WASHINGTON — As bank regulators embark on a broad recalibration of the post-crisis regulatory framework, policy levers meant to bolster bank culture — to defend against potentially damaging behavior — appear to remain a low priority.
But how to strengthen ethical values within a bank's corporate structure remains top of mind for some policymakers and executives, suggesting that supervisors would like to craft policy actions around culture but find it hard to employ the right tools.
Regulators' clearest opportunity to address bank culture in the Dodd-Frank Act was a provision requiring regulators to ban incentive-based compensation plans that could trigger risky behavior, yet financial regulatory agencies have failed to agree on a rule implementing the measure.
Financial reform advocates say that the relegation of that rule — covered under Section 956 of Dodd-Frank — to an inactive state is a major oversight, and said the failure of bank regulators to take it up amounts to an acceptance of the status quo.
“It’s just an example of how reforms that the regulators themselves, the supervisors themselves admit are needed, just were strangled and delayed in back rooms and torpedoed by big bank interests,” said Marcus Stanley, policy director for Americans for Financial Reform.
Yet some regulators insist that issues pertaining to bank culture are on their radar.
In a speech Monday, outgoing Federal Reserve Bank of New York President William Dudley said that a culture of rule-bending in the financial services industry is a major concern, one that has cost the banking industry hundreds of billions in fines and penalties since the financial crisis.
He also said in an interview with American Banker that events like the Wells Fargo cross-selling scandal, and the manipulation of interbank interest rates and foreign exchange rates, have created a perception among prospective future bankers and financial services workers that the industry is corrupt.
“We've had a number of conversations with deans of business schools, and one theme that came out of those conversations was that … an increasing proportion of people graduating from business school who didn't want to go into the financial services industry because they thought it wasn't ethical,” Dudley said. “That's not a great dynamic. If the only people that are willing to go in are people who don't care about the ethics of the industry, that's a really negative self-selection process.”
Bank scandals carry political liability as well. The Wells Fargo scandal remains a potent political liability not only for the bank but for regulators charged with overseeing the firm. Sen. Elizabeth Warren, D-Mass., recently called on Federal Reserve Bank of San Francisco President John Williams to testify before Congress about his oversight of the firm, which is drawing scrutiny amid reports that Williams is a leading candidate to succeed Dudley atop the New York Fed.
Mike Alix, partner and financial services consulting risk leader at PricewaterhouseCoopers, said that cultural issues pose a unique challenge to the banking industry precisely because they affect the perception of the industry as a whole, regardless of whether an individual bank might be involved in scandal. That dynamic requires a collective solution, but the competitive nature of the industry makes those solutions hard to achieve, he said.
“Unlike some other risks, where your competitors bear the brunt of the risk and it doesn’t affect you, here a failure of culture in one institution sullies the reputation of that institution, but others in the industry as well,” Alix said. “Cultural problems can spread beyond the original source of the problem, and you end up with an industry that is not held in high regard … and will not attract the best and the brightest.”
Bank culture — like the ethical strength of any industry — is hard to quantify. But Dodd-Frank attempted to address the role that pay incentives played in inflating the housing bubble. The law required regulators to “prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks” to covered institutions.
Six federal agencies, including the Fed, issued a joint proposal on executive compensation in 2016 — their second attempt after a previous 2011 proposal had stalled — but the rulemaking has yet to be finalized. Since last year, it has been relegated to the “long term actions” list at the agencies, with no specific timeline for finalization or re-proposal.
Randal Quarles, vice chairman for supervision at the Fed, seemed to confirm that the rule was in a state of limbo in comments in January, saying he had not yet discussed the rule with other bank regulators.
“I don’t have any updates on that for you,” Quarles said. “It’s not something that I’ve talked to the other regulators about yet.”
Stanley said the numerous starts and stops on writing the compensation rule could be a sign that regulators are lukewarm on finishing it.
“You have to ask, ‘Are the regulators serious about doing something as opposed to just talking about this?’ and certainly, under this administration, they’ve decided to pretend that this rule doesn’t exist,” he said.
While Dudley’s speech mentioned proposals regulators could consider to strengthen culture, such as an industrywide database of bad actors, he conceded that relying on regulation alone to influence bank culture was unlikely to have the desired effect.
A positive and ethical banking industry has to originate from the industry itself, he said. Dudley said it was incumbent on the industry, therefore, to review its own incentive systems and for regulators and legislators to help reduce the barriers to a more effective incentive structure.
“We need to recognize that an effective regulatory regime and comprehensive supervision are not sufficient,” he said. “We also need to focus on the incentives facing banks and their employees. After all, misaligned incentives contributed greatly to the financial crisis and continue to affect bank conduct and behavior.”
Wayne Abernathy, executive vice president for financial institutions policy and regulatory affairs at the American Bankers Association, said ideas like a database of bad actors could have unintended consequences, such as potentially fatal legal issues around fairness and libel.
“That’s not a new idea. Banks for a long time have wanted to be able to know the integrity of the people they want to hire,” Abernathy said. “But there are a lot of laws that make it difficult for somebody who fired somebody or let somebody go to lay out the kind of information that a new employer would like to have.”
Another proposal Dudley embraced was the idea of paying executives in unsecured debt, known as Total Loss Absorbing Capacity, or TLAC, that could be used to recapitalize a firm if it were to fail.
Different versions of that idea have floated around for some time. Arthur Wilmarth, a law professor at George Washington University, wrote papers in 2010 and 2011 discussing the idea of paying executives, at least in part, with bail-in debt. He said he was pleased that Dudley was supportive of the idea, and said regulators have the power to make it a cornerstone of executive compensation.
“I do think that required changes in what is permissible for compensation would actually have a very significant effect on culture, and regulators can do that,” Wilmarth said.
Stanley said financial reform advocates are also supportive of that idea. Bail-in debt, he noted, is superior to paying executive compensation in the form of stock grants, which can still encourage firms to prioritize short-term gains over long-term stability.
“We favor it. It’s an obvious move, really,” Stanley said. “But the truth is, even if you paid people in deferred cash … anything is better than stock payments, which produces exactly the wrong incentives.”
Abernathy agreed that bail-in debt should be an option for bank executive compensation, but he warned that it may not be the panacea that it is made out to be. Different banks have different goals and business models, and a compensation scheme that works for one bank may not work for others, he said.
He also noted that stock incentives to pay executives is an idea that came out of an earlier era, when regulators "thought … [they] wanted to give bank leaders an incentive for the bank to do well."
"Then they discovered there were some downsides to that, too,” Abernathy said.
Enforcement also plays an important role in bank culture, Wilmarth said. The Fed’s recent enforcement action against Wells Fargo included letters to former CEO John Stumpf and former independent director of the bank’s board, Stephen Sanger, that pointedly criticized their leadership. But the fact that no penalties were levied against either individual can give other executives in the industry the impression that their companies will bear the brunt of any misconduct.
“The Fed sends letters to [Stumpf and Sanger] and they say, ‘You didn’t do your job,’ which is true, and the letters were fairly strong,” Wilmarth said. “But if that is true, why didn’t they bring a cease-and-desist order, why didn’t they bring a civil money penalty action, why didn’t they bring even a suspension or bar [them] from future service in the industry? They could have done any of those things if they thought … that those officials were responsible for gross negligence, if not worse?”
Alix said bank culture is unlikely to fade into the background, especially if new scandals bring fresh scrutiny of the industry. Banks are attuned to the risks, he said, but if they want to avoid criticism of their internal controls against malfeasance, those controls need to be more effective.
“It’ll be an issue for everybody as long as there are scandals of one sort or another in financial services,” Alix said. “The opportunities and the nature of financial services make it really important … to identify, surface and weed out the bad apples. Every industry has them; it’s just a matter of how you deal with them. And the question is, will it be quicker, harsher, [and] will it allow the big banks to avoid the big problems?”