Banks need to stop rewarding the kind of bad behavior that led to the Wells Fargo fake accounts scandal and other banking misdeeds, New York Fed President William Dudley said Monday.
With Congress pushing through rollbacks to the Dodd-Frank reforms passed following the financial crisis, Dudley said the lessons from the systemic failure of the banking system shouldn’t be ignored.
While acknowledging some need for fine-tuning in the regulations, he pushed for several other changes to make sure the mistakes of the past aren’t repeated.
“We need to recognize that an effective regulatory regime and comprehensive supervision are not sufficient. We also need to focus on the incentives facing banks and their employees,” Dudley told the U.S. Chamber of Commerce in Washington D.C. “After all, misaligned incentives contributed greatly to the financial crisis and continue to affect bank conduct and behavior.”
He cited several high-profile bank scandals: the Wells Fargo case, in which employees trying to meet sales goals created some 3.5 million fake accounts; trader manipulation of the London Interbank Offered Rate, an overnight fee that banks charge each other to borrow; and manipulation in the forex market.
In each of the three cases, financial incentives drove bank employees to cheat.
“These recent cases were particularly disturbing in terms of their scale and flagrancy, and — in the case of the rate-rigging scandals — the collusion by employees across firms,” Dudley said. “These episodes underscore the tremendous power that incentives have to influence and distort behavior, potentially leading to massive damage to bank cultures, reputations, and finances.”
Dudley proposed several changes to combat the way bad behavior is awarded. Among them:
- Making managers, not shareholders, more personally liable for fines and “other legal liabilities” incurred through violations.
- Changing compensation structure away from cash and deferred stock grants to reward performance not focused just on the short term.
- Keeping a database of “rolling bad apples,” or violators who move from one firm to the other, unbeknownst to their employers.
- Conducting an industry-wide survey focused on assessing corporate culture and risk-taking.
“Having a regime in place that creates strong incentives for management to steer aggressively away from bad outcomes would be better than one in which management has incentives to temporize in the face of rising risks,” Dudley said.
The current batch of changes to the Dodd-Frank reforms includes adjustments to the so-called Volcker Rule that prohibits banks trading for their own benefit with client money and raising the asset threshold under which banks face intense regulatory scrutiny. Primarily, the changes are focused at making regulations easier and less costly for community and regional banks, but critics worry that the changes will make the system less stable.
As things stand now, Dudley said the banking system has improved greatly since the crisis days.
“The banking system is much sounder and more resilient as a result, in a number of ways,” he said. “But, even as we reduce or eliminate old vulnerabilities, we must not rest on our laurels, for new vulnerabilities will inevitably take their place.”
Dudley is in the final months of his position atop the New York Fed. He announced previously that he will retire in mid-year, and a search committee is continuing to seek his replacement.
