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April 20, 2018

William C Dudley, the President and CEO of the New York Fed, spoke at the U.S. Chamber of Commerce in Washington DC. He discussed financial regulation and the ways in which proper incentives help ensure resilience in the financial system. He highlighted that there should be increased focus on incentives, which can help ensure that regulations are dynamic and that banks are incentivized to take action early to steer away from trouble. He added that regulation and supervision are necessary but not sufficient; they must be supplemented by bank cultures that encourage ethical behavior, the early identification of problems, and a willingness to address those problems proactively.

Mr. Dudley began by highlighting the significant progress made since the financial crisis, as systemically significant banks are much safer, considerable progress has been made in terms of resolution, and some obvious systemic vulnerabilities exposed by the financial crisis have been remedied. However, on the regulatory side, more work needs to be done to ensure that a systemically important bank can be resolved effectively on a cross-border basis in the event of failure. Additionally, the efficiency, transparency, and simplicity of the regulatory system could be improved without weakening the core reforms to capital, liquidity, and resolution that have made the financial system much stronger. He agreed with “Vice Chairman Quarles' observation that there is more we can do to make the regulatory regime more efficient, transparent, and simple-including relief for small banks, greater tailoring based on a firm's level of systemic importance, and simplifying the Volcker Rule.” He also outlined examples of bad incentives that contributed to the financial boom and bust, mentioning that some lessons on incentives that stand out for him include:

  • Guarding against technical design flaws that can be manipulated and exploited for profit
  • Ensuring that incentives are aligned and consistent with desired behaviors
  • Recognizing how rules can be gamed
  • Having appropriate mechanisms in place to identify problems early and to ensure rapid escalation and amelioration

He also discussed the complementary roles of regulation, supervision, and culture, before moving on to the areas where further work on incentives is warranted. Changes in the 2018 Comprehensive Capital Analysis and Review program enable banks to avoid a FED objection, based on the quantitative assessment by raising new capital. While this is a step in the right direction, the current regime may not be sufficient to ensure that banks will raise capital more proactively, highlighted Mr. Dudley. Compensation is also a powerful incentive. While compensation practices today feature a larger deferred component, greater emphasis on deferral in the form of long-term debt—which can also be recognized as total loss-absorbing capacity (TLAC)—could better align senior managers' interests with the long-term safety and soundness of the firm. He added that this approach could have two benefits. One benefit is that it would reduce the incentives for risk-taking. The second benefit is that, if TLAC debt holdings were at risk of conversion to equity in the event of failure, senior bankers would be incentivized to cut dividends or raise equity capital earlier to reduce the risk of failure.

Having a regime in place that creates strong incentives for management to steer aggressively away from bad outcomes would be better than one in which management has incentives to temporize in the face of rising risks. "Some banks have experimented with such compensation schemes, and I would encourage more to do so.” However, this type of reform may need to be pushed from the regulatory side. Banks may be reluctant to adopt such pay structures on their own for competitive reasons. They may perceive that there is a first-mover disadvantage in attracting and retaining talent. He noted that the many regulatory reforms introduced over the past decade may create incentives of their own, with important implications for bank behavior. Such incentives may alter the nature and locus of risk-taking, and, therefore, need to be closely monitored. Risks could be shifted outside the banking system, or the incentives could lead to different bank strategies, business models, and product offerings that introduce new risks.

 

Related Link: Speech

Keywords: Americas, US, Banking, Incentives, Compensation, TLAC, CCAR, NY FED

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