posted on 10 November 2016
from Liberty Street Economics
-- this post authored by Hamid Mehran and Joseph Tracy
Given the long list of problems that have emerged in banks over the past several years, it is time to consider performance bonds for bankers. Performance bonds are used to ensure that appropriate actions are taken by a party when monitoring or enforcement is expensive.
A simple example is a security deposit on an apartment rental. The risk of losing the deposit motivates renters to take care of the apartment, relieving the landlord of the need to monitor the premises. Although not quite as simple as a security deposit, performance bonds for bankers could provide more incentive for bankers to take better care of our financial system.
Many of the largest banks were engaged in misconduct leading up to the financial crisis. Since then, regulations and supervision have been strengthened, and banks are now required to have more capital and liquidity to make them more resilient. Important as these actions are, they do not address a principal failing of some banks - their failure to take care of their customers. Consequently, it is not surprising that several bank scandals have emerged subsequent to the financial crisis and regulatory reforms.
Wells Fargo’s sales practices are at the center of the most recent scandal to plague the banking industry, notwithstanding regulatory reform. In this case, a focus on cross-selling rather than customers led to the opening of more than 1.5 million unauthorized accounts. What were the consequences? In September 2016, the Consumer Financial Protection Bureau, the Office of the Comptroller of the Currency, and the Office of the Los Angeles City Attorney, collectively, levied a fine of $185 million against Wells Fargo, and additional investigations and civil lawsuits are under way. Significantly, however, this fine was paid by shareholders, not by the people who caused or could have prevented the problem. In essence, the renters trashed the apartment. There wasn’t a large enough security deposit to either deter the damage or cover the cost.
Are Clawbacks Enough?
Wells Fargo has announced that at least two former executives have agreed to clawbacks that would cover about a third of the $185 million fine. John Stumpf, the CEO who resigned after the scandal, will forfeit all of his outstanding unvested equity awards, valued at approximately $41 million. Carrie Tolstedt, the former head of Community Banking, will also forfeit all unvested equity awards, valued at $19 million. However, taking back pay that has already been paid out can be difficult and costly, particularly when the employee has left the bank. (In much the same way, getting former renters to pay for damages after the fact will likely impose costs on landlords that they would not have faced had they required a security deposit.) For this reason, clawbacks have focused mostly on unvested deferred compensation - a practice that limits the degree to which senior management can be held financially accountable. Performance bonds aim to address this limitation, among other concerns, by putting a significantly greater portion of senior management’s compensation at risk of forfeiture for a longer time period.
How Would Performance Bonds for Bankers Work?
Broadly speaking, bankers’ pay consists of salary and bonuses in the form of current cash plus deferred equity compensation that typically vests and is paid over three years. Unvested equity compensation can be revoked, but the short vesting time limits the cumulative amount at risk. As we explain in a recent article in the Bank’s Economic Policy Review, introducing performance bonds could be accomplished by splitting the deferred pay into deferred equity (that continues to vest over three years) and a performance bond consisting of cash that is deferred for five years and vests over the next five years. The much longer vesting and payout period increases the chances that problems will come to light before the deferred cash is paid out.
Would Performance Bonds Have Performed at Wells Fargo?
Assume that Wells Fargo had performance bonds in place starting in 2005 that split deferred equity and deferred cash equally as described above. Drawing on compensation information in Wells Fargo’s SEC filings and following the methodology discussed in our Economic Policy Reviewarticle, we calculate that the accumulated performance bonds in 2015 would have been about $140 million in total for the two executives who agreed to clawbacks. Together, the executives’ performance bonds and unvested deferred equity would sum to more than twice their deferred equity under Wells’ current compensation program - enough to pay the entire $185 million fine, not just a third of it.
In our article, we explore the benefits of a broad-based program of performance bonds for banks in which all senior managers and material risk takers (for example, traders) are covered as described above. We estimate that if the program had been in place since 2005 at the top three U.S. banks, then by 2013, each bank would have accumulated a total deferred cash balance of about $14 billion, on average - more than enough to cover the very large fines levied against these banks in the recent scandals. In addition, if any of these banks got into solvency problems, the deferred cash could be written down, providing additional assistance to the bank.
To be sure, the purpose of performance bonds for bankers is not simply to cover losses inflicted by every business problem. Rather performance bonds are designed to discourage banker misconduct and enhance financial stability. Arguably, the best solutions to business problems are those that prevent them from occurring in the first place. Performance bonds internalize the expected cost of misconduct to those involved, thereby improving internal monitoring and the escalation of information about misconduct. As a result, performance bonds would support better business decisions and complement bank supervisory efforts.
Because the failure of a large bank poses more risk and costs to the financial system and the economy, larger banks face stricter capital and liquidity requirements than smaller banks. The impact of misconduct on the financial system and the economy may also be larger for the bigger banks. Accordingly, we argue that larger banks should require performance bonds for their senior managers and material risk takers as a way of motivating them to shun misconduct and take better care of our financial system.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
About the Authors
Hamid Mehran is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
Joseph Tracy is an executive vice president and senior advisor to the president of the Federal Reserve Bank of New York.
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