Dormant Exec Comp Rule Back on Regulators' Agenda

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WASHINGTON — Federal banking regulators are trying to resuscitate a languishing regulation first proposed three years ago that attempts to rein in excessive executive compensation at banks.

Federal Reserve Board Gov. Dan Tarullo on Monday became the second top regulator this month to tout the plan, saying he hopes the agencies can finalize it in the "not-too-distant" future. He followed Comptroller of the Currency Thomas Curry, who similarly raised the proposal in a recent op-ed. Both regulators see it as a way to address flaws in banks' culture, which Tarullo warned needs to be tightened.

"My expectation is that if banks do not take more effective steps to control the behavior of those who work for them, there will be both increased pressure and propensity on the part of regulators and law enforcers to impose more requirements, constraints, and punishments," said Tarullo in remarks to a closed-door conference at the Federal Reserve Bank of New York.

Regulators first proposed a plan in 2011 that would seek to ensure incentive-based compensation pacts do not lead to excessive risk. It was panned by industry critics, but it's not clear why regulators have stalled on finalizing the rule. Sources suggested it was because the agencies simply couldn't agree on how to deal with various aspects of it.

But Tarullo made another push for it Monday in a clear sign it is back on regulators' agenda.

"I hope the long-awaited interagency final rule… will be forthcoming in the not-too-distant future, so as to provide a common objective baseline for incentive compensation programs," he said.

The interagency rule is just one way in which regulators have put a renewed emphasis on banks' culture. This month, the Basel Committee on Banking Supervision revived proposed guidelines that set corporate governance principles in an effort to address perceived weaknesses in bank culture.

Observers said the regulatory push on culture is building to a crescendo.

"It's a clear shot across the bow in terms of these culture issues at banks," said Patricia Jackson, head of Financial Regulatory Advice for EMEIA Financial Services, EY. Tarullo "does indicate most banks are trying to change their culture, but he's really underlining the point that it has got to move ahead."

In his speech, Tarullo acknowledged that the concept of culture is a squishy one, making it difficult to regulate or even define. He said to address cultural issues, policymakers must instead look at the behavior or actions of a bank's employees to see what it implies about the tone at the top. His speech appeared to make a concerted effort to move away from nebulous academic debates about what culture means and dig instead into specifics.

"The fact that Tarullo focused on the outcomes and behavior, I thought was significant," said Eugene A. Ludwig, chief executive of Promontory Financial Group. "He wants to see the beef, or the outcomes, not just the bun and the relish of culture. Culture can be a soft concept and he wants to see the harder behaviors achieved."

Tarullo specifically urged banks to be more transparent when terminating bad actors, not just ushering the person "out the door discreetly" so employees understand what is tolerated.

"It is important that the consequences of violations of a firm's norms and expectations, much less regulations and laws, be well-specified and clearly communicated to employees," said Tarullo.

Tarullo added that the "government can play a more direct role" in punishment of individuals at a firm. Although regulators cannot pursue criminal penalties against bankers, they can take other steps, he said.

"We can, and do, require dismissal of employees as part of our enforcement actions against firms. And we do have the authorities to remove malefactors from their positions in any institution that we regulate and to prohibit them from working in the banking industry," said Tarullo. "Somewhat like criminal prosecutions, these are not easy cases to make. But it is important that we be willing to expend the resources to initiate such actions in appropriate cases."

Speaking at the same conference, New York Fed President William Dudley went even further. He suggested the creation of a "central registry" that would track the hiring and firing of traders and other "financial professionals across the industry." Dudley pointed to a similar registry already in use for broker dealers.

"Under this approach, new regulations could also require that all financial institutions search the database prior to hiring any trader or financial professional; so that any prior reported events could be taken into account in the course of a hiring decision," Dudley said.

Observers said added enforcement could have a big impact.

"I do agree with Tarullo to the extent that this concept of culture" and "the ability of regulators to judge from the outside or mandate it is at best, uncertain," said Karen Shaw Petrou, managing partner at Federal Financial Analytics. "Vigorous enforcement is the best way to align incentives."

Mayra Rodriguez Valladares, managing principal at MRV Associates, said Tarullo's comments put "a lot more force into this issue of having very weak corporate governance.

"When Tarullo says it, it sends a very strong message to the industry," she said.

Tarullo also specifically cited how a bank incentivizes employees, including through its compensation practices, and punishes bad actors as keys to addressing culture. He warned that firms that incentivize employees based on how much and how quickly they can make money for the bank is dangerous. Instead, he suggested that risk metrics should be "targeted to specific activities, and risk adjustments should be more consistently applied."

"There is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees," Tarullo said. "And it is important that compensation arrangements, including clawback and forfeiture provisions, cover risks associated with market conduct and consumer protection, as well as credit and market risks. These kinds of improvements would give more precise signals to employees as to the risk calculus expected of them in making decisions that affect the firm."

He also suggested that banks should consider tying compensation to factors that include avoiding potentially risky behaviors.

"Firms might reward employees with increased compensation or promotion not just for increasing revenues, but also for forestalling losses, such as by identifying non-obvious risks in proposed transactions or products," Tarullo said. "In order to be effective signals, though, the fact of these rewards, and the standards under which they were granted, need to be transparent."

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