How Serious is NY Fed Dudley’s Tough Talk About Fixing Banking Culture?

Last week, New York Fed President William Dudley gave a speech on remedying cultural problems in financial services firms, meaning the tendency of employees to loot them and leave the mess in taxpayers’ laps. It caught pretty much everyone by surprise because it contained two sensible and effective reform ideas, namely, that of putting compensation measures in place that would have the effect of rolling them a long way back towards the partnership model, as well as making it harder for bad apples to find happy homes in other firms.

My sources are of the view that Dudley was browbeaten into taking a tougher line by the Federal Reserve Board of Governors, specifically Danny Tarullo, rather than being keen to be more aggressive himself. It was blindingly obvious that the banks had a culture problem in 2009 and 2010, when industry incumbents paid themselves record bonuses rather than at least feigning gratitude and building up their capital bases. We described in July how the Fed was having tea and cookies conversations about banks shaping up their cultures, which looked to be a pathetic exercise in public relations for the rubes.

Nevertheless, the fact that Dudley is pushing some tough ideas is an important shift, even if the New York Fed president was under pressure to look serious. One notable contrast between the US and the UK has been the willingness of the central bank to criticize the conduct of its major charges. The Bank of England, at least under Mervyn King, engaged in regular, pointed criticisms, and fought fiercely for a version of Glass Steagall to be implemented. It only partially won that fight due to bitter opposition from Treasury; the compromise of ring-fencing retail operations is still a meaningful improvement over status quo ante.

By contrast, the authorities have been loath to say anything negative, as in reality-based, about the major banks, lest they upset the confidence fairy.

The novel idea in the Dudley speech is to defer a big chunk of bonuses of big producers, particularly traders and senior executives, for a sufficiently long period that any reversals, such as trades that produced book profits in one period turning a cropper later on, or lawsuits and fines, would have surfaced. Those bonuses are paid only after these charges are deducted. Dudley calls this a performance bond; you can also think of it as the most junior equity, sitting underneath common equity.

This is Dudley’s pitch for this arrangement:

In addition to a strong compliance function, firms need to foster an environment that rewards the free exchange of ideas and views. Individuals should feel that they can raise a concern, and have confidence that the issues will be escalated and fully considered. This is a critical element to prevention. A firm’s employees are its best monitors, but this only works well if they feel a shared responsibility to speak up, expect to be heard and their efforts supported by senior management….

The optimal structure of deferred compensation likely differs with respect to the goals of providing incentives to support prudent risk-taking versus encouraging the right culture. For example, consider trades that might appear to be highly profitable on a mark-to-market basis, but take some time to be closed out and for the profits to be realized in fact, not just on paper. In this case, as long as deferred compensation is set at a horizon longer than the life of the trade, this can ensure the firm’s and the trader’s incentives are aligned and the “trader’s option” is effectively mitigated. This component of deferred compensation could take the form of either cash or equity.

However, in contrast to the issue of trading risk, unethical and illegal behavior may take a much longer period of time—measured in many years—to surface and to be fully resolved. For this reason, I believe that it is also important to have a component of deferred compensation that does not begin to vest for several years. For example, the deferral period might be five years, with uniform vesting over an additional five years. Given recent experience, a decade would seem to be a reasonable timeframe to provide sufficient time and space for any illegal actions or violations of the firm’s culture to materialize and fines and legal penalties realized. As I will argue below, I also believe that this longer vesting portion of the deferred compensation should be debt as opposed to equity…

Assume instead that a sizeable portion of the fine is now paid for out of the firm’s deferred debt compensation, with only the remaining balance paid for by shareholders. In other words, in the case of a large fine, the senior management and the material risk-takers would forfeit their performance bond. This would increase the financial incentive of those individuals who are best placed to identify bad activities at an early stage, or prevent them from occurring in the first place. In addition, if paying the fine were to deplete the pool of deferred debt below a minimum required level, the solution could be to reduce the ratio of current to deferred pay until the minimum deferred compensation debt requirement is again satisfied—that is, until a new performance bond is posted.

Not only would this deferred debt compensation discipline individual behavior and decision-making, but it would provide strong incentives for individuals to flag issues when problems develop. 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. This would create a strong incentive for individuals to monitor the actions of their colleagues, and to call attention to any issues. This could be expected to help to keep small problems from growing into larger ones. Importantly, individuals would not be able to “opt out” of the firm as a way of escaping the problem. If a person knew that something is amiss and decided to leave the firm, their deferred debt compensation would still be at risk. This would reinforce the incentive for the individual to stay at the firm and to try to get the problem fixed.

The five-year deferral component resembles the arrangement that Berkshire Hathaway has in its reinsurance business, where bonuses that total 15% of unit profits are paid out five years after the business is booked. That’s a long enough period to determine whether the deal has worked out or not.

The performance bond element is clearly better than popular but failed idea of having bankers get restricted stock. Both Bear Stearns and Lehman had very significant stock ownership by employees.

The second element of Dudley’s idea is to create an industry database similar to one used for retail brokers, to track the hiring and firing of professionals. This isn’t a bad idea, but it would tend to catch only employees who engaged in flagrantly bad conduct. It’s not obvious that those who engaged in “didn’t pass the smell test” behavior would get any demerits. But this is still an idea that can’t hurt and has the potential to do some good at the margin.

But how serious is this? The New York Fed does not have the power to implement the rule, so the industry knows that even if Dudley had his heart behind these proposals, this is more bark than bite. But the flip side is that industry leaders ought to recognize this as a long-overdue shot over their bows. And the fact that Dudley has endorsed this notion means it’s fair game for legislation. In other words, even though financiers are too deeply invested in their own sense of entitlement to get Dudley’s message, he’s telling them that if they don’t clean up their acts, something they don’t like really could be imposed on them. I’d love to be proven wrong, but I wouldn’t place a large wager that anyone will take the hint.

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  1. vlade

    There was a third part to Dudley’s speach, which was also interesting, and in effect said (IIRC) “you can reform yourself, or we can reform you. The latter is going to be more painful”.

    First I thought it to be positive, but now, when you say that he was pressured for this, I think he may have been offering a way out – where the industry makes some trivial, not substantive reforms, and sells it as the solution so the other ideas don’t get implemented. TBH, I doubt any industry led initiative here would be honest, as there’s no incentive for them to do so.

    1. Yves Smith Post author

      Given that Dudley can’t do that directly (the NY Fed lacks that authority), I also discounted that part of the speech. The US doesn’t do things the Japanese were willing to do torture firms into behaving, like have horribly intrusive audits going all the time. You did not want to be on the receiving end of MOF (Ministry of Finance) audit. That treat alone would bring foreign firms to heel (Japanese firms knew better than to mess with the MOF).

  2. not_me

    rather than at least feigning gratitude and building up their capital bases. Yves Smith

    Purely private* banks would surely be cognizant of the need to maintain adequate capital (and reserves for that matter) or else they’d be devoured by their competitors.

    Why should banks be privileged when all other businesses are expected to swim or sink on their own? TBTF is a consequence of “Too privileged to be responsible.”

    And purely private banks would surely be very picky in who was allowed to run them since one ruined bank would be the end of its senior management and board members for the rest of their lives.

    *no government deposit insurance, no fiat lender (actually creator) of last resort, no borrowing by the monetary sovereign.

    1. washunate

      Yep, that seems to be the situation nobody wants to touch. The banks aren’t really private entities.

      1. Schofield

        “Yep, that seems to be the situation nobody wants to touch. The banks aren’t really private entities.”

        Indeed the creation of money is a political act in its ramifications or consequences but main-stream economists refuse to countenance this!

        Peter Radford makes this clear in his article “Is Economic Orthodoxy Anti-Democracy?” (You can substitute “Anti-Political Equality” for “Anti-Democracy if this makes his article clearer). Here is a key sentence describing the Neo-Liberal, or Neo-Conservative, Utopian Myth we currently live under:-

        “At its onset the modern neo-liberal project was a search for a way of organizing civil society without that organization being imposed in what had hitherto been an overt political, that is power relationship, sense.”

        1. not_me

          “At its onset the modern neo-liberal project was a search for a way of organizing civil society without that organization being imposed in what had hitherto been an overt political, that is power relationship, sense.” Peter Radford

          Except neo-liberals absolutely depend on the power of the State or they have at least co-opted it. Let’s make no mistake, government deposit insurance, a fiat lender of last resort, borrowing by the monetary sovereign all require the power of the State. The huge irony is that the enemies of neo-liberals usually think those are GOOD things! They’ve been hoist by their own petard!

          1. skippy

            The problem being is banks are just a hop and a skip away from the agency which drove – twisted even good polices to ruin, this is where some go off the rails because of some metaphysically informed bias and a global game of risk. –

            “A partial list of FEE’s original donors in its first four years includes: The Big Three auto makers GM, Chrysler and Ford; top oil majors including Gulf Oil, Standard Oil, and Sun Oil; major steel producers US Steel, National Steel, Republic Steel; major retailers including Montgomery Ward, Marshall Field and Sears; chemicals majors Monsanto and DuPont; and other Fortune 500 corporations including General Electric, Merrill Lynch, Eli Lilly, BF Goodrich, ConEd, and more.

            The FEE was set up by a longtime US Chamber of Commerce executive named Leonard Read, together with Donaldson Brown, a director in the National Association of Manufacturers lobby group and board member at DuPont and General Motors.”

            Now some like to point at banking when the shadow system is orders of magnitude larger and largely unregulated and a big part of the GFC.

            Skippy… sadly the free market folks brought this all on themselves, metaphysical arguments in vacuums based on antiquarian concepts, bundled ad hoc together as a PR marketing psy-opt…. do have consequences….

            1. not_me

              twisted even good polices to ruin, skippy

              Stealing from the poor for the benefit of the rich and other so-called credit worthy is NEVER a good policy. Sure it can give the poor jobs – as wage and debt slaves.

              As for shadow banking, I doubt it could exist to any large extent without the highly privileged commercial banking system including the central banks. But even if it could, its depositors would be 100% voluntary so who cares anyway? Do we cry over those who go to Las Vegas and lose? I don’t.

              “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Henry Ford from

              1. skippy

                The shadow system does not need CBs, IMF or any other network intermediaries, lack of knowlage can distort reality imo. This get back to your past hand waving at derivatives, you said, you had no need to understand such things as they were irrelevant. A case of convenience or blinkers IDK, yet they can be called HPM, so there you go.

                As your premise wrt to money is wrong so will your thoughts about it be dysfunctional.

                Skippy…. No fan of Ford here… See – “The following is excerpted from a report printed by the United States Senate Committee on the Judiciary in 1974:

                The activities of General Motors, Ford and Chrysler prior to and during World War II…are instructive. At that time, these three firms dominated motor vehicle production in both the United States and Germany. Due to its mass production capabilities, automobile manufacturing is one of the most crucial industries with respect to national defense. As a result, these firms retained the economic and political power to affect the shape of governmental relations both within and between these nations in a manner which maximized corporate global profits. In short, they were private governments unaccountable to the citizens of any country yet possessing tremendous influence over the course of war and peace in the world. The substantial contribution of these firms to the American war effort in terms of tanks, aircraft components, and other military equipment is widely acknowledged. Less well known are the simultaneous contributions of their foreign subsidiaries to the Axis Powers. In sum, they maximized profits by supplying both sides with the materiel needed to conduct the war.

                During the 1920’s and 1930’s, the Big Three automakers undertook an extensive program of multinational expansion…By the mid-1930’s, these three American companies owned automotive subsidiaries throughout Europe and the Far East; many of their largest facilities were located in the politically sensitive nations of Germany, Poland, Rumania, Austria, Hungary, Latvia, and Japan…Due to their concentrated economic power over motor vehicle production in both Allied and Axis territories, the Big Three inevitably became major factors in the preparations and progress of the war. In Germany, for example, General Motors and Ford became an integral part of the Nazi war efforts. GM’s plants in Germany built thousands of bomber and jet fighter propulsion systems for the Luftwaffe at the same time that its American plants produced aircraft engines for the U.S. Army Air Corps….

                Ford was also active in Nazi Germany’s prewar preparations. In 1938, for instance, it opened a truck assembly plant in Berlin whose “real purpose,” according to U.S. Army Intelligence, was producing “troop transport-type” vehicles for the Wehrmacht. That year Ford’s chief executive received the Nazi German Eagle (first class)….

                The outbreak of war in September 1939 resulted inevitably in the full conversion by GM and Ford of their Axis plants to the production of military aircraft and trucks…. On the ground, GM and Ford subsidiaries built nearly 90 percent of the armored “mule” 3-ton half-trucks and more than 70 percent of the Reich’s medium and heavy-duty trucks. These vehicles, according to American intelligence reports, served as “the backbone of the German Army transportation system.”….

                After the cessation of hostilities, GM and Ford demanded reparations from the U.S. Government for wartime damages sustained by their Axis facilities as a result of Allied bombing… Ford received a little less than $1 million, primarily as a result of damages sustained by its military truck complex at Cologne…

                Due to their multinational dominance of motor vehicle production, GM and Ford became principal suppliers for the forces of fascism as well as for the forces of democracy. It may, of course, be argued that participating in both sides of an international conflict, like the common corporate practice of investing in both political parties before an election, is an appropriate corporate activity. Had the Nazis won, General Motors and Ford would have appeared impeccably Nazi; as Hitler lost, these companies were able to re-emerge impeccably American. In either case, the viability of these corporations and the interests of their respective stockholders would have been preserved.

                Extracted from Bradford C. Snell, American Ground Transport: A Proposal for Restructuring the Automobile, Truck, Bus and Rail Industries. Report presented to the Committee of the Judiciary, Subcommittee on Antitrust and Monopoly, United States Senate, February 26, 1974, United States Government Printing Office, Washington, 1974, pp. 16-24.”

                1. not_me

                  I’m not a fan of Ford either and no doubt he probably took advantage of the system he criticised IF he criticized it since he said “It is well enough that people of the nation do not understand our banking and monetary system, ”

                  And again, I don’t see why you have such concern for gamblers, as long as they are not subsidized by government, which currently they are. So let’s eliminate those subsidies.

                  As for derivatives, they are just bets, as far as I can see, and that’s what gamblers do, make bets.

                  1. skippy

                    When I use the term banks, I use it in the payment system manner. The risk was dealt with before but, a mob decided to set metaphysical rational pony’s free.

                    Born got the treatment for speaking up with an informed opinion, about a bet that has wrought wreckage to everyone, save the top to include sovereign nations. So blithe hand waving seems misinformed or worse. Additionally all capitalism is about risk, at its core, so gambling is its very nature at the end of the day.

                    It might behoove you to take the political view before getting all done in the head by antiquarian biases, as informed by say just the 1900s, especially the changes post WWII and the big ones around the 70s inflection point.

                    Skippy… pro tip… don’t use stuff you don’t understand and then offer milquetoast excuses.

                    1. not_me

                      When I use the term banks, I use it in the payment system manner. skippy

                      Of course we need a payment system, but the solution for the risk-free storage and transactions with what is after all government money, fiat, is a Postal Savings Service for all citizens or, if you like, every citizen shall have an account at the central bank thus removing the distinction between people and banks.

                      And whether we have a Postal Savings Service (PSS) or central bank accounts for all citizens there should be no fiat lender of last resort; if checks bounce then they bounce. If private entities wish to underwrite checks, then they may, of course. Nor should the PSS or central bank pay interest (because the accounts are risk-free) and it should be a free service up to median account size and number of transactions provided as a normal duty of a monetary sovereign. Past the median, account holders would pay.

                      Now if people want interest then they could lend money themselves or entrust that task to the now 100% private banks with 100% voluntary depositors.

                      Thus we would have a clear distinction between risk-free storage and transactions with fiat and lending such that risk takers would bear all risk and not the general public.

                      The current system is a corrupt mishmash of risk-free storage and lending for interest and there’s no legitimate excuse for it.

                    2. skippy

                      What is risk free about losing PPP at 2%ish a year in PSS deposit and as far as I can tell noone lost deposits. Still as one of today’s links shows and all the data supports, is people don’t have enough wages to engage in oldtimey savings for emergencys or retirement. It smells like the IS-LM metric, another failed sociopolitical template.

                      It all goes back to the deliverance of wages to productivity, that has to be addressed first, next is job longevity and quality. It is the basis of everything else. Which goes hand in hand with bringing both corporatism and lending institutions to heal.

                      Skippy… banking did not blow up the world… a failed ideology did… now their grinding gears…

                    3. not_me

                      It all goes back to the deliverance of wages to productivity, that has to be addressed first, next is job longevity and quality. … Skippy… banking did not blow up the world… a failed ideology did … skippy

                      Without government-backing for private credit creation for the benefit of the business and industry among other co-called creditworthy, business and industry would have been FORCED, by competitive pressure, to share productivity gains with workers either by paying higher interest for the workers’ savings or by paying them to some extent with shares in the ownership of the company.

                      Now admittedly, existing gross wealth inequality would have made it less necessary for business and industry to share equity with workers. Still, new companies often displace old companies and if those new companies are ethically financed then existing wealth inequality is reduced without new wealth inequality to replace it. Consider how General Motors, a common stock company, rapidly overtook and surpassed Ford, which was privately owned.

                    4. skippy

                      You have century’s to contend with regardless of your religiously informed biases. Hardness.

                      Sure Gov should not slavishly bend to corporatist will, but hay, the generational effects of fighting the gawdless meant certain sacrifices and a magnification of individuality to offset it.

                      That those involved in this little play now cry split milk and want to secure their proceeds, is just one more sign of their disposition to everyone else, including the orb. The bit about emotive moralizing for the plight, of the small fry, is just another indication of some kinda psychosis.

                      Skippy… random thought experiments conducted in vacuums has about as much mass as it environment.

      2. fresno dan

        Remember that old line, “Owe the bank a million, and you have a problem. Owe the bank 100 million, and the bank has a problem.”
        I suggest it be rephrased, “get 340 dollars a month from the government and your a lazy, shiftless, welfare cheat. Get 34 Billion a month and your a virtuous, risk taking capitalistic GDP growth promoting paragon of virtuous entrepreneurship and capital allocation (because free markets, which may seem to be contradicted by government giving banks trillions, but that’s because your not a sophisticated economist….)

  3. Jesper

    The proposal is still “Heads I win, tails you lose”: If the trade is profitable there’ll be bonus, if the trade is a disaster the consequence is no bonus….

    Under such terms, who would not make the gamble?

    1. diptherio

      Quite true…but at least folks would have the incentive to make better gambles…

      I’m filing this one under “too little, too late”—subheading “I’ll believe it when I see it.”

  4. Si

    Ok….what I know about “culture change” is that it starts from the top. Without massive change here, nothing beyond ‘optics’ is going to be different. So, ask if there will be wholesale change at the heads of the TBTF banks. I will spare you the agonising…. No!

    No-one has been jailed for the fraud, so what are going to be the painful repercussions for those who don’t change? The simple answer, I am afraid to say, is that this is a PR exercise, designed to do nothing more than give the impression that the masses are going to be in ‘good hands’.

    We are not. Nor are we going to be.


  5. charles 2

    Mmmmh… If implemented, this is how I see this develop :
    1) Bankers sell their interest in the performance bond to “special situation” hedge funds at deep discount (say 50%)
    2) The most senior of them get remunerated by the funds for bringing people (from their current firm or other firms).
    3) After a few years of calms, these hedge funds show solid profitability, low volatility and the shares of these fund becomes liquid, they get marketed to funds of funds
    4) To boost profitability, the funds of funds use leverage, by borrowing from banks ( why not the same who issue performance bonds)

    When the proverbial waste hits the proverbial rotating device with blades. the banks loose not much less than in the present system, bankers and lawyers are still rich, and bank shareholders/creditor fleeced.

    Wrong solution to an ill-diagnosed problem. The real problem is maturity mismatch. Funds these long term deals (or activities) with matching maturities and they probably won’t exist any more.

  6. washunate

    That’s some pretty weak tea from the let them eat iPads division. How about instead of deferred compensation, we arrest criminals, put bankrupt firms through bankruptcy, and not allow any organization to be big enough (or interconnected enough) that its failure causes systemic problems?

    Although, to be fair to the highly paid staff at the Fed, that’s probably too complicated for them.

    1. Banger

      This is an effort for the community to police itself and try to make it more sustainable. After awhile, rewarding criminality becomes destructive to any system unless the enterprise is 100% criminal–and as bad as the financial industry is it hasn’t gone there yet.

      Let’s be clear here, you can’t put oligarchs in jail unless other oligarchs agree–you can talk about democracy and equal justice under law but that is a fantasy–we don’t live in that kind of society and are unlikely to live in one anytime soon.

      1. washunate

        I hear you that this could be self-policing advocacy. But I feel like it warrants more ridicule than that. This reads like an attempt at external communication – superficial PR – not internal financial community commentary. Dudley’s concern isn’t about the substance of the financial system. It’s about how the public perceives it.

        Except that, like Dudley’s foray into inflation and grocery shopping, he’s so out of touch he doesn’t realize how out of touch he is.

        This is the beginning of his prepared remarks [my bold]:

        “As I noted earlier at the start of today’s workshop, improving culture in the financial services industry is an imperative. This endeavor is important in order to ensure financial stability over time, but also to ensure the public trust in our financial system.”

      2. washunate

        P.S., just to give a little bit of the more detailed HR/OB humor in Dudley’s remarks, thought I’d highlight this passage:

        “Firms must take a comprehensive approach to improving their culture that encompasses recruitment, onboarding, career development, performance reviews, pay and promotion. All of these elements need to be aligned with the desired culture. Through our supervisory process, we have seen that a number of firms have started this process by developing or refining employee surveys and 360 feedback processes to target issues of behavior and culture. Some firms are incorporating case study discussions into training programs to highlight ethical dilemmas and decision-making. ”

        Ooh, look at all that activity. 360 evals and employee surveys and case studies and ethical dilemmas. That’ll fix things.

      3. Vatch

        “you can’t put oligarchs in jail unless other oligarchs agree”

        As far as I can tell, in the U.S. this is true. The richest American to have been imprisoned appears to be J. Allen Stanford. Can anyone think of a richer American who has gone to prison?

  7. JEHR

    “but I wouldn’t place a large wager than anyone will take the hint.”

    should be “but I wouldn’t place a large wager THAT anyone will take the hint.”

    I thought that the constant misuse of “that” and “than” was a hit of the wrong key but it turns out not to be. It is very puzzling to have these two words reversed in usage as one is a conjunction and introduces a clause and the other is a subordinating conjunction:

    gkisseberth says:

    “THAT can be used as a conjunction, a determiner, or to start a noun or adjective clause.

    THAN is usually used only when making comparisons . . . .”

    In some languages the equivalent word is the same (e.g. in Spanish the word “que” is used for both meanings) so it can be confusing.

  8. susan the other

    Yes, it’s a real confidence builder to have Dudley admonish the banksters almost 10 years too late, and not to even mention the word “fraud.” Just unethical and illegal. And “illegal” was hard for him to spit out. Unless serious justice happens, even now at this late date, crap like this is goin nowhere.

  9. Jay M

    The Dud, hostage mode:
    Freeze, don’t exercise that Collateralized Debt Obligaition! I have tools in my toolkit–don’t move, I will lower interest rates.
    The Dud, reflective and philisophical:
    ZIRP nipped the emergence of a challenging middle class in the bud.
    The Dud, after “not inhaling:
    The bud will be distributed . . .
    (these are imaginary quotes and the Dub is a fictional character in this post, Thanks)

  10. ewmayer

    @ “you can’t put oligarchs in jail unless other oligarchs agree”

    …unless you’re an “evil thug with dictatorial tendencies” like, say, Vladimir Putin.

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