Attempting to Align Incentives: Banking Employees Edition

William Dudley, President of the New York Federal Reserve Bank, has an interesting idea on how to align the incentives of banking employees with the desires of bank regulators: Defer their bonus payments for 10 years and take regulatory fines out of the bonus pool. From his speech:

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.

There is no question that banking incentives are broken. In the run up to the 2008 financial crisis employees were generating what looked like revenue in the short term, but ended up actually destroying many companies. Other companies were found to be systematically violating regulations designed to protect consumers, often because a simple cost benefit analysis can find that breaking the rules now and paying the fines later is more profitable than other approaches. Employees involved might accurately estimate that the chance of significant bonus clawbacks are generally close to zero percent. It's the shareholders who are stuck with the bill years after the bank's employees have walked away with between 40% to 50% of the revenue they generated.

What challenges will a Dudley style system encounter?

If the bonus pool is too lumped together the responsibility will be too diffuse to matter. Bear Stearns and Lehman both had significant employee stock ownership, and yet both firms went belly up in the 2008 crisis. Work will have to be done to ensure that the people causing the trouble are hit first and hardest by the problems they cause.

The deferal unilaterally changes the deal between shareholders and employees, and employees who do not want to wait for their bonus payments will leave the regulated sector. This may actually be a good thing, as FDIC insured institutions shouldn't be in the business of creating free call options for employees looking for a quick payout.

Base salaries will go up as a portion of total compensation to make up for slower payouts. Higher base salaries and smaller bonuses can cause employees to act in a more risk averse manner.

If this system isn't implemented unilaterally through all FDIC insured banks at once the employees with the most earnings potential will leave banks implementing this policy for greener pastures. Like reform to the modern college education system, reform has to come from the high status players or all at once.  

If a mandatory deferred compensation system was imposed from the top down as one of the requirements for deposit insurance or for institutions with access to the Federal Reserve discount window or for primary dealers then it has the potential to help more than harm. Shareholders win because they are more protected from the bad behavior of their employees. Citizens who are better protected against renegade employees and less likely to fund bank bailouts win, while certain employees who have been enjoying a "heads I win, tails you lose" dynamic are inconvenienced.

One caveat: Top down regulations on compensation are generally undesirable. Right now it is arguably too difficult to comply with all of the regulations that banks are supposed to follow - it's crazy that Citi needs 30,000 people working in compliance. This part of the system is also broken. And a congress plus a regulatory body trying to implement Dudley's reforms in some form may end up doing much more harm than good. But the financial industry, with both government subsidies and significant moral hazard, needs better ways to reign in broken incentives. Dudley's proposal gets a lot of things right.