actions or violations of the firm’s culture to materialize and fines realized.
Deferred debt compensation could be used as a “performance bond,” similar to security deposits on rental properties. Fines would be paid for out of a firm’s deferred debt compensation, with only the remaining balance carried by shareholders. In the case of a large fine, the senior management and “material risk-takers” would forfeit their performance bond. “Each individual’s ability to realize their deferred debt compensation would depend not only on their own behavior, but also on the behavior of their colleagues,” he said. “This would create a strong incentive for individuals to monitor the actions of their colleagues, and to call attention to any issues.”
As for traders, “who cross ethical boundaries and move from one firm to another in order to escape the consequences,” Dudley pitched a central registry to track the hiring and firing of financial professionals across the industry. “It would be helpful if individuals in finance who are convicted of an illegal activity were prohibited from future employment in the financial services industry,” he said.
Tarullo, speaking at the same conference, make a push for “good compliance, not mere compliance.” “In some firms the attitude we perceive is one of a mere compliance exercise,” he said. “The firm proceeds to address the deficiencies identified by the Fed in a discrete, almost check-the-box fashion.”
He asked: “Are compliance programs put in place by risk managers or general counsels understood as a kind of background noise that should not drown out the voices urging employees to ‘make their numbers,’ or are they seen as reflecting the views and priorities of senior management?”
Tarullo conceded that regulators can “unwittingly reinforce a mere compliance mentality” because banks need to be able to determine how a regulation actually applies to them. “Beyond that kind of unavoidable focus on narrow compliance, however, management and line employees are more likely to adopt a mere compliance mentality where regulations appear to them to have been poorly drafted or implemented,” he said.
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