Supervisors on Supervision

“I think the problem you’re getting at is: what is the authority under which the supervisor or regulator can argue that culture is part of their purview?

It’s sort of a soft concept. That’s what people are unhappy with. I get that. I mean, what is culture, exactly? That’s one of the challenges.

Since culture is pretty hard to identify and evaluate — and behaviors are also hard to evaluate — it’s difficult for supervisors to be confident that what they’re doing is going to meaningfully move the needle in terms of outcomes.

So I've backed away from ‘culture’ as the way I talk about this. I talk about it more in terms of incentives. We need to have the right incentives in the system because incentives drive behavior, and behavior sets the social norms. And then that collection of social norms ultimately defines what we call culture.

So the culture is the end of the road rather than the beginning of the road. And that puts culture as less central. It’s sort of the result of all this.

But the social norms are what we really need to be working on. And the incentives to shape those social norms are what we should be working on. And I think that makes it a lot more tangible.”

“The culture gets affected by how people perceive the governance and the outcomes of the governance. So if someone who is, for example, a very high revenue producer but an asshole gets kept on and promoted and well-compensated — that's a governance issue. The governance let that happen. But it has cultural implications. Good governance is going to affect the culture outcome, for sure.

So the two are definitely related. I mean, good governance is going to affect the cultural outcome for sure. If you have a bad culture, you're probably going to have poor governance. You're going to have gaps in governance. You're going to have a lack of accountability in governance, presumably. So it probably goes both directions.

Governance is something that’s more tangible. Culture can be regarded as being too soft to be actionable, but we can do something about governance.”

“The Financial Crisis got me going because you saw so many egregious things that were clearly not in the gray area. They were well over the line into what I thought was very bad behavior. The most obvious one was the manipulation of LIBOR. That is blatantly criminal; that's not in the gray area. 

You remember Charlie Prince's famous ‘when the music is playing, you've got to get up and dance’ line? That really got under my skin, because it implied that people lack the free will to actually decide what they want to do.”

“If you have good behaviors, good outcomes, that creates credibility about and confidence in the regime. And if you don't, then — look what happened in the outgrowth of the Great Financial Crisis. People were so angry about the firms that were rescued versus what happened to people as individual mortgage holders. That asymmetry of treatment caused tremendous loss of confidence in U.S. institutions. 

Loss of confidence in U.S. institutions really has a very pernicious effect on the ability of the system to perform well. And when a large number of people in the United States are deeply alienated that’s an erosion of trust and is not a good outcome.”

“One way to motivate all this stuff is you can get the G20 to decide they want to do something. When you look at the movement on things like central clearing, that was all because the G20 made decisions that these things had to happen, and then the regulatory community came quickly behind that. 

Where regulators can be helpful is twofold. 

Number one, identifying best practices. One thing regulators have going for them is they can look at different banks and say, ‘Look, I've done a horizontal review of these banks, and you think you're pretty good in this area? No, you're not, because I've looked at how other banks do it.’ Regulators do have better information about certain things than any individual bank.

The second thing, in the same vein, is they can identify what's good and what's not so good and share that across the banking community.”

“I always used to say to the senior guys, ‘Look, I want your bank to be well-run, and I would hope that you want your bank to be well-run. Where we disagree is that I don't really care as much about your share price as you do. And I don't really care how much you're paid. But in terms of the bank being well-run, that should be a shared interest.’ 

A good example for me is it was very easy to be motivated working at the New York Fed because of the public mission, the public interest. I wasn't going to work to earn a lot of money; I was going to work because this can make a difference in terms of how well the US economy operates.”

“You can’t tell other people to fix themselves if you don’t try to fix yourself as well. People watch what you do, not what you say. You’ve got to walk the walk. No question about that. 

That’s why at the New York Fed, we also took a really deep dive and looked at our own supervisory practices during the Great Financial Crisis.”

“The interesting question is not so much that people do bad stuff. The question is: why does that bad stuff persist?

There does seem to be a sort of slippery slope aspect to all this. But I think the question is: why didn't people put up their hands and say something? I guess the question is: how broadly known were the bad behaviors, and then what did people do about it? If people are colluding — a number of bad actors are colluding — that’s one thing. It's another thing if people are broadly aware and just looking the other way. So we have to distinguish those two issues.

So a good example is: when do I speak up? When do I object? When do I say, ‘Hey, what about this?’ And how does the firm react to that, or how does my boss react to that? Is a good defense, ‘I followed the rules,’ or is that not a good defense?

I mean, the thing that makes me the most annoyed when I'm in an organization is when someone says, ‘Well, I did everything I was supposed to do.’ ... ‘I followed the hierarchy.’”

“I define culture as the norms that drive people’s behaviors. They’re often unwritten rules. That’s one of the big issues with working from home. How do you get inculcated with a firm’s culture if you’re remote all the time?”

“I think supervision is too often about process, like, ‘You didn't include that file in this report.’ I remember when I was a bank examiner very, very early in my career for the state of Massachusetts. Literally, examinations where you went in, looked at the mortgage, and saw if they had all the required paperwork in the mortgage file. But no one was actually driving out to look at the house to see if the valuation was consistent with the mortgage.”

“It’s amazing how much talking past on another there is between the regulators and the bankers. 

I always felt one of my comparative advantages was that early in my career, I worked at the Fed. Then I worked at JP Morgan in regulatory policy. And because I worked in both places, I could talk to the regulators and the bankers and understand both sides. 

But they often couldn’t. They literally could not understand each other. Partly because the language is different, the goals are different, the incentives are different. But I think that's another thing to focus on — to try to get to the dialogue between the regulatory community, the supervisory community, and the bankers — to improve the quality of that dialogue.”

“I think there are some legitimate issues with supervision. The supervisory process can get too down in the weeds. It can get way too complex, where the cost-benefit of the outcome is pretty low. 

Living wills are a good example. They are thousands and thousands of pages. What’s the point? Who can even take that on board?”

“One thing the regulators have going for them is they can look across different banks and say, look, I've done a horizontal review of these banks. You think you're pretty good in this? No, you're not — because I’ve looked at how other banks do. So regulators do have better information about certain things than any individual bank. 

And I think the regulators can also help identify, in the same vein, best practices — what's good and what's not so good — and share that across the banking community.”

“When someone is dismissed from a firm and a new firm hires that person or is thinking of hiring them, the firm calls the old firm, and the old firm's incentives are on the side of ‘no comment’ because they don't want to risk being sued. They don't want the potential legal liability. And so that allows bad actors to essentially move around the regime. 

It would be pretty simple to set up a registry that people could query to ask ‘what are the reports about this person?’ And if there was a consistent story of bad behavior, then people would be aware of it. 

The purpose is not just preventing bad people from being hired again. It creates a different set of incentives: if I know that I do something bad, and not only am I going to cost myself a job at my current firm, but it might cost me my career in the industry. That raises the bar considerably.”

“A lot of times, if you don’t like the outcomes, it’s usually because the incentives are misaligned. I’ve argued that having more of the compensation be deferred, long-term subordinated debt — sort of mimicking a partnership-type structure — might create different incentives for risk taking, a longer time horizon, and greater consequences if the firm were to get into great difficulty or even fail.”

“I've had many conversations over the years where it took me quite a bit of time to convince senior bankers that no, fixing the problems the supervisors have uncovered is not sufficient. It’s necessary, but it’s not sufficient.

You need to be able to figure out how to do this on your own. And only when you do it on your own will you be where you need to be in terms of the supervisory community. 

A classic example is the three lines of defense for risk. I think it works as long as people understand what each line is supposed to do… For a long time, banks didn’t really get that the first line needed to own it.

And for many, many years, banks didn't get that when the supervisor came in and had a finding, it wasn't sufficient for the bank to remedy the failure that was uncovered. The bank really needed to get to the point where they could identify the problems and fix them on their own.”

“Something that could be helpful is more rotation across the different lines. I feel like one thing that could be helpful is if part of a person’s career path was that they actually had to spend some time in the second line. People often don’t understand the perspective of the other side. That makes it harder to solve things in a less adversarial, more coherent way.”

“I think the legal profession is not always so helpful for culture, frankly, because the legal profession is about ‘what am I allowed to do?’ And there's a presumption that, as long as what I'm doing is legal, then it's okay to do. And the reality is, that's just not true in my opinion. 

The legal profession is always going to be behind — the laws and regulatory structures are always going to lag behind the current reality. People are going to innovate to get around legal constraints. So I think part of what we probably should be looking at is the rule of law versus the rule of reason. That’s sort of the classic issue, from a legal perspective. 

Maybe we need to think about how we promulgate regulations and supervision that are more based on the rule of reason than the rule of law, more focused on what outcomes we are trying to achieve, as opposed to what constraints we are putting in place.”

“You have a conflict right now between the fact that confidential supervisory information is confidential, yet oftentimes it's material from the perspective of the stock price, and yet the company can't disclose it. 

I'd like to see all supervisory actions that are truly a restraint and material to the firm have to be disclosed, with a lag — not necessarily the day of the finding, but maybe six or twelve months later. 

It creates better incentives for firms. They are now really well-motivated because, let's say the timeline is six months, they’d better have a pretty damn good plan for how they're going to mitigate this problem. That creates more focus from senior management on the issue and also gives shareholders a better sense of what's really going on. It seems like a win-win.”

“To my mind, how about some notion of a periodic review of how supervisors are doing things? For example, the Fed is now doing a five-year monetary policy review. The ECB does a five-year monetary policy review. Why don't we do periodic reviews of supervision and ask, ‘What's working, what's not working? Where can we peel back?’”

“The problem is that in Basel, the BCBS, is really too narrow and technical and there are no other committees that it really fits into. The FSB seems like its mandate is too broad relative to banking. So it’s a good question [to ask who can lead related global efforts].”

“It's better if the banks understand that it's in their interest to own this — because not only can it lead to better outcomes, less risk, fewer blow-up kind of events, but it can also lead to better relations with their regulators, better trust, more scope to do what they want to do from a strategic perspective. So I don't really see this as regulator-driven.”