Fed’s Dudley Says Banker Pay Rules Could Help Curb Risk-Taking

Federal Reserve Bank of New York President William C. Dudley said regulators should consider imposing compensation structures to strengthen bank executives’ incentives to “proactively manage risk.”

“Imagine how incentives would change if a significant portion of senior bank management’s compensation each year were deferred to be available to cover future capital losses,” Dudley, 60, said today in a speech in New York. “The terms and the form of deferred compensation are an important tool that could be further developed to generate a better set of incentives consistent with our financial stability objectives.”

Regulators should tighten oversight of financial institutions to reduce the odds of failure, even while developing a system to wind down troubled banks, Dudley said. The 2010 Dodd-Frank Act requires the largest firms to prepare living wills that describe how they would be wound down in a bankruptcy.

“We also need to create new mechanisms and incentives for bank management to act early, well before resolution becomes necessary,” Dudley said. “These actions can take many forms -- cutting capital distributions earlier, raising new capital faster, restructuring businesses sooner, and reorganizing senior management and boards of directors more radically when the firm is not performing well.”

Supervisors should also consider changing the form of deferred compensation, Dudley said.

‘Risk Tolerance’

“If most of the deferred compensation were in the form of debt rather than equity, I suspect this would also affect management’s risk tolerance and the appetite to cut dividend payments, reduce share repurchases or raise more capital more promptly when the firm began to become stressed,” he said.

U.S. stocks and commodities slid as faster economic growth spurred concern the Fed will scale back stimulus sooner than expected, while Twitter Inc. surged in its trading debut. The euro fell, while the region’s bonds rose, as the European Central Bank cut interest rates. The Standard & Poor’s 500 Index declined 0.9 percent to 1,754.08 at 2:55 p.m. in New York.

The New York Fed president said he disagrees with the “idea that we’re close to overburdening the banking system” with too stringent capital requirements that will damage credit creation. Tougher oversight has been “a huge benefit to the United States,” Dudley said in response to an audience question.

Dudley, who didn’t comment on the outlook for the economy or monetary policy in his prepared remarks, also criticized Wall Street culture and said increased oversight may not go far enough toward addressing that issue.

‘Current Regime’

“Collectively these enhancements to our current regime may not solve another important problem evident within some large financial institutions --- the apparent lack of respect for law, regulation and the public trust,” Dudley said. “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.”

Still, “tough enforcement and high penalties” would help motivate bankers to correct legal and ethical lapses, he said.

Dudley said he’s “not yet convinced” that breaking up so-called too-big-to-fail institutions is “the right approach.”

“Evaluating the socially optimal size, scope and organizational structure of financial firms is a complicated exercise, and so is establishing a viable transition path to a system of much smaller banks,” Dudley said.

“It would be helpful in this regard if advocates of the break-up solutions would develop detailed proposals that address the essential questions of how such downsizing or functional separation would be accomplished, and what the expected benefits and costs could be from such a restructuring,” he said.

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