Officials at the Federal Reserve are telling banks to change their risk-taking culture or else. Their argument is familiar, but it’s being pressed with new force.
In 2010, the Dodd-Frank Act stressed the importance of changing the incentives under which bankers work. The standard deal on bankers’ pay provides for big bonuses in good times, with little downside when bets that produce short-term profits turn bad. This imbalance encourages excessive risk-taking and sometimes outright misconduct—especially if banks assume that taxpayers will rescue them when things go wrong.
Referring to a spate of banking scandals, Federal Reserve Governor Daniel Tarullo and New York Fed President William Dudley said on Oct. 20 that banks must encourage executives to behave more responsibly. If they don’t, Dudley said, regulators would conclude that “your firms need to be dramatically downsized and simplified so they can be managed effectively.”
A better system of bankers’ pay, as Dudley suggested, would lean heavily on compensation that’s both deferred and contingent. Instead of paying bonuses all in cash upfront, banks could delay them for, say, five years, and then pay them in installments over the five years after that. If the bank got into trouble, the deferred bonuses would be withheld and used to help recapitalize a restructured operation; they would also be used to pay any fines imposed on the bank. This would encourage more cautious behavior, and it would address the injustice of punishments that penalize bank shareholders rather than executives.
It’s such a promising idea that one wonders why regulators haven’t done more to make some version of it a reality. Threatening to break up the big banks unless they adopt such practices isn’t all that credible—and, even if it were, small and medium banks need to fix their incentive structures, too.
If authorities can’t carry out the Dodd-Frank mandate, then maybe it’s the regulatory agencies that are too big and complex to be managed effectively.