Federal Reserve Bank of New York President William C. Dudley suggested making long-term debt part of senior bankers’ pay to avert excessive risk-taking.
“Structuring a long-term debt requirement so that a meaningful component consists of deferred compensation held by senior management would presumably strengthen the incentives for proactive risk management,” Dudley said today in the text of remarks given in Auckland, New Zealand. “More research is needed into how the structure of management compensation for financial firms could incentivize good risk management and limit the appetite for excessive risk.”
Regulators should tighten oversight of financial institutions to reduce the odds of failure, while also developing a system to wind down troubled banks, Dudley said. Having enough long-term debt that can be converted into equity is “an important element” of being able to resolve such institutions, he said.
“Making this long-term debt a component of management compensation might also be used to help reduce the likelihood of a default,” Dudley said. “Long-term debt provided by outside creditors exposed to risk of default can create useful market discipline. However, outside creditors do not have the same information or decision rights as inside management.”
The Fed and the Federal Deposit Insurance Corp. are considering a rule to require a minimum amount of long-term unsecured debt outstanding by bank holding companies to convert into equity to help absorb losses and keep a distressed bank running until the firm could be sold or dismantled.
While regulators have made “considerable progress in strengthening the financial system” there remains “a significant amount of hard work ahead,” particularly in addressing so-called too-big-to-fail institutions, Dudley said.
“The structure of the financial system has evolved towards larger and more complex firms than can be justified by economies of scale and scope,” Dudley said. “This is an unacceptable regime and this policy dilemma needs to be resolved.”
In addition to reducing the risk of default and establishing a “credible” resolution regime, regulators must “improve the resiliency of our financial system” and “build out a global data model” for monitoring markets, Dudley said.
“If we can execute on these four elements, then I believe that we can retain the economic benefits from having large financial firms that support the global economy while minimizing the risks that the activities of such firms might pose to the global financial system,” Dudley said.
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