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December 23, 2014

Good Medicine for Bad Bankers

By Alan S. Blinder

Maybe someone should launch a reality show called “Bankers Behaving Badly.” Because too many of them are. That’s the conclusion of William Dudley, president of the Federal Reserve Bank of New York, one of America’s most powerful financial regulators and (full disclosure) a friend.

In a remarkable Oct. 20 speech at the New York Fed that didn’t receive as much attention as it deserves, Mr. Dudley highlighted the “ongoing occurrences of serious professional misbehavior, ethical lapses and compliance failures” at giant financial institutions. And he warned the audience, which included a number of the world’s leading bankers, that unless the epidemic of bad behavior stops, “the inevitable conclusion will be reached that your firms are too big and complex to manage,” in which case “your firms need to be dramatically downsized and simplified.”

Virtually all the transgressions that Mr. Dudley wants stopped-say, traders conspiring to fix London interbank offered rates or advisers helping clients evade taxes-typically originate several levels below the C-suite. But Mr. Dudley wasn’t letting CEOs off the hook on the “few rotten apples” theory. No, he said, “the problems originate from the culture of the firms, and this culture is largely shaped by the firms’ leadership.” So “as a first step, senior leaders need to hold up a mirror to their own behavior.” The not-very-subtle hint: You shouldn’t like what you see.

Given what we have all witnessed since the 2008 financial crisis, it is hard to be optimistic that big banks will reform themselves unless pushed-hard. Apparently, neither the revelation of the horrible behavior that led up to the crisis nor the publicly financed rescue operations that saved their hides (and for which the industry has shown little gratitude) were enough. Mindful of this, Mr. Dudley offered several suggestions.

First, firms that self-report transgressions they discover internally should be treated more leniently than “those that drag their feet.” In other words, if you watch out for bad behavior and report it to your regulators, you should get lighter penalties.

Second, top management should encourage, support and even reward whistleblowers. It is the people on the ground who see legal and ethical problems as they develop.

Third, companies should tone down some of the high-powered, short-term-oriented compensation incentives that tempt people to cut corners or look the other way. Specifically, Mr. Dudley suggested that more of the pay of traders and other risk takers should be deferred-and for longer periods of time. (Some of that seems to be happening.)

Fourth, he would like to see more people who break the law or violate their firm’s code of conduct barred from further employment in banking. The Fed can actually do something about that. Right now, it is handing out far fewer bars from banking than the Financial Industry Regulatory Authority is from the securities business.

Let me add two more items to Mr. Dudley’s list. Both ideas originate with Joseph Fichera, CEO of Saber Partners in New York and also a friend. Mr. Fichera suggested in a New York Times op-ed last month that, in addition to whatever fines or penalties are imposed, each violation should earn the offending bank “points,” the way the Department of Motor Vehicles assigns a driver points for traffic violations. As with the DMV, more points would come with more severe offenses. A recidivist bank that accumulated enough points would lose its banking license-just as serial traffic-law violators lose their driver’s licenses. But a bank would see this danger lurking as it accumulated points, and that, presumably, would give it powerful incentives to clean up its act.

Mr. Fichera has another clever idea on his blog: When regulatory fines and civil penalties are imposed on a financial institution, bank supervisors should insist, as part of the settlement, that the losses be pushed down to the business unit or profit center where the violations occurred-where they will affect the local bonus pool, probably heavily.

As things stand now, penalties are borne mostly by the bank’s shareholders, as the company’s profits decline. That system makes it all but certain that most of the pain is shifted to innocent parties such as outside investors, that only a small fraction accrues to the bank’s employees, and that only a negligible portion finds its way to the miscreants themselves.

But if bankers in, say, a particular trading unit know that any financial penalties for wrongdoing will be shared within the group, rather than dispersed among shareholders, they are more likely to answer Mr. Dudley’s call and either get the offenders in line or blow the whistle on them. In other words, when bankers discover bad behavior that threatens their own bonuses, these Masters of the Universe may turn into Protectors of Integrity. Wouldn’t that be nice?

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).


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