Mark Roe writes: At a closed-door conference attended by senior bankers, regulators, and some academics, Federal Reserve Governor Daniel Tarullo and Federal Reserve Bank of New York President William Dudley used their bully pulpit to do something unexpected. Instead of focusing on how to bolster bank stability \u2013 channeling more capital toward the largest institutions, curbing their riskiest activities, and determining how to manage a failing bank without bailing it out \u2013 the officials discussed the bankers themselves.<\/p>\n
Tarullo focused on managerial misbehavior, arguing that managers who do not comply fully and willingly with regulations should face tougher sanctions than they do now. Instead of blaming \u201ca few bad apples\u201d for wrongdoing, he insisted, institutions should implement controls that prevent \u201cbad apples\u201d from poisoning the organization. To this end, organizations should embed respect for law, regulation, and the public trust in internal compensation systems.<\/p>\n
Moreover, Tarullo cited criminal prosecution and imprisonment of individuals as the most effective way to deter illegal conduct, such as breaches of antitrust law. Of course, as he acknowledged, prosecuting an individual for such violations is difficult, because regulators lack criminal enforcement powers, evidentiary hurdles are high, and the circumstances are often uncertain. But regulators have not taken enough advantage of the authority that they do have to punish errant managers: they can ban these individuals from working in finance.<\/p>\n
According to Tarullo, a few well-chosen \u201cbans from banking\u201d could change the financial industry for the better. He urged bank boards and senior executives to preempt such bans by firing highly problematic managers publicly, rather than sending them quietly out the back door. Public executions would deter the rest of the organization from bad behavior.<\/p>\n
Dudley also placed the onus for change on senior bank managers. In discussing bank culture \u2013 a major topic of interest for him and the New York Fed \u2013 he encouraged senior bankers to align their organizations\u2019 cultures with the public interest and regulatory parameters. Instead of viewing the law as a problem to manage and, if possible, evade, bankers should recognize and respect its vital importance (a point that Tarullo also made). In this sense, Dudley said, the banking industry \u201cis not close to where it needs to be.\u201d<\/p>\n
Like Tarullo, Dudley stressed that violations should not be treated as isolated actions by deviant employees, but as evidence of failure by senior managers \u2013 from the boardroom to the executive suite \u2013 to orient bank culture properly. Violations should thus catalyze a concerted effort by senior managers to bring so-called rogue bankers under control and to infuse their organizations with an ethos of compliance and integrity. If they are unable to do so, Dudley argued, a reasonable conclusion would be that the organization is too big to manage.<\/p>\n
For at least a few listeners, this statement probably evoked memories of the trader known as the \u201cLondon Whale,\u201d who lost at least $6 billion at JP Morgan Chase \u2013 America\u2019s largest bank \u2013 in 2012. The bank\u2019s risk-management team, reputedly the best in the world, failed to identify a rogue trader in their midst until it was too late.<\/p>\n
The focus on individuals\u2019 responsibility within banks represents a notable change in regulators\u2019 approach, and it was reinforced by a third initiative, which other speakers emphasized: using deferred debt-based compensation to tie managers\u2019 pay to bank safety and soundness.<\/p>\n
Catalyzing a shift in bank culture will not be easy. Bankers know that assuming substantial amounts of low-probability, high-impact risk often benefits bank shareholders and bolsters their own bonuses. But, when things go wrong, the government picks up much of the bill \u2013 and the real economy suffers.<\/p>\n
Complicating matters further is that risk-taking by banks \u2013 even at extreme levels \u2013 is not always unethical, rogue, or fraudulent. It often appears responsible and innovative. The problem with innovation is that no one can predict the precise impact it will have. In fact, the 2008-2009 financial crisis was more a consequence of error and misdirection than fraud and explicit misconduct by bankers.<\/p>\n
Nonetheless, the kind of cultural and behavioral initiatives that Tarullo and Dudley proposed are worth pursuing. Indeed, aligning the financial interests of managers and senior bankers with regulators\u2019 efforts to boost capital, reduce risk, and make bank failure a real possibility would go a long way toward making banks safer.<\/p>\n
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