Deep in a speech this week by Federal Reserve Bank of New York President William Dudley is a nugget executives at all the large banks ought to read.
In his talk at the Global Economic Policy Forum, Dudley said regulators might want to "structure compensation practices to strengthen senior bank managers' incentives to proactively manage risk."
"[I]magine 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 mused. "I suspect that over time this would meaningfully alter management's risk tolerance."
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Translated out of Fed-speak, Dudley is saying regulators could force banks to withhold a big chunk of executives' annual pay and then use that money to fill holes in capital when trouble hits.
This was not a throwaway line. Dudley has clearly given this detailed thought.
"[I]n addition to the quantity of the deferred compensation, the form it takes could also affect incentives," he said. "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 concludes that the "terms and the form of deferred compensation are an important tool…to generate a better set of incentives consistent with our financial stability objectives."
The bottom line: Dudley believes regulators need to do more to incentivize bank management to fix problems before they get out of hand.
Karen Shaw Petrou, managing director of Federal Financial Analytics, hits this point in her always spot-on Friday note to clients.
Based on the time-honored central-bank mission of taking away the 'punch bowl,' the New York Fed head now suggests that regulators also go after the honey pot," Petrou writes.
"Bank regulators are already deferring bonuses in hopes of incentive alignment and clawing back compensation when bad things happen. Going still farther and adding still more grief for being a big cheese at a big bank will work only to make the industry even less efficient as the vital intermediary it's still supposed to be."