Sorry William Dudley, Regulation Itself Is the Culture Killer

The Federal Reserve's talking heads have been hard at work over the last week. They have tackled issues ranging from early childhood education, to the Fed's "duty to advance the maximum well-being of all citizens," to regulatory compliance by financial firms. The Fed's musings on topics far outside of its mandate seem odd for an institution that has a lot more thinking to do about-just to throw out a crazy suggestion-monetary policy. But the Fed's regulatory mandate is also large, so its reflections on compliance are worth a closer look.

New York Fed President William Dudley and Fed Governor Daniel Tarullo both gave speeches on the subject on Monday. They rejected the idea that "a few bad apples" are to blame for the industry's troubles, and concluded the problem runs much deeper. Mr. Dudley believes that the "pattern of bad behavior" in the financial industry and the industry's resulting poor public image "originate from the culture of the firms [which] is largely shaped by the firms' leadership."

In reality, the problems originate not from inside the firms, but from the regulatory structure within which firms operate. Bank regulators write the intricate rules with which firms must comply. Regulatory agencies engage in hands-on management of banks' compliance through on-site supervision, threats of enforcement action, and granting or withholding privileges (such as approval of dividend payouts or mergers).

Regulators also influence compliance by directing firm decision-making in key areas from capital, to customer relationships, to compensation, to crisis management. As my colleague Stephen Miller points out, regulations help to dictate the type of assets that banks hold. And, as a supervisory order directing a bank to stop serving payday lenders (published this week in connection with a congressional inquiry) illustrates, bank regulators also weigh in on whether particular customer relationships are appropriate. In the last crisis, regulators influenced strategic decision-making by large financial institutions, in part through the use of government funds and guarantees.

Even the example of bank malfeasance that Mr. Dudley uses in his speech-the manipulation of the London Interbank Offered Rate (LIBOR)-reminds us of just how central a role regulators play in influencing banks' compliance culture. Mr. Dudley longs for a world in which an employee who suggests manipulating LIBOR is met with a resounding "no way" and a referral to compliance. Yet, when a banker told one of the New York Fed's employees in late 2007 that "LIBOR's being set too low anyway," her recorded response was not moral outrage, but an unfazed "Yeah."

Mr. Tarullo acknowledges that outside influences, like regulators, can play a role in setting the unwritten rules by which financial firms operate. Lacking criminal prosecutorial power and the power to throw people in prison, Mr. Tarullo recommends that regulators make liberal use of enforcement actions and mandated firings to shape the industry's compliance norms.

Mr. Dudley's speech embodies an even subtler way to influence firms. He signals that the Fed is watching whether the tone that emanates from the top of financial firms is sufficiently compliance-oriented. Would the Fed give a firm that raised questions about the wisdom or quality of Fed regulation a passing grade for compliance culture? Does "respect for law"-something Mr. Dudley calls a "core element of any firm's mission and culture"-mean that firms must pretend that the regulations with which they are dutifully complying are well-intentioned and well-designed? Mr. Dudley also suggests that employees receive an "ethics and compliance score." This score would be available to future employers, perhaps as part of "a central registry" of hired and fired employees. Would questioning the technical workability of regulatory obligations or pointing to potential deleterious consequences of compliance result in a lower score?

Regulators should be wary of firms and employees that intentionally disregard regulatory mandates. We should all be wary of regulatory attempts to grade firms and their employees on their attitudes toward compliance. There is no surer way to keep firms and their employees from challenging their regulators. Regulators are not always right, and regulated entities must be free to point out their errors without fearing retribution. Professor Julie Hill has shown that the appeals process for challenging bank supervisory determinations is dysfunctional and rarely used. Attitude monitoring by bank regulators will only further dampen regulated entities' appetite for challenging regulators.

Mr. Dudley is correct that "a good culture cannot simply be mandated by regulation or imposed by supervision." A bad culture, however, can be cultivated by regulators that micromanage firms and offer banks cover when they make mistakes. Allowing market pressures to work-even to the point of firm failure-would be a more effective way than giving tough speeches, threatening enforcement action, and monitoring attitudes toward compliance to encourage firms to reassess their own corporate cultures.