THE BLOG
10/22/2014 01:09 pm ET Updated Dec 22, 2014

Decimate Wall Street

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The Roman army responded to desertion by randomly executing a tenth of those soldiers remaining. They called it decimation, derived from the word "tenth." This discipline, of course, prompted all soldiers to police against desertion so as to save their own skins.

New York Federal Reserve Bank President William Dudley seems to have borrowed a piece of this incentive structure for a current financial situation. In a speech October 20, this key regulator of the nation's largest banks proposed that a major chunk of pay for all senior executives at a particular bank be forfeited when the bank violates the law.

Specifically, Dudley proposes that part of senior bankers' pay be sequestered in a "performance bond." If the bank must pay a large fine, this bond is forfeited and paid as part of the fine. "This 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."

Making bankers pay for fraud may stifle a replay of one of the glaring judicial miscarriages following the response to the financial crisis of 2008. Despite the massive frauds subsequently documented by the Department of Justice, no senior executives faced penalties. The billion dollar fines meted out by the DOJ were, in fact, borne by shareholders innocent of any conspiracy.

Prosecutors have offered varying reasons for this indefensible result, including the recent excuse offered by James Cole, who just retired as Deputy Attorney General at the DOJ: The fraudsters were "rocket scientists" who simply outsmarted the prosecutors. Under the Dudley scheme, even if the DOJ failed to track down some of the guilty individuals, all the senior bankers at a firm would nevertheless suffer at least some financial pain.

Dudley isn't alone in thinking about the links between compensation and bad or risky behavior. Federal Reserve Board Gov. Daniel Tarullo offered parallel remarks at the same Oct. 20 conference. "It is important that compensation arrangements, including clawback and forfeiture provisions, cover risks associated with market conduct."

Dudley and Tarullo are centrist figures, not outliers. Dudley worked for Goldman Sachs. Tarullo heads the Fed's bank regulation effort.

Happily, this idea enjoys a vehicle. One of the last remaining interagency rules required from the Dodd-Frank Wall Street Reform Act requires regulators to adopt compensation packages that remove incentives for bankers to take "inappropriate" risks. This is known in the law as Section 956. Tarullo made specific reference to this Section 956 in his speech. Criminal activity is certainly an "inappropriate" risk.

Putting pay on the line for criminal behavior may reduce the cozy deals the DOJ cuts with mega-banks in what is called the deferred prosecution agreement. HSBC violated money laundering laws and JP Morgan participated in the Madoff Ponzi scheme but the DOJ settled both outside of a trial with deferred prosecution agreements. If such agreements mean the entire class of senior bankers at a firm must take a major pay cut, the bankers may choose instead to take their chance on trial in the hope of winning acquittal and protecting their pay. In turn, that could force prosecutors to bring welcome trials and true convictions of criminal bankers.

Bad Wall Street pay practices led to the financial crash. In Dudley's view, high Wall Street pay attracts intelligent people whose skills are more richly compensated than if they pursue careers in other fields such as rocket science. Many are "risk-takers drawn to finance like they are drawn to Formula One racing." And one risk that many of these intelligent, compensation-hungry gamblers prove willing to take is fraud, he concludes.

Reform the pay incentives and we might keep the rocket scientists exploring space instead of the frontiers outside the law. We need only look to Roman history for counsel.