Enhancing culture was the theme at a workshop on “Reforming Culture and Behavior in the Financial Services Industry” held at the Federal Reserve Bank in New York City last week.

In two presentations, William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York and Daniel Tarullo, Governor of the Board of Governors of the Federal Reserve System, urged financial institutions to modify compensation arrangements to help promote more desirable employee conduct.

Mr. Dudley specifically argued that more compensation should be deferred and for longer periods, and suggested that re-structuring long-term deferred compensation as debt might better align senior managers’ focus with their firms’ “long-term enterprise value.”

Likewise, Mr. Tarullo claimed that “[t]here is still considerable work to be done in developing and implementing incentive compensation arrangements that truly give appropriate incentives to employees.” However, he also argued that, sometimes, poorly conceived or implemented regulations can contribute to a “mere compliance mentality” as opposed to a more meaningful culture.

In his remarks, Mr. Dudley opined that “[c]ulture relates to the implicit norms that guide behavior in the absence of regulations or compliance rules—and sometimes despite those explicit restraints.” He pointed to a number of factors that, in his view, contributed to “cultural failures” that resulted in a number of recent widely reported large sanctions against financial services institutions: the “sheer size, complexity and global scope” of some firms that may have left them “too big to manage;” the trend away from client-focused commercial and investment activities to trading; and large pay packages tied to short-term profits coupled with a “flexible and fluid job market” that has caused employees to have less firm loyalty.

Mr. Dudley argued that a respect for law must be a “core element” of firms’ mission and culture. This, he said, requires a culture of self-policing and self reporting:

If audit uncovers an instance of fraud in one unit, the firm’s leadership should ask, “Where else could this behavior occur?” If the press reports fraud at a competitor in a particular business line, the same self-assessment should apply. “Could this happen to us, could we have a similar problem here?” When fraud is detected, boards and senior leaders must ensure that they are informed promptly, and that a thorough inquiry is undertaken at once. The senior leaders of financial firms, and those who report to them, must also be proactive in reporting illegal or unethical activity. Early self-reporting sends a powerful message to employees and to regulators about a firm’s respect for law.

To better align the broader interests of a firm with employees’ interests, Mr. Dudley argued that at least some employees should have a component of their compensation deferred with vesting occurring over an additional time frame (he gave as an example a five-year deferral period with vesting then occurring over an additional five years).

Mr. Dudley suggested that, for senior managers, the vesting portion of compensation should be paid as debt and used as a “performance bond.” Whereas now, he said, shareholders typically pay for any large sanctions imposed by regulators, going forward, the aggregate total of senior managers’ performance bonds should be first used to pay such fines. According to Mr. Dudley,

[t]his would increase the financial incentive of those individuals who are best placed to identify bad activities at an early stage, or prevent them from occurring in the first place.

Without being as specific, Mr. Tarullo also argued that firms need to amend their incentive arrangements to dissuade them from adopting a culture solely of “mere compliance,” as opposed to “internalize[ing] the aims of the risk-management processes and systems that we expect of them,” which he termed “good compliance.”

Mr. Tarullo noted, however, that sometimes regulators unintentionally “can reinforce … a mere compliance mentality.” He said that this can happen when regulators impose requirements that are generally opposed, even if those inside a firm generally support the requirements’ objectives:

[I]n cases where those inside a firm would stipulate the stated objective of the regulation and still find a regulation badly conceived or implemented, there will be less possibility of internalization or integration into a broader set of firm norms and expectations. This is an outcome that regulators can avoid, and something with which the regulated firms themselves can assist by pointing out what they would regard as more sensible methods for achieving stated regulatory purposes.

Both Mr. Dudley and Mr. Tarullo also argued for more public disclosure when employees are dismissed for misconduct, with Mr. Dudley specifically calling for the creation of a central financial services industry-wide registry that would include information on the hiring and firing of all traders and other financial professionals (modeled after the BrokerCheck system of the Financial Industry Regulatory Authority for securities professionals).

Culture and Ethics: Maintaining a strong compliance culture is essential for each firm in the financial services industry, and balancing incentives to promote culture, no doubt, plays an important part. This means not only interjecting an element of deferral into compensation, but ensuring that compensation appropriately rewards those that control risks as well as those who take risks. However, as Mr. Dudley astutely points out, regulators must be careful not to overwhelm companies with requirements that are too numerous and of questionable utility. Otherwise firms will be too busy fixing these matters of questionable worth and not addressing core values—the difference between “mere compliance” and “good compliance.” In the end, however, it’s all about ensuring that every employee applies the grandmother test to every action he or she takes: do not engage in conduct that you would not be proud to defend to your grandmother when she inquires after reading about it in the morning tabloid (especially if that tabloid is the New York Post)!