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.