Reining In Bankers' Pay

William Dudley has an idea for a bonus plan.

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 financial reform law stressed the importance of changing the incentives under which bankers work. Among other things, it called for new rules on the way bankers are paid. U.S. financial regulators have been debating the details ever since, and they remain unresolved.

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. In a perfect world, banks wouldn't need a regulator to tell them to fix this problem. On their own, however, they've been slow to act.

So Federal Reserve Governor Daniel Tarullo and New York Fed President William Dudley have been making the case. Referring to a spate of banking scandals -- involving the rigging of benchmark interest rates, gross failures of internal controls (see the "London Whale" fiasco), tax-evasion and money-laundering schemes -- they said banks must encourage their 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."

Bankers should be paid. About this, there is no argument. But a better system of bankers' pay, as Dudley suggested, would lean heavily on compensation that was both deferred and contingent. Instead of paying bonuses all in cash, 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.

Four years ago, Dodd-Frank called for new rules on the way bankers are paid. If authorities can't carry out that simple mandate, then maybe it is the regulatory agencies that are too big and complex to be managed effectively.

--Editors: Clive Crook, Michael Newman.

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net