WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo issued a stark warning to bankers Monday to improve their culture and ensure employees are not behaving badly before regulators are forced to do it for them.

"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 a closed-door speech to the Federal Reserve Bank of New York.

During the speech, a copy of which was released by the Fed, Tarullo acknowledged that defining a business' "culture" is difficult. Instead, he said policymakers must look at the actions of a firm's employees and what they imply about the tone at the top. How a bank incentivizes employees, including through its compensation practices, and punishes bad actors are also key to understanding its culture, Tarullo said.

He warned that firms that incentivize employees based on how much and how quickly they can make money for the bank is dangerous and said he hoped regulators would finalize soon a long-awaited interagency proposal on compensation at big banks.

"There is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees. In many cases risk metrics need to be better targeted to specific activities, and risk adjustments should be more consistently applied," 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."

Overall, Tarullo said regulators are wary of a "check-the-box" compliance mentality from banks in which the "attitude we perceive is one of a mere compliance exercise." He said although a bank may correct deficiencies identified by regulators, there is sometimes a sense that they are just doing so just in order to get Fed approval to issue dividends or make other capital distributions.

"I would say that our sense is that management at these firms wants the hurdle to capital distribution removed, but once the specific problems have been remedied, they want to move on," said Tarullo. "If this is the attitude we perceive, I suspect the working level employees of such firms do the same. The supervisory reaction in such cases is quite likely to be an inclination toward greater scrutiny."

Tarullo also said that the "government can play a more direct role" in criminal punishment of individuals at a firm. He urged banks to take more public actions when terminating bad actors, not just ushering the person "out the door discreetly" so employees clearly understand what is or is not 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," he said.

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