The Federal Reserve does not need to break up big banks. There’s a better way to incentivize good behavior.

The Wall Street Journal reported on October 20, 2014 that Federal Reserve Bank of New York President, William Dudley,  told Wall Street’s top management to essentially “Shape up or be broken up.” His draconian remarks were prompted by the view that there have been consistent and pervasive rule violations.  See Federal Reserve Website Enforcement Actions.

“(Dudley’s) comments, at a closed-door meeting at the New York Fed with big bank executives, continue his campaign of publicly and privately criticizing what he sees as Wall Street’s ongoing ethical lapses. Mr. Dudley said that if big banks don’t make significant changes to improve their ability to comply with laws, pressure to break up the banks will only increase.

“The inevitable conclusion will be reached that your firms are too big and complex to manage effectively,” he said. “In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.”

Perspective

The late Ace Greenberg, former CEO of Bear Stearns in the 1980s and 90s (when I was a Managing Director at Bear Stearns), created the kind of culture that Dudley and most all of Wall Street should want now. (It is important to note that Ace gave up management of the firm in 2001.) Making money was the top objective, but not if it required breaking any rules. One of Ace’s great phrases was “We believe everybody is honest but they’re more honest if you watch them like a hawk.”

Ace also made it known that if any employee thought his/her superior was doing something wrong, turn him/her in and the person would be promoted to the job. He did that with the head of the preferred stock desk who miss-marked a position and the employee, AJ Cass, got the job (AJ is now at Goldman). Ace also said “The definition of good trader is someone who takes losses and moves on. The definition of an ex-trader is someone who takes losses and tries to hide them.” These were not threatening notes from a regulator; they were the words of the firm’s CEO.

Dudley suggests holding only top management personally accountable for some of the losses that would occur from bad behavior. That may have worked with Sarbanes-Oxley and centralized financial accounting. However, it would probably not be sufficient to create the type of culture throughout firms that both regulators and the majority of Wall Street executives want.

One major complaint about Wall Street that arose from the credit crisis is that profits are privatized and losses socialized. On the risk-reward tradeoff as investment bankers, we have tremendous upside, but if we lose big time, the public bails us out.

Yet, something similar is true within the financial institution’s ecosystem when it comes to compliance costs. Individual business units make the profits and divvy them up among themselves. While they are also affected by the firm’s overall profitability, and may take a hit in bad years, the majority of compensation comes from individual performance. However, when one of their own causes a loss to the firm, say from a regulatory penalty or fine, those losses are moved largely to shareholders and away from the individual business unit. This is particularly true if the penalty, though nominally substantial, doesn’t affect the firm’s overall profitability. The shareholder’s checkbook dilutes the effect of a penalty to the firm on business units and bankers.

A successful bank’s culture ensures that everyone is a stakeholder in compliance with the rules by establishing direct financial consequences. I learned early on that “Investment banking is about making money; compliance is about keeping it.” In other words, it is in your self-interest to comply with the rules. The key is that these financial penalties should apply to individual as well as to the business units as a team. Holding senior management accountable through a top down method is one approach, but a bottom up, team approach is probably more effective.

Proposal

So, here’s a practical idea on how to make that happen, my “Modest Proposal” (apologies to Jonathan Swift):

Whenever a financial penalty is assessed to a bank for any wrongdoing, as part of the settlement with the bank, the bank must agree to assign the penalty to the profit center or business unit from which the violation occurred. This means that it will affect the bonus pool of the business unit, which means it will affect the compensation of all individuals in the business unit.

Results

What would this do? In essence, it could bring back an element of the investment banking partnership culture that existed before they became public companies. In a partnership, there is shared reward but also shared liability.

After becoming public companies, investment banks became more a collection of “independent contractors” than an interwoven collection of employees. This is particularly true on the trading floor.

Individual banker behavior is driven by compensation, especially because so much of it is in cash and directly related to the banker’s revenue production. Moreover, there usually is no significant penalty to one managing director from another managing director’s bad behavior in the business unit. This isolation from compliance consequences permeates the organization.

With this proposal (whose details would need to be carefully worked out to ensure fairness), all employees in all business units would know that their personal compensation could be affected by the behavior of colleagues that violate rules and result in regulatory penalties. Whether the violators are rogue employees or not, all employees would become “bonus stakeholders” in compliance. The public shareholder checkbook would no longer dilute the effect of penalties.

Conclusion

By having the bank tell employees that “If we have to pay a fine because any one of you breaks the rules, you will ALL have to pay,” we will bring everyone into watching everyone else. The most effective policing of the firm will never be by bank examiners or SEC investigations but by employees, at every level of the firm.

So, let’s stop talking draconian approaches of breaking up banks to try to get at the bad behavior of the minority that have put the firms at risk. Let’s focus on setting the right compensation incentives to support the fundamental rules of integrity and honesty that are Wall Street’s bedrock principles.

For more on Wall Street compensation, see: Of Money and Merit: The Upside Down Effects of Wall Street’s Bonus System, 1988.