FRB Governor Tarullo Remarks on Quality Compliance, Incentives and Role of Government in Discouraging Bad Actors (with Lofchie Comment)
Federal Reserve Board Governor Daniel K. Tarullo spoke at a Federal Reserve Bank of New York conference on reforming behavior in the financial services industry. Governor Tarullo discussed the respective roles of banks and their regulators in discouraging bad actors, suggested that banks should continue to reform incentive compensation arrangements and remarked that he hoped an interagency rule on executive compensation would be "forthcoming in the not-too-distant future."
Looking at the quality of compliance programs, Governor Tarullo suggested that, while many firms have internalized the aims of the risk-management practices expected by the Federal Reserve, some firms still engage in "check-the-box" compliance, which is intended to address the deficiencies identified by regulators and then move on.
Governor Tarullo argued that "well-crafted compliance programs are essential," and that a strong program should reflect the views and priorities of senior management. He advised policymakers to look at the actions of a firm's employees and ask what these actions imply about senior management's tone, how a bank incentivizes employees, and how it punishes bad actors. In addition, Governor Tarullo emphasized that incentive compensation programs should reward not just bankers who increase revenues, but also those who avoid losses and identify risks that could hurt the institution. In that regard, Tarullo noted that the industry has already started to address this concern: "[p]rior to the crisis, incentive compensation arrangements at many firms incorporated virtually no adjustment for risk. Today, firms routinely take into consideration adverse outcomes."
Considering the extent of the post-crisis legal problems facing the industry – including, among other things, the alleged manipulation of LIBOR and foreign exchange rates and front-running through dark pools – Governor Tarullo noted the "more direct role" typically performed by the government in discouraging bad behavior at banks. Governor Tarullo explained that, while U.S. banking regulators do not have the power to prosecute criminally, they have the ability to remove bad actors from their companies, their positions and even the industry. He also reflected on the historical practice of some banks of dismissing bad actors in a "private way" and noted that this practice had the unintended consequence of "signal[ing to] the rest of the firm's employees that dismissal, even for very serious reasons, carried quite manageable consequences."
Governor Tarullo concluded by stating that his expectation is this: if banks do not take steps to control the behavior of their employees more effectively, "there will be both increased pressure and propensity on the part of regulators and law enforcers to impose more requirements, constraints, and punishments."
Lofchie Comment: The government should tread lightly when suggesting that private firms brand their employees with a scarlet letter when they are dismissed. This may be acceptable if the employee is guilty of a crime or a serious act of misconduct, but as a general matter, businesses ought to avoid wrecking the careers of those whom they fire.The regulatory "improvements" that Governor Tarullo favors are not beyond question. It is not obvious that the government is better than private corporations and market forces at establishing (or dictating) employee compensation. One of the driving forces behind the success of a market system is its allowance for decisions to be made by those closest to the facts. In matters of compensation and hiring, these are decisions better made by private companies rather than the government.