New Regulation Aims to Make Banking Fraud Less Lucrative

By | November 10, 2016

Carrie Tolstedt, the former head of Wells Fargo’s community banking division, was required to forfeit $19 million in compensation after the company came under intense public scrutiny for opening over 2 million unauthorized customer accounts. From 2011 to 2016, while the bank was firing over 5,000 low-level branch employees for engaging in this fraud, it paid her more than $36 million in incentive-based compensation, largely due to her success in meeting the company’s goal of “cross-selling” its products to customers. Tolstedt’s potential gains from the practice likely influenced the setting of unrealistic sales goals that drove so many employees to commit fraud.

Compensating executives through stock awards and options theoretically aligns the interests of managers with those of shareholders – both share a desire to see the company’s stock price increase. However, the financial crisis revealed that what is known as the principal-agent problem, cannot be solved so easily. Complex incentive-based compensation structures drove many on Wall Street to engage in excessive risk-taking designed to boost short-term earnings and stock prices while ignoring the long-term implications of their actions. The consequences of this short-termism proved catastrophic for the financial system and the world economy.

Aiming to address some of the pre-crisis excesses, Section 956 of the Dodd-Frank Act required federal regulators to develop rules that prohibit incentive-based compensation arrangements that encourage excessive risk-taking by covered financial institutions. A draft rule was released in April and is scheduled to be finalized by January, although many firms claim to already be in adherence with the rule’s main provisions. Its goal: to ensure that bank managers make decisions that are in the long-term interest of the company.

At the largest banks, those with over $250 billion in consolidated assets, the rule’s provisions cover all employees who receive incentive-based compensation, with enhanced requirements for “senior executive officers” (SEOs) and “significant risk takers” (SRTs). For these employees, incentive-based compensation would be subject to requirements such as a deferral period, forfeiture, and clawbacks.

For SEOs at the largest banks, the rule requires that at least 60 percent of qualifying incentive-based compensation be deferred for a period of no less than four years (the requirement is 50 percent for SRTs). For an example of what this means in practice, assume that a CEO will receive $10 million in stock options if the company meets certain performance targets in 2016, such as return-on-equity. If these goals are reached, $6 million of the options wouldn’t be paid until 2020.

If during the deferral period, the company uncovered misconduct by the CEO or suffered from a risk-management failure, then the CEO could be forced to forfeit some or all of the $6 million in unvested stock options. Even after the four-year deferral period, the proposed rule allows companies to claw back vested incentive-based compensation if specific conditions are met.

The proposed incentive-based compensation rule may discourage some of the risky behavior that led up to the crisis, but will likely not be enough to prevent financial industry fraud. Still, by requiring firms to take back previously awarded compensation, as Wells Fargo did with Tolstedt, it will help make fraud less profitable.

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