William C Dudley: Enhancing financial stability by improving culture in
the financial services industry
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the workshop on "Reforming Culture and Behavior in the
Financial Services Industry", Federal Reserve Bank of New York, New York City, 20 October
2014.
* * *
As I noted earlier at the start of today's workshop, improving culture in the financial services
industry is an imperative. This endeavor is important in order to ensure financial stability over
time, but also to ensure the public trust in our financial system. In my remarks today, I will
first talk about what I see as the culture problem. Then, I will focus on how incentives could
be improved within the financial services industry to encourage better culture and behavior.
This includes how we compensate employees of a financial institution, but it also extends to
how these firms identify wrong-doers and punish them. As always, what I have to say today
reflects my own views and not necessarily those of the Federal Reserve System.1
The existing culture problem
In recent years, there have been ongoing occurrences of serious professional misbehavior,
ethical lapses and compliance failures at financial institutions. This has resulted in a long list
of large fines and penalties, and, to a lesser degree than I would have desired employee
dismissals and punishment. Since 2008, fines imposed on the nation's largest banks have far
exceeded $100 billion.2 The pattern of bad behavior did not end with the financial crisis, but
continued despite the considerable public sector intervention that was necessary to stabilize
the financial system. As a consequence, the financial industry has largely lost the public
trust. To illustrate, a 2012 Harris poll found that 42 percent of people responded either
"somewhat" or "a lot" to the statement that Wall Street "harms the country"; furthermore,
68 percent disagreed with the statement: "In general, people on Wall Street are as honest
and moral as other people."
I reject the narrative that the current state of affairs is simply the result of the actions of
isolated rogue traders or a few bad actors within these firms. As James O'Toole and Warren
Bennis observed in their Harvard Business Review article about corporate culture: "Ethical
problems in organizations originate not with 'a few bad apples' but with the 'barrel makers'."3
That is, the problems originate from the culture of the firms, and this culture is largely shaped
by the firms' leadership. This means that the solution needs to originate from within the firms,
from their leaders.
What do I mean by the culture within a firm? Culture relates to the implicit norms that guide
behavior in the absence of regulations or compliance rules - and sometimes despite those
explicit restraints. Culture exists within every firm whether it is recognized or ignored,
whether it is nurtured or neglected, and whether it is embraced or disavowed. Culture reflects
the prevailing attitudes and behaviors within a firm. It is how people react not only to black
and white, but to all of the shades of grey. Like a gentle breeze, culture may be hard to see,
but you can feel it. Culture relates to what "should" I do, and not to what "can" I do.
A number of factors have contributed to the cultural failures that we have seen. An important
question is whether the sheer size, complexity and global scope of large financial firms today
have left them "too big to manage." Large problems can originate in small corners of these
firms, as illustrated by the Financial Products Group experience at AIG, and the "London
Whale" episode at JPMorgan. Differences in attitudes and business practices across
countries can also be difficult to reconcile within a firm's overall compliance function. Recent
fines against BNP Paribas for violating U.S. sanctions programs and providing dollar funding
to a country engaged in genocide and against Credit Suisse for facilitating tax evasion by
U.S. citizens, point to these challenges. Another important element affecting culture has
been the shift in the prevailing business model away from traditional commercial and
investment banking activities to trading; that is, from client-oriented to transaction-oriented
activities. Clients became counterparties - the other side of a trade - rather than partners in
a long-term business relationship. In general, interactions became more depersonalized,
making it easier to rationalize away bad behavior, and more difficult to identify who would be
harmed by any unethical actions.
High-powered pay incentives linked to short-term profits, combined with a flexible and fluid
job market, have also contributed to a lessening of firm loyalty - and, sometimes, to a
disregard for the law - in an effort to generate larger bonuses. Often allegiance to an
external network of traders has been more important than the ties the trader has to his or her
particular employer. This is particularly evident in the illegal manipulations of the London
Interbank Offered Rate (LIBOR), and with respect to reference rates in the foreign exchange
markets.
Although cultural and ethical problems are not unique to the finance industry, financial firms
are different from other firms in important ways. First, the financial sector plays a key public
role in allocating scarce capital and exerting market discipline throughout a complex, global
economy. For the economy to achieve its long-term growth potential, we need a sound and
vibrant financial sector. Financial firms exist, in part, to benefit the public, not simply their
shareholders, employees and corporate clients. Unless the financial industry can rebuild the
public trust, it cannot effectively perform its essential functions. For this reason alone, the
industry must do much better.
As was discussed earlier, in the U.K., seven of its largest banking institutions have recently
founded the Banking Standards Review Council under the leadership of Sir Richard Lambert,
who joined us today. I would strongly encourage the largest institutions based here in the
United States to work to develop collaborative solutions aimed at improving culture and
rebuilding the public trust.
The key role for senior leadership
Correcting this problem must start with senior leadership of the firm. The "tone at the top"
and the example that senior leaders set is critical to an institution's culture - it largely
determines the "quality of the barrel." As a first step, senior leaders need to hold up a mirror
to their own behavior and critically examine behavioral norms at their firm. Sustainable
change at any firm will take time. Turning around a firm's culture is a marathon not a sprint.
Senior leaders must take responsibility for the solution and communicate frequently, credibly
and consistently about the importance of culture. Boards of directors have a critical role to
play in setting the tone and holding senior leaders accountable for delivering sustainable
change. A healthy culture must be carefully nurtured for it to have any chance of becoming
self-sustaining.
Firms must take a comprehensive approach to improving their culture that encompasses
recruitment, onboarding, career development, performance reviews, pay and promotion. All
of these elements need to be aligned with the desired culture. Through our supervisory
process, we have seen that a number of firms have started this process by developing or
refining employee surveys and 360 feedback processes to target issues of behavior and
culture. Some firms are incorporating case study discussions into training programs to
highlight ethical dilemmas and decision-making. Some are revamping senior level promotion
criteria to reinforce what are the desired characteristics and behaviors of leaders. These
efforts are at various stages in terms of their depth, breadth and maturity. Supervisors will
need to see how these frameworks evolve, and more importantly, see evidence of how these
efforts yield results in the form of more open and routine escalation of issues, consistent
application of "should we" versus "could we" in business decisions, rigor in identifying and
controlling of conduct risk, and how compliance breaches factor into compensation.
Measurement and accountability for progress in developing a healthier culture across the
industry is paramount to us as supervisors and central bankers. An important measurement
of progress is employees' assessment of their firm's culture. To this end, we encourage the
industry to harness the various individual efforts that have been initiated at a number of firms
in order to develop a comprehensive culture survey. This anonymous survey would be
fielded across firms each year by an independent third-party and the results shared with
supervisors. Having a common survey instrument would promote benchmarking of, and
accountability for, progress on culture and behavior.
A core element of any firm's mission and culture must be a respect for law. Federal Reserve
guidance advises that banks should strive to "[m]aintain a corporate culture that emphasizes
the importance of compliance with laws and regulations and consumer protection."4 To
maintain such a culture, senior leaders must promote effective self-policing. If audit uncovers
an instance of fraud in one unit, the firm's leadership should ask, "Where else could this
behavior occur?" If the press reports fraud at a competitor in a particular business line, the
same self-assessment should apply. "Could this happen to us, could we have a similar
problem here?" When fraud is detected, boards and senior leaders must ensure that they are
informed promptly, and that a thorough inquiry is undertaken at once. The senior leaders of
financial firms, and those who report to them, must also be proactive in reporting illegal or
unethical activity. Early self-reporting sends a powerful message to employees and to
regulators about a firm's respect for law. This is one important reason why those who
selfreport in a timely way should be treated preferentially, compared to those that drag their feet
and whose bad behaviors are only uncovered by enforcement investigations.
How will a firm know if it is making real progress? Not having to plead guilty to felony charges
or being assessed large fines is a good start. Firms should also pay closer attention to how
they and the industry are broadly viewed by the public. Internally, one important marker for
progress is the frequency of problems, and whether small problems stay small, or instead,
grow into large problems. A healthy culture is one where problems are identified early and
promptly addressed.
In addition to a strong compliance function, firms need to foster an environment that rewards
the free exchange of ideas and views. Individuals should feel that they can raise a concern,
and have confidence that the issues will be escalated and fully considered. This is a critical
element to prevention. A firm's employees are its best monitors, but this only works well if
they feel a shared responsibility to speak up, expect to be heard and their efforts supported
by senior management.
Let me give you an example to take this from the abstract to the more specific. As I noted in
a speech a few weeks ago on the issue of reference rate reform, in the case of the LIBOR
setting process, the information barriers between the traders and LIBOR submitters were
paper thin and porous.5 At times, traders and LIBOR submitters colluded to manipulate
LIBOR for the gain of the traders and the firm.
What should have happened instead goes like this: A trader asks the LIBOR submitter to
adjust the submitted rate. The submitter says "no way," tells the trader that this request is
inappropriate and that the trader will be reported to compliance. The submitter reports the
trader's attempt at manipulation to legal and compliance. Compliance investigates to confirm
the facts. The trader is fired and is fully prosecuted for any criminal actions. For this all to
happen, a firm doesn't just have to have the right rules and procedures in place, but it also
needs the right culture to ensure that those rules and procedures are followed, that the bad
behavior sees the light of day immediately and that the transgressors are punished in a way
that is known broadly throughout the firm - that is, a clear example of the consequences is
demonstrated to others.
How can better incentives help?
In my example, for matters to work properly, I think it is important that all the players -
traders, compliance, risk and legal, have the right incentives to behave in the way that is
appropriate and that aligns their interests with the broader interests of the firm in rooting out
bad behaviors. One way in which incentives can be shaped is through the structure of
compensation. I believe that a proper compensation system can be an important tool for
enhancing culture, promoting financial stability and rebuilding the public trust in the financial
industry.
Incentives matter for individual behaviors and decisions in all industries, including the
financial industry. Some might argue, however, that risk-takers are drawn to finance like they
are drawn to Formula One racing, and that regardless of risk or reward, these types of
individuals will always want to push the boundaries. This logic might lead one to conclude
that incentives are unlikely to be an effective tool to limit excessive risk-taking and to promote
more ethical behavior in the financial sector. I disagree. First, the degree to which an industry
attracts risk-takers is not pre-ordained, but reflects the prevailing incentives in the industry.
After all, risk-takers have options. Second, and, more importantly, incentives matter even for
risk-takers.
In my speech on ending too big to fail, I stressed the importance of reducing the likelihood
that large financial firms would face insolvency, as well as the need for a credible resolution
plan that does not involve taxpayer money. Compensation policies can play a useful role in
reducing excessive risk-taking. Similarly, compensation policies can complement an
improved culture, and play a role in reducing unethical and fraudulent behavior. Individuals
who decide to bend the rules or to step over the line usually do this in the context of an
assessment of the expected risks and rewards of their actions.
This implies that one objective should be to rebalance the scales so that the expected risks
from unwanted behaviors are more likely to outweigh the expected rewards. The expected
risks are a function of the likelihood that an individual (or set of individuals) is caught and the
attendant consequences. The expected rewards include any financial and psychic benefits to
the individual from the behavior if undetected. Improved culture helps to tip the balance in the
favor of better behaviors by increasing the likelihood that an individual will both feel an
obligation to behave properly, and be prevented by others from carrying out bad behavior. In
addition, a strong culture can also reduce the rewards some employees may hope to enjoy.
In its simplest form, a strong culture means that individuals who get away with unethical or
illegal activities will not have the satisfaction of "bragging rights" about their actions because
there are no congratulations for breaking the law or outwitting compliance. A strong culture
will reinforce the simple reward of having done the right thing. A clear conscience can be a
powerful reward.
A well-designed compensation structure can also help favorably tip the balance by effectively
extending the time horizon of senior management and material risk-takers, and by forcing
them to more fully internalize the consequences of their actions. There are two important
dimensions of the structure of compensation - first, how much compensation is paid out
immediately versus deferred into the future, and second, the form of the compensation that is
deferred - cash, equity, equity options or debt. For deferred compensation, the rules for how
it vests and under what conditions it can be forfeited are important. Getting the balance right
is critical. For my part, I believe that in order to improve financial stability and rebuild the
public trust, more compensation in finance needs to be deferred and for longer periods. Also,
I think there needs to be a shift in the mix of deferred compensation away from equity and
towards debt.
The optimal structure of deferred compensation likely differs with respect to the goals of
providing incentives to support prudent risk-taking versus encouraging the right culture. For
example, consider trades that might appear to be highly profitable on a mark-to-market basis,
but take some time to be closed out and for the profits to be realized in fact, not just on
paper. In this case, as long as deferred compensation is set at a horizon longer than the life
of the trade, this can ensure the firm's and the trader's incentives are aligned and the
"trader's option" is effectively mitigated. This component of deferred compensation could take
the form of either cash or equity.
However, in contrast to the issue of trading risk, unethical and illegal behavior may take a
much longer period of time - measured in many years - to surface and to be fully resolved.
For this reason, I believe that it is also important to have a component of deferred
compensation that does not begin to vest for several years. For example, the deferral period
might be five years, with uniform vesting over an additional five years. Given recent
experience, a decade would seem to be a reasonable timeframe to provide sufficient time
and space for any illegal actions or violations of the firm's culture to materialize and fines and
legal penalties realized. As I will argue below, I also believe that this longer vesting portion of
the deferred compensation should be debt as opposed to equity.6
I noted earlier that improving a financial firm's culture will take sustained determination and
commitment from its senior leaders. Deferred compensation can play a useful role in
reinforcing buy-in of senior leadership to this endeavor. As I discussed last November, an
important element of a Title II resolution under Dodd-Frank is that there is sufficient long-term
unsecured debt at the holding company level to recapitalize a failing bank. I indicated in my
remarks that it would be useful if a meaningful component of this debt was contributed by the
senior management and the firm's material risk-takers. That is, if a bank ran into solvency
problems, this component of deferred compensation would be used to recapitalize the
restructured bank. The goal is to incent senior management and the material risk-takers to
focus on maximizing the long-term "enterprise" value of the firm, not just the short-term share
price. In this framework, I would expect the relative size of the debt component of deferred
compensation to increase as one moved up the management ranks to the senior managers
of the firm. That is, the individuals who have the greatest impact on a firm's strategic
direction should have the strongest incentives to maximize the firm's long-term enterprise
value.
If we have this deferred compensation structure in place for financial firms, then we can
leverage it to strengthen the incentives for senior leaders to design and implement the
necessary changes to improve their firm's culture. That is, this deferred debt compensation
can be used as a "performance bond." Performance bonds are used in many situations such
as security deposits on rental properties. Today, when a financial firm is assessed a large
fine it is paid by the shareholders of the firm. Although senior management may own equity
in the firm, their combined ownership share is likely small, and so management bears only a
small fraction of the fine. Now, having shareholders pay may create market discipline in that
they have an incentive to better monitor the firm's actions. However, financial firms are not
transparent enterprises, and it would be difficult even for a diligent shareholder to be able to
know when these bad behaviors are taking place, much less to be able to take actions to
prevent them. This limits the potential effectiveness of market discipline exerted by
shareholders.
How can we improve on this situation? Assume instead that a sizeable portion of the fine is
now paid for out of the firm's deferred debt compensation, with only the remaining balance
paid for by shareholders. In other words, in the case of a large fine, the senior management
and the material risk-takers would forfeit their performance bond. This would increase the
financial incentive of those individuals who are best placed to identify bad activities at an
early stage, or prevent them from occurring in the first place. In addition, if paying the fine
were to deplete the pool of deferred debt below a minimum required level, the solution could
be to reduce the ratio of current to deferred pay until the minimum deferred compensation
debt requirement is again satisfied - that is, until a new performance bond is posted.
Not only would this deferred debt compensation discipline individual behavior and
decisionmaking, but it would provide strong incentives for individuals to flag issues when problems
develop. Each individual's ability to realize their deferred debt compensation would depend
not only on their own behavior, but also on the behavior of their colleagues. This would
create a strong incentive for individuals to monitor the actions of their colleagues, and to call
attention to any issues. This could be expected to help to keep small problems from growing
into larger ones. Importantly, individuals would not be able to "opt out" of the firm as a way of
escaping the problem. If a person knew that something is amiss and decided to leave the
firm, their deferred debt compensation would still be at risk. This would reinforce the
incentive for the individual to stay at the firm and to try to get the problem fixed.
This might work for senior managers, but what about those material risk-takers who are early
in their careers at a firm and do not have much wealth tied up through deferred
compensation to serve as an effective performance bond? How do we provide strong
incentives for these traders not to put the firm at risk by their potential illegal behavior? In
these cases, we can create the performance bond in a slightly different manner. Individuals
who enter finance have generally invested heavily to develop the specialized skills required
in the field. These skills typically have a higher return in finance than they do in any other
occupation. That is, workers in finance earn a premium relative to their next best alternative
job outside of the industry. Over the course of a career, this premium can be expected to add
up to a significant sum of money. This cumulative premium can act like a performance bond.
For this to be the case, however, an individual who is convicted of illegal activities, or who
violates a firm's code of conduct would need to face the risk of being permanently denied
employment in the financial industry. Rather than paying for the performance bond upfront,
the bond is posted in terms of the privilege to continue to work in the industry.
There are several steps that can be taken to implement this concept. The first step is to
make it more difficult for employees in finance who cross ethical boundaries to be able to
move from one firm to another in order to escape the consequences. Currently, lenders who
are considering making a loan to a borrower can look up the borrower's credit score which
reflects the borrower's performance on past loans. In a similar manner, it would be helpful if
financial firms, prior to making a hiring decision, could look up a candidate's "ethics and
compliance score" that reflects the individual's past performance at other financial firms.
Along these lines, one approach would be to create a central registry that tracks the hiring
and firing of traders and other financial professionals across the industry. There would be
many details to sort out regarding how to do this in a manner that was both transparent and
consistent with due process. The database could be maintained by the official sector -
specifically, by financial institution supervisors - based on information provided by
supervised financial institutions. A similar regime already exists in the broker-dealer context,
in which supervised institutions are required to file U4 and U5 forms when they hire and part
ways with licensed professionals. Banking supervisors could consider whether it was
appropriate to import these concepts to the banking industry. To help support the
completeness and accuracy of the filings, the filing firms could be subject to a safe harbor,
akin to the civil immunity for filing a Suspicious Activity Report, so that employers do not fear
liability for good faith reporting. 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. As I mentioned, there would, of course, need to be adequate safeguards for
employees to challenge an entry, consistent with due process.
Furthermore, as a complementary step to the registry, it would be helpful if individuals in
finance who are convicted of an illegal activity were prohibited from future employment in the
financial services industry. Currently, Section 19 of the Federal Deposit Insurance Act
prohibits anyone convicted of a crime of dishonesty, breach of trust, or money laundering
from working at an insured depository institution or bank holding company.7 One possibility
could be to amend Section 19 to cover the entire financial services industry. The precise
formulation of an amendment would need to be worked out, but the application should be
sufficiently broad so that it also covers asset managers, hedge funds and private equity
funds. Like the registry, a broad and permanent industry prohibition changes the time horizon
for the perceived costs of misconduct - from a one-time fine, or perhaps a few years in
prison, to a lifetime prohibition from earning a living in finance, regardless of the type of
employer involved. I would welcome the industry's participation in developing this concept.
Conclusion
To ensure the behavior that is required for a safe, sound and trusted financial system, we
must also be effective in our role as regulators and supervisors. As part of this, we as
supervisors must continually work to improve our own cultures to ensure that we can
successively carry out our responsibilities. But it also requires good culture at the institutions
that we supervise. Supervisors simply do not have sufficient "boots on the ground" to ferret
out all forms of bad behavior within a giant, global, financial institution. Moreover, regardless
what supervisors want to do, a good culture cannot simply be mandated by regulation or
imposed by supervision.
In conclusion, if those of you here today as stewards of these large financial institutions do
not do your part in pushing forcefully for change across the industry, then bad behavior will
undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your
firms are too big and complex to manage effectively. In that case, financial stability concerns
would dictate that your firms need to be dramatically downsized and simplified so they can
be managed effectively. It is up to you to address this cultural and ethical challenge. The
consequences of inaction seem obvious to me - they are both fully appropriate and
unattractive - compared to the alternative of improving the culture at the large financial firms
and the behavior that stems from it. So let's get on with it.
Thank you for your attention.