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Update: Wall Street leaders hash out Main Street trust issues

Financial institutions need to create incentives for their staffs to act in ways that help maintain public trust and decrease risk, or they will face increased regulation, regulators and CEOs of some of Wall Street's biggest firms said at a conference in New York.

William Dudley, who retired as chief of the New York Federal Reserve last week, said at a June 18 conference on banking culture that Wall Street firms need an internal "recalibration" to avoid driving away investors, customers and talented employees. Upon his retirement, Dudley was replaced at the New York Fed by John Williams, the former president of the San Francisco Fed.

Over the long term, the consequences of falling trust go beyond individual entities. "[W]hen the next financial crisis inevitably occurs, the loss of trustworthiness might diminish the public's support for forceful intervention, potentially placing the stability of the financial system at risk," Dudley said.

In addition, Dudley said creating benchmarks across the industry and overcoming hurdles to sharing information about employee misconduct are critical to maintaining public trust in a nation's banking system.

What often trips up firms is a "tyranny of success," said James Gorman, CEO of Morgan Stanley.

Mortgage securitization, one of the main causes of the 2008 financial crisis, originally "evolved as a good thing," Gorman said. However, when investors no longer understood the risk, "too much was kept on the bank's balance sheets, so when there was a liquidity run," there was a problem, he said.

Restoring trust must occur at all levels including customers, communities and regulators, said Elizabeth Duke, chairman of Wells Fargo & Co.

Duke was named chairman early last year, after a board reshuffle following allegations that Wells Fargo staff created fake accounts and sold customers car insurance they did not need.

"It's hard to take a company that was run as 80-some separate businesses and run it as one enterprise," Duke said, adding that Wells Fargo had to begin to "think of ourselves as a single enterprise."

'What the client needs'

Ultimately, Gorman said the customer must be the focus. "You're not trying to figure out which product you're trying to get into the hands of clients, you're trying to figure out what the client needs," he said.

Dudley said he had floated a proposal under which banks would create performance bonds for senior managers and risk takers with deferred compensation that could provide a pool for potential regulatory fines and to recapitalize distressed institutions.

"It would also promote financial stability by reducing the incentives for excessive risk-taking and by providing a source of funds for recapitalization of a troubled firm," he said.

His proposal, Dudley conceded, had not gained traction.

Should financial institutions fail to align incentives with performance, Dudley warned that they could face increased regulation, "sometimes an inefficient substitute for trust" that "could limit the scope and scale of activities of financial firms."

The former Fed president said that as the economy improved, the last financial crisis "has become a distant memory."

The bank CEOs agreed with that assessment. "They say bad loans are made in good times," Duke said.

"The world is moving onto a healthier front," Gorman said, adding, "that's the most scary time."