Eliminate incentives that encourage bad behavior: N.Y. Fed's Dudley

WASHINGTON — New York Federal Reserve Bank President William Dudley called on the banking industry to take a proactive stance in policing its culture, starting with how institutions incentivize workers.

Speaking before the U.S. Chamber of Commerce Monday, Dudley said the scandals that have plagued the industry leading up to and especially following the financial crisis pose a greater risk than is generally assumed. He noted that banks have paid, according to one estimate, $320 billion in fines associated with misconduct since the crisis.

“We need to recognize that an effective regulatory regime and comprehensive supervision are not sufficient,” he said. “We also need to focus on the incentives facing banks and their employees. After all, misaligned incentives contributed greatly to the financial crisis and continue to affect bank conduct and behavior.”

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Dudley, who is retiring later this spring, has been a frequent critic of the banking industry’s culture in the past. He argued in Monday’s speech that ongoing misconduct — including the Libor scandal, manipulation of foreign exchange markets and most recently the cross-selling problems at Well Fargo — suggests a deeper prioritization of short-term profit over long-term stability.

To improve its culture, the industry could take more collective, industry-wide actions to screen out so-called “rolling bad apples” — corrupt individual employees who move from institution to institution, he said. An anonymous third-party survey of bank employees could give bank management a better idea of what is happening within the industry, and an industrywide database of employee misconduct could help prevent bad actors from remaining in the business.

It is also critical that bank management align their own compensation — as well as employee pay — away from short-term goals like share price and toward more long-term stability and prudence. One way of doing this would be to have deferral payments to senior management made in the form of long-term debt — known as Total Loss Absorbing Capacity, or TLAC — rather than stock grants. This would have the dual effect of incentivizing stability and putting management's own compensation on the line in the event of failure.

In addition, Dudley said that top officials should take more responsibility for paying fines associated with misconduct.

“Shareholders should not be shielded from costs and fines — they may also have profited from short-term gains — but it doesn’t seem fair or prudent to shield the decision-makers from responsibility for costly breakdowns as much as they are now,” he said. “I suspect changes in these areas would lead senior managers to encourage their staff to speak up earlier about emerging risks, be more attentive when red flags were raised, and respond sooner and more forcefully.”

Some banks have experimented with this idea, Dudley said, but he added that it is also critical for the Fed and other regulators to partner with banks in overcoming first-mover disincentives and other practical considerations.

“Ultimately, establishing and maintaining an effective culture with appropriate risk governance and controls is the responsibility of individual firms and the industry, but the official sector can help by highlighting best practices and addressing collective action problems and other market failures,” Dudley said.