Submission to Banking, Housing, and Urban Affairs Committee Re Silicon Valley Bank Compensation
March 27, 2023
Chair Sherrod Brown
Ranking Member Tim Scott
Honorable Members
U.S. Senate Committee on Banking Housing and Urban Affairs
Washington, DC 20515
Dear Chair Brown, Ranking Member Scott, and Honorable Members,
On behalf of more than 500,000 members and supporters of Public Citizen, we provide the following information and documents for your consideration that are relevant to your hearing March 28 on the federal regulators’ response to the recent bank failures. On the day that federal regulators ceased control of Silicon Valley Bank, Public Citizen called for Congressional hearings, citing the scale and gravity of this failure.[1] We are gratified by your prompt response.
When Federal Reserve Board Chair Jerome Powell testified before the House Financial Affairs Committee March 8 in the semi-annual monetary policy report, Rep. Rashida Tlaib (D-Mich.) presciently asked him the status of rulemaking for Dodd-Frank Section 956. This is the basic banker reform provision in the 2010 law meant to help prevent another government bailout of the financial sector. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act followed the 2008 financial crash, where bonus-chasing bankers loaded the system with fraudulent mortgage securities. Lawmakers well understood the central role of bad compensation structures in that crash and set a deadline for completing this rule: May 2011. (Congress mandated a deadline for only a few of Dodd-Frank’s 400 rules.) Yet 12 years later, the Federal Reserve and other agencies responsible for implementation have yet to finalize this rule. Chair Powell dismissed Rep. Tlaib’s concern about this failure, noting only that a six-agency rule involves complications. (Also prescient, Sen. Robert Menendez (D-N.J.) submitted a question in writing for Chair Powell on the status of Section 956.)
Two days after Chair Powell’s hearing, Silicon Valley Bank (SVB) failed.
In the weeks before this failure, as management undoubtedly understood the bank’s peril, senior executives cashed out their stock. CEO Gary Becker netted $2.27 million in the weeks leading up to the Friday collapse..[2] Alone, this is appalling. It may amount to illegal insider trading. But it also reveals how prominently executive compensation must have figured in the minds of senior managers.
Importantly, as the committee explores what went wrong with SVB, we encourage attention to the role that executive compensation structure played in the poor decisions by SVB management regarding its Treasury securities portfolio. As has been well documented, SVB management’s fatal mistake was to invest in long-term Treasuries at a time when the Federal Reserve raised interest rates precipitously. [3]
Compounding this mistake, SVB terminated a hedge against certain other securities, exposing it to even greater interest rate risks. It did so, arguably, to boost net income. Noted one observer: “Essentially, to juice its P&L [profit and loss] in the short term, SVB ambled into 2023 almost completely unhedged — in effect, a massive multibillion-dollar bet that interest rates were approaching their peak.”[4] Net income served as the principal driver of the firm’s incentive compensation plan. In 2021, CEO Becker received $3 million through the incentive compensation plan. This was three times the value of his salary.[5] The board explains that the incentive compensation plan is driven by return on equity. This is a simply mathematical formula, where net income is divided by the difference between assets and liabilities (shorthanded as equity). Without net income, there is zero return on equity, and surely the board could not justify any bonus for zero return on equity.
It appears that in 2022, SVB was headed for a loss, that is, negative net income. Income from investment securities plummeted from a gain of $761 million in 2021 to a loss of $285 million in 2022. In 2021, the firm reported overall net income of $1.7 billion.[6] With other 2022 line items also trailing their counterparts from 2021, that swing in investment losses of more than $1 billion might well have put the bank in the red. One way to paper this over: terminate the hedge. The firm explains that the hedge covered roughly $16 billion in certain securities and reports tersely, “All hedges using the last-of-layer method were terminated in 2022.” Experts estimate the cost of a hedge for a portfolio of this size is more than $1 billion.[7][8]
We attach a timeline of the SVB case to help the committee explore the link between this failure and executive compensation.
Section 956 explicitly states that banks must not pay “excessive” compensation, especially when it may lead to “inappropriate” risk-taking. We believe that a bonus based on return on equity that is three times the value of a base salary may qualify as “excessive.” (In a2013, the EU capped banker bonuses at twice the value of base salary.[9]) We certainly believe that holding long-term securities at a time of rapidly rising interest rates was “inappropriate.” We also believe that selling a hedge to protect against those rising interest rates was “inappropriate.”
A strong rule may have prevented this. In a 2016 proposal on Section 956 (which was not finalized), the regulators wisely proposed that a significant portion of senior executive bonus pay be deferred into a fund. In the case of misconduct or failure, this fund would be forfeited, either to help pay for the resolution of the bank, or to pay fines associated with the misconduct (instead of having shareholders effectively pay the fines). This dynamic would essentially deputize and incentivize all bankers to police one another. These “inside cops” would be better positioned than regulators who only visit the bank occasionally, better than shareholders who must depend on imperfect, dated information, better than rating agencies, and better than auditors. Had SVB’s senior executives all had their bonuses at risk, one or more of them may have insisted on changing course. (The 2016 proposal left forfeiture to the discretion of the bank’s board; we insist that forfeiture be mandatory.[10])
SVB may be the most conspicuous current example of how badly constructed compensation figures in a banking crisis, but it is not alone, as well-known cases abound. JP Morgan lost $6 billion in flawed derivatives bets known as the “London Whale,” connected to plan to boost senior executive pay.[11] [12] Goldman Sachs bribed Malaysian government officials to win lucrative bond underwriting deals, which also involved embezzlement of more than $1 billion that might have gone to needed development in that country.[13] Wells Fargo placed untenable quotas on its agents to increase consumer accounts, forcing them to create fake accounts so as to boost senior executive pay linked to account growth metrics.[14] [15] Supporters of a OneWest merger flooded regulators with suspect endorsement letters in a deal that promised a $24 million payout for the CEO. The firm faced criticism for massive foreclosures, an action that might have stymied the merger under the Community Reinvestment Act.[16]
In 2022 alone, numerous cases link compensation to fraud and investor abuse by banks, including examples such as: ; investor abuse by Allianz[17], First Republic Bank,[18] and Credit Suisse[19][20]; and maintain insufficient anti-money laundering controls by USAA Federal Savings Bank[21] [22]and Wells Fargo. [23]
Public Citizen has documented this persistent problem in several reports. We attach a recent report, entitled “Inappropriate,” to this letter.
We understand there are many failures to explore in the SVB case. We trust you will insist that regulators complete Section 956 and include a strong compensation deferral mechanism as one of the remedies.
For questions, please contact Bartlett Naylor at bnaylor@citizen.org.
Sincerely,
Public Citizen.
Timeline: Silicon Valley Bank Failure
AVS: Available for Sale securities, which are recorded at currently traded values, or the price they’d fetch if sold today.
Bps: basis points. A basis point is a percent of a percent.
FDIC: Federal Deposit Insurance Corp
Fed: Federal Reserve Board, which is head quartered in Washington, and maintains 12 regional reserve banks, one of which is in San Francisco
HTM: Hold to maturity securities, usually Treasury bonds, which are recorded at the price the bank will receive if held to the maturity date.
SVB: Silicon Valley Bank, a $211 billion asset bank headquartered in Palo Alto, Ca.
10Q: quarterly filing required of all publicly traded U.S. companies.
10k: annual report required of all publicly traded US companies.
Dec. 17, 2015: Fed increases interest rates (Federal Funds Rate) 25 bps. It increases rates 25 bps every quarter through 2018 ending year at 2.5%
2018: Congress approves S. 2155, raising from $50b to $250b the level of assets a bank must have to face “enhanced supervision” with more “stringent standards.” SVB assets in 2016: $45b. SVB assets 2017: $51b; 2018: 57b
2019: Fed reduces interest rates three times, each 25 bps, calling it a “mid-cycle adjustment.”
2019: SVB assets $71b
March 13, 16, 2020: Fed cuts interest rates twice for a total of 1.5%, leaving them at zero, citing Covid.
2020: SVB assets: $115b
2021 SVB annual earnings of $1.7 b, up from 2020 earnings of $1.2b. see p. 95 of annual report. SVB assets $211 b
2022 SVB establishes a bonus opportunity for CEO based on return on equity (net income/[assets – liabilities]) which results in a bonus that is three times salary. SVB assets $211b
March 17, 2022: Fed Increases rates 25 bps.
April 2022, SVB chief risk officer Laura Izurieta departs bank, w $7.1 in compensation (stock option gains). Reportedly, management sought her ouster after she sold $4m worth of stock on Dec. 6, 2021. She is not replaced for eight months.
May 5, 2022: Fed increases rates 50 bps, putting Federal Funds rate at 1%.
May , 2022, SVB 10Q shows Treasury (HtM) unrealized securities loss of $7b ($91b market, $98b book)
June 30, 2022, SVB 10q shows Treasury (HTM) unrealized securities loss of $11b ($84 market, $95b book)
Nov. 7, 2022 SVB 10Q shows Treasury (HTM) unrealized securities loss of $16b ($77b market, $93b book), same as SVB capital)
2022 SVB annual report reveals “All hedges using the last-of-layer method were terminated in 2022.” This generates $X in income for the bank. See p. 144 of annual report. Company reports 2022 net income of $1.5 billion (down from $1.7b in 2021, but would have been loss without termination of hedge).
Late Jan, 2023: CEO Gary Becker, others, change 10b5-1 plans, providing for stock sales. (A new SEC rule, which isn’t in effect as of this date, prohibits sales following a new 10b5-1 plan for six months.)
Feb 27, 2023: Gary Becker sells $3+m worth of stock, netting $2.2m.
March 8: SVB announces it will raise capital
March 9, 2023: bank run.
March 10: FDIC takes over SVB. Stock price goes to zero.
Inappropriate
Bartlett Naylor and Zachary Brown
September 9, 2022
Executive Summary
The 2008 financial crash stemmed from numerous causes, and risk-taking by bankers in pursuit of incentive-based compensation figured as one of the most conspicuous triggers. Bankers committed massive frauds selling flawed mortgages, ultimately sending the economy into a Great Recession. Congress responded in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act.[24] This law mandated several executive pay reforms, including requiring the drafting of a rule to prohibit compensation structures that promote “inappropriate” risk-taking. Fraud certainly is inappropriate. Congress set a deadline for implementation of this rule: May 2011. Twelve years since passage of the law, this rule remains unimplemented.
Perhaps there might be an excuse for the government’s inaction if the rule were no longer relevant or urgent. However, that is not the case. Bankers continue to engage in inappropriate risk-taking, including perpetrating fraud. Well-known cases abound. JP Morgan lost $6 billion in flawed derivatives bets known as the “London Whale,” connected to plan to boost senior executive pay.[25] [26] Goldman Sachs bribed Malaysian government officials to win lucrative bond underwriting deals, which also involved embezzlement of more than $1 billion that might have gone to needed development in that country.[27] Wells Fargo placed untenable quotas on its agents to increase consumer accounts, forcing them to create fake accounts so as to boost senior executive pay linked to account growth metrics.[28] Supporters of a OneWest merger flooded regulators with suspect endorsement letters in a deal that promised a $24 million payout for the CEO. The firm faced criticism for massive foreclosures, an action that might have stymied the merger under the Community Reinvestment Act.[29]
In 2022 alone, numerous cases link compensation to fraud and investor abuse by banks, including examples such as: a fake account scam at U.S. Bank[30]; abuse in student loans by Navient[31]; investor abuse by Allianz[32], Schwab[33], First Republic Bank,[34] and Credit Suisse[35]; and maintaining insufficient anti-money laundering controls by USAA Federal Savings Bank[36] and Wells Fargo. [37]
This ongoing litany of inappropriate action by executives in search of enrichment clearly demonstrates the urgency of why regulators must take swift action to finalize this pay reform rule.
Introduction
Bankers pursuing incentive-based compensation figured as one of the most important causes of the financial crash of 2008.
The 2008 financial crash centered around unsafe mortgage-making and trading. Risky mortgages became part of complicated debt packages, sold to investors around the world. When mortgage borrowers began to default, the problems spread throughout the financial plumbing. Misguided pay structures figured at every stage. Mortgage sales agents intentionally sold expensive, subprime mortgages to borrowers who qualified for better, prime mortgages. That’s because subprime mortgages generated better commissions for sales agents.[38] Securitization of those mortgages into bonds meant lucrative underwriting fees for investment bankers. When the supply of sound mortgages began to dwindle, as most qualified borrowers already owned homes, the industry reduced its underwriting standards, awarding mortgages to unqualified borrowers to keep the fee-generating securitization machine buzzing.
Bankers also profited from failure. Goldman Sachs bankers generated fees for themselves by bundling bad mortgages into securities they sold to investors, and then won more by placing bets those securities would falter.[39]
“[F]lawed incentive compensation practices in the financial industry were one of the many factors contributing to the financial crisis that began in 2007,” according to a collective statement by federal regulators.[40] Separately The Financial Crisis Inquiry Commission found that pay systems too often encouraged “big bets” and rewarded short-term gains without proper consideration of long-term consequences.[41] Wall Street bankers themselves agree, with surveys demonstrating that more than 80 percent of financial market participants believe that compensation practices played a role in promoting the excessive risk that led to the financial crisis.[42]
The 10 senior executives of Bear Stearns and Lehman Brothers, which failed under those executives’ leadership, were paid $1.4 billion, including severance packages, in the years leading to the ’08 crash. That’s an average of $140 million each. They made riches to risk—and lose—their companies.[43]
The Senate Permanent Subcommittee on Investigations found that pay incentives throughout the firm played a major role in inducing Washington Mutual to make inappropriately high-risk loans, eventually driving the firm into bankruptcy.[44]
In the restrained terms of the Securities and Exchange Commission (SEC): “Poorly structured incentive-based compensation arrangements can provide executives and employees with incentives to take inappropriate risks that are not consistent with the long-term health of the institution and, in turn, the long-term health of the U.S. economy. Larger financial institutions are interconnected with one another and other companies and markets, which can mean that any negative impact from inappropriate risk-taking can have broader consequences. The risk of these negative externalities may not be fully considered in incentive-based compensation arrangements, even arrangements that otherwise align the interests of shareholders and other stakeholders with those of executives and employees.”[45]
In these examples from the ’08 crash, senior bank managers obscured vital risk information. This misled shareholders, auditors, and prudential supervisors.[46] The risky behavior at cause stemmed from the fact that senior managers were compensated largely in stock options. Firms that pay executives with stock options provide an asymmetric incentive to produce financial results that may involve excessive risks. If the risks lead to rewards, the stock options can pay handsomely. If those risks instead lead to losses, the manager does not suffer a loss of pay. Individual regulators agree. Steven Harris, then a member of the Public Company Accounting Oversight Board, observed that certain stock-option plans proved to be “strong incentive for excessive risk-taking.”[47]
Bankers also engaged in wholesale fraud based on the compensation packages leading to the 2008 crash. For this, 49 financial institutions paid various government entities and private plaintiffs nearly $190 billion in fines and settlements, according to one analysis.[48]
Before the pay-fueled financial crash of 2008, compensation figured at the center of other bank-related fiascos. The Wall Street crash of 1929 leading to the Great Depression of the 1930s, followed massive fraud by senior bankers aiming to fatten their already enormous compensation.[49] The Latin American debt crisis of the 1980s, where American bankers plied Central and South American governments with more loans than they could repay, stemmed from pay packages connected to the volume of loan-making.[50]
And, as detailed below, this compensation-fueled risk taking and wrongdoing is not a relic of the past, and instead is currently driving bad decision-making by bankers.
Pay Reform: Section 956
Following the financial crash of 2008, Congress responded in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).[51] This statute directed regulators to write and implement some 400 rules designed to increase the safety of banks and combat reckless loan-making. One of these is Section 956, part of a suite of six pay rules designed to blunt the role of compensation in promoting bad banking. Section 951, for example, requires a shareholder vote on compensation disclosures, ideally enlisting bank owners to guard against bad pay practices. Section 954 calls on banks to recover pay in the past when it turns out that performance metrics to which the pay was linked were untrue. Before the crash, bankers might have been paid for making good loans; when those loans went bad, that pay could be recouped.
Then there is Section 956. This brief section of the statute “prohibit[s] any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by…financial institutions.” (Emphasis added.)[52] To establish this prohibition, Congress called on five regulators to coordinate a final rule: The Federal Reserve, Federal Deposit Insurance Corp (FDIC), the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC) and the National Credit Union Administration.
Of the 400 rules of the 853-page Dodd-Frank Act, few placed deadlines on the regulators. Presumably, this meant that they were of less urgency, and given the massive number, Congress may have understood that finalization would take regulators time to complete. Congress did mandate deadlines for a few rules. One of these was Section 956, presumably underscoring its importance and urgency. That deadline was May 2011, which passed without agencies finalizing a rule.
The agencies did propose a rule in 2011 but, as noted, failed to finalize it. Public Citizen and others criticized this initial proposal and called for a more robust rule. In 2016, regulators obliged with another, somewhat stronger proposal. But they again failed to finalize this rule. During the Trump administration, regulators failed to propose any rule.
The most common explanation for this delay in regulatory action on Section 956 has been the complication of five-agency coordination. But under the Obama administration, the agencies were able to propose a rule—twice. Moreover, other Dodd-Frank rules required multiple agencies, such as the so-called Volcker Rule that bars proprietary trading, which was finalized in 2013.[53]
For the American public, the important question is whether implementation of Section 956 remains relevant. Afterall, the financial crash took place 14 years ago.
The sad, urgent, and perhaps obvious answer is yes.
Major Cases of Banker Misconduct Tied to Compensation
Below is a sampling of some of the more infamous instances since 2010 where major harms to Americans and others resulted from “inappropriate” actions taken by bankers and where their compensation structures can be identified as a contributing factor. What is “inappropriate” risk-taking may be subject to interpretation, especially when it applies to banks. By nature, banks take risks when they make loans—a risk that the borrower will not repay. Some borrowers may be less creditworthy. Others may be involved in socially problematic enterprise. For example, Public Citizen believes that banks should not lend to firms that exacerbate climate change.[54] However, there can be no debate that engaging in activity that involves fraud, consumer abuse and other actions that result in penalties and/or prison for bankers is “inappropriate.” Where compensation may promote such fraud and abuse, Section 956 should apply. The following well-known cases involved fraud and abuse that led to government sanctions, and have been shown to have been prompted, at least in some part, by executives’ search for increased riches.
Goldman Sachs Bribery
In 2020, the Department of Justice (DOJ) announced that during a period of five years, Goldman Sachs conspired in “a sweeping international corruption scheme” that involved more than “$1.6 billion in bribes to multiple high-level government officials across several countries so that the company could reap hundreds of millions of dollars in fees.”[55] There can be no debate that bribery is inappropriate.
One government that was involved in this scandal was Malaysia. The Malaysian government created a fund known as 1Malaysia Development Berhad, or 1MDB, to promote economic development in the country through global partnerships and foreign direct investment. The funds were intended to be used for improving the well-being of the Malaysian people. Malaysia is a relatively successful emerging economy; poverty rates have declined in the last two decades.[56] The funds were intended to help keep these improvements on track.
Instead, more than $1 billion of these funds—generated in part by Goldman Sachs bond underwriting—“were taken and spent on a wide variety of extravagant items, including luxury homes and properties in Beverly Hills, New York, and London; a 300-foot superyacht; and fine art by Monet and Van Gogh,” according to the DOJ.[57] Other funds went to acquisition of a boutique hotel in Beverly Hills; a movie production company that made “The Wolf of Wall Street” (!), the redevelopment of the Park Lane Hotel in Manhattan; and shares in EMI, the largest private music-rights holder.[58] Najib Razak, the Malaysian prime minister who established and oversaw the fund reportedly deposited $731 million of these funds into his personal bank account.[59]
In October 2020, Goldman Sachs “admitted to conspiring to violate the Foreign Corrupt Practices Act (FCPA) in connection with a scheme to pay over $1 billion in bribes to Malaysian…officials,” according to the DOJ.[60] Goldman Sachs paid these bribes to win underwriting deals for roughly $6.5 billion in three bond deals for 1MDB. The bank received some $600 million in fees for these deals.
The embezzlement led to protests involving hundreds of thousands of Malaysians. At least three murders are associated with the scandal and investigation, including one Malaysian prosecutor.[61]
The fees meant a major reward for certain senior Goldman Sachs bankers, notably Tim Leissner, the former Southeast Asia Chairman and participating managing director of Goldman Sachs. Leissner sealed three bond deals that netted Goldman $600 million and meant he received “large bonuses,” according to U.S. prosecutors.[62] Leissner pleaded guilty to violations of anti-bribery laws. [63]
Leissner’s Goldman partner, Ng Chong Hwa, also known as Roger Ng, was convicted in 2022 by a federal jury in the embezzlement scheme. Commented prosecutor Breon Peace, the verdict was “a resounding victory for justice and for the people of Malaysia who were the victims of this massive scheme that the defendant and his partners in crime carried out in a frenzy of greed to get rich by stealing millions of dollars from [a] fund intended to benefit that country’s economy.”[64]
Other Goldman executives may have participated in the scheme to benefit their compensation as well, and not simply one or a few rogue bankers.[65] More than 30 senior Goldman executives reportedly knew about the bank’s dealings with 1MDB.[66]
Goldman Sachs CEO, Lloyd Blankfein, attended two meetings with the Malaysian financier at the center of one of the schemes, including one meeting after Goldman’s compliance department had raised multiple concerns about the financier’s background and said the bank shouldn’t do business with him, according to the Wall Street Journal.[67] In addition, CEO Blankfein openly praised his Malaysian bankers at a meeting in 2014: “Look at what Tim and Andrea [Vella, a third executive who helped structure the bonds] did in Malaysia…We have to do more of that.”[68]
After Goldman admitted to criminal wrongdoing in the Malaysian bribery and embezzlement scheme, Goldman announced it would claw back $174 million in pay to past and present executives: CEO Lloyd Blankfein, COO Gary Cohn and CFO. David Viniar. It also announced pay cuts for the current chief executive and his top lieutenants.[69]
Bankers who “work…behind the scenes for their own illegal benefit, and not that of their citizens and shareholders, their behavior lends credibility to the narrative that businesses don’t succeed based on the quality of their products, but rather their willingness to play dirty,” said Assistant Director in Charge William F. Sweeney Jr. of the FBI’s New York Field Office. “Greed eventually exacts an immense cost on society, and unchecked corrupt behavior erodes trust in public institutions and government entities alike.” [70]
JP Morgan’s London Whale
At JP Morgan, some of the largest paychecks go to derivatives traders. Some of these are employees who make bets on the direction of a financial metric, such as interest or exchange rates. At the end of 2012, JP Morgan deployed about $180 billion worth of deposits into trading, which the bank primly calls “other available-for-sale securities.”[71] These “other” securities, it turns out, include bets that the bank dignifies with the term “derivatives.” Former Rep. Brad Miller (D-N.C.) observed that JP Morgan’s bets “had nothing to do with real credit. These derivatives trades did not make it possible for more businesses to buy equipment, pay overtime or hire new employees; no household was able to buy a new car or replace their furnace. Instead, the trades were “synthetic” credit, a bet on whether a borrower would default on debt to someone else.”[72] JP Morgan did well on some of these bets. For example, it bet that American Airlines would go bankrupt. When American Airlines did declare bankruptcy, JP Morgan realized a profit of $450 million.[73] [74] The traders earned handsome bonuses for this success. One trader made $11 million that year, and the trader’s supervisor earned $14 million in that same period.[75]
One bet went seriously awry in the case known as the “London Whale.” A handful of traders in JP Morgan’s London office handling that “excess cash” made mistakes. The bank lost more than $6 billion on the bets, and a U.S. Senate investigation later turned up evidence that an attempt to increase senior management compensation motivated the trades.
In “Exhibit 46” of the Senate report, JPMorgan’s chief investment officer directed subordinates to implement a plan to enable the bank to buy back stock. That plan depended on convincing regulators that such a step would be financially prudent. In a series of emails about the trades, the CFO stated she was “trying to work” with the regulators on an “acceptable…increased buyback plan.”[76] In conventional terms, the committee report alleged that JPMorgan sought to manipulate how the “whale” trade would conform with regulatory safeguards so that JPMorgan could buy back stock – an action that typically boosts a share price and thus leads to higher executive compensation.[77] [78]
Wells Fargo Fake Accounts
Wells Fargo’s compensation structure drove widespread fraud in many of its business operations, including checking accounts, credit cards, car insurance, investment accounts and more. Account growth figured as one of the long-standing metrics for senior employees’ pay bonuses. Wells Fargo wanted its customers to have not one or two, but as many as eight (“go for gr-eight”) connections to the bank, such as a checking account, a credit card, a mortgage and more.[79]
Wells Fargo reported these account connections, known as “cross-selling,” as a key indicator of how it could manage growth. When it acquired other banks, such as Wachovia, its employees faced pressure to show how those cross-selling numbers would continue to rise steadily. That satisfied shareholders who might otherwise have been concerned that growth might lead to management complications. And satisfied shareholders meant a rising stock price, and as a result, greater senior management pay. Public Citizen documented this decades-long dynamic in “The King of the Cross-Sell.”[80]
Internal whistleblowers alerted their superiors and eventually the media that much of these cross-selling figures were fabricated. Bank employees created fake accounts to meet quotas. Wells Fargo terminated many of these line employees, but senior managers nevertheless retained their bonuses. Eventually, the Consumer Financial Protection Bureau (CFPB) and the City Attorney of Los Angeles brought charges for these fabrications and leveled a record fine against Wells Fargo.[81] When greater scrutiny of the bank followed, even more abuses were revealed, and eventually, the CEO resigned. The fruits from this fraud amounted to $130 million in compensation for the CEO, and millions more for other senior managers.[82]
Once known as the benign mega-bank, the fake account scandal at Wells Fargo became only the first of a wave of problems that surfaced at the company, involving illegal student loan servicing practices, car insurance scams, federal home insurance misconduct and more, arguably most connected to bankers attempting to fatten their compensation packages.[83]
Credit Suisse Bribery
In 2021, Credit Suisse paid $475 million to U.S. and U.K authorities for fraudulently misleading investors and violating the Foreign Corrupt Practices Act (FCPA) in a scheme involving underwriting for state-owned organizations meant to promote tuna fishing in Mozambique. Bankers are paid underwriting fees.
The SEC said the underwriting transactions raised more than $1 billion to “perpetrate a hidden debt scheme, pay kickbacks to now-indicted former Credit Suisse investment bankers along with their intermediaries, and bribe corrupt Mozambique government officials.”[84]
As a result of the Mozambique scam, along with major losses from deals with Archegos Capital Management, and an accounting fraud loss with a Chinese client, the bank’s board responded by cutting executive pay.[85] [86] The Swiss Financial Market Supervisory Authority (FINMA) required pay reforms as well.[87]
One West Homeowner Abuse
High pay also figured in some questionable decisions by the CEO of OneWest, who surprisingly went on to become the nation’s chief bank police officer as Comptroller of the Currency. This episode began when hedge fund manager, and subsequently Treasury Secretary, Steven Mnuchin purchased the failed IndyMac savings and loan association from the FDIC and renamed it OneWest. Mnuchin brought in a mid-level manager named Joseph Otting from US Bancorp to serve as OneWest CEO. Under this new ownership, the bank foreclosed on thousands of homeowners by using fraudulent methods: They fabricated foreclosure documents such as filing unnotarized documents with state and federal courts. OneWest’s regulator itemized these misdeeds, and under new CEO Otting, the bank signed a “consent order” acknowledging those former misdeeds along with a promise to reform. However, the bank did not reform, and under Otting, OneWest affiliate Financial Freedom allegedly made false claims to the government for federal insurance and paid a $89 million penalty.[88] Otting’s bank put thousands of families out of their homes.[89] One judge deemed this “harsh, repugnant, shocking and repulsive” conduct.[90]
Otting and Mnuchin arranged to sell OneWest to CIT group for a profit; completion of the deal promised Otting a $24 million bonus.[91] What stood in the way of his huge payout were protests by some of those thousands of families and other victims of OneWest’s practices. Under the Community Reinvestment Act (CRA), regulators can block mergers where a firm fails to serve its community. In trying to secure approval for OneWest’s merger with CIT Group, Otting’s bank created an online petition urging Federal Reserve Chair Janet Yellen to approve the transaction without a public hearing. Many of the names were Wall Street associates. The California Reinvestment Coalition noted, “In Mr. Otting’s judgment, his friends on Wall Street, thousands of miles away, were somehow better situated to provide input on a California bank merger than the community members who were actually going to be impacted by the merger.”[92]
The email campaign also included some irregularities. One petition was composed of 593 individuals purportedly supporting the merger with Yahoo email accounts. (Yahoo has a 3 percent market share for email.) Many these emails were time stamped as 2 a.m., February 13, 2015. Yahoo had suffered a security breach before this period. Other emails came from persons who, after they received receipt confirmation from the Washington regulator, denied they had originated them and theorized their email had been hacked.[93]
Despite the foreclosures and violations, despite the protests of the merger, despite the irregularities in the pro-merger petitions, and despite the fact that CIT terminated Otting shortly after then merger, Otting nevertheless received his $24 million payoff.[94][95]
HSBC Money-laundering
In 2012, the DOJ filed a criminal charge against HSBC for money laundering, entering a so-called “deferred prosecution agreement” and fining the company $1.25 billion. According to the DOJ, HSBC “severely understaffed” its anti-money laundering division, failing to “monitor over $670 billion in wire transfers and over $9.4 billion in purchases of physical U.S. dollars from HSBC Mexico during this period, when HSBC Mexico’s own lax AML controls caused it to be the preferred financial institution for drug cartels and money launderers.”[96] The Senate Permanent Subcommittee on Investigations noted that those attracting the funds from money launderers received bonuses.[97]
Public Citizen and others questioned why the government didn’t seek a final criminal charge, sanction the bank more harshly (the fine amounted to a month’s worth of profit), and identify and prosecute responsible individuals.[98] Then-Attorney General Eric Holder told a Senate committee that some firms had become “so large” that a criminal charge against one of them could endanger the world economy; they were “too big to jail.”[99]
Public Citizen and others warned that inadequate justice promotes recidivism. In 2021, officials fined HSBC again for money laundering violations.[100]
Cases From 2022
In addition to the well-publicized examples highlighted above, very recent instances of “inappropriate” behavior connected to compensation abound. Below is a sampling of cases announced this year—2022—which as of this research, is only nine months old.
Credit Suisse (again)
On January 9, 2022, the Financial Industry Regulatory Authority (FINRA) fined Credit Suisse $9 million for an assortment of misdeeds, including failure to explain to clients in its research reports that its Credit Suisse employees might receive compensation from the deals described in these reports.[101] According to FINRA, Credit Suisse issued more than 20,000 research reports between 2006 and 2017 that contained inaccurate disclosures regarding potential conflicts of interest. FINRA requires firms to “disclose in research reports if the firm or any of its affiliates received compensation for [investment banking] services from the subject company in the past 12 months, or if the firm or any of its affiliates expect to receive or intend to seek compensation for [such] services from the subject company in the next three months.” In this way, an investor can better understand if a report that promotes an investment might include puffery that serves a current or prospective Credit Suisse client. [102]
Navient
On January 13, 2022, 39 state attorneys general won a $1.85 billion settlement from student loan servicing giant Navient to resolve allegations of widespread unfair and deceptive practices and abuses in originating predatory student loans.[103] The state law enforcers claimed that since 2009, Navient steered struggling student loan borrowers into costly long-term forbearances instead of counseling them about the benefits of more affordable income-driven repayment plans.[104]
Navient compensates its executives based on several factors, including “fee income.” The firm explains that “fee income emphasizes the continuing importance of our fee-based businesses, which generate income through loan servicing [and] asset recovery.”[105] In addition, the CFPB alleged that Navient’s compensation policies for its customer service representatives “incentivized them to push numerous borrowers” into these forbearance plans that were inferior for the student but more profitable for Navient.[106]
USAA Federal Savings Bank
On March 31, 2022, the Financial Crimes Enforcement Network (FinCEN) fined USAA Federal Savings Bank $80 million for anti-money laundering surveillance violations. FinCEN detailed several customers with questionable activity that the bank failed to surveil. For example, “Customer B,” a 22-year-old individual in Los Angeles, California, held checking and credit card accounts with USAA for four years. Customer B reported to USAA that she owned a “performance art company.” Customer B reported that her annual income was between $50,000 and $100,000, and that her account was for personal and household expenses. However, the bank found that the “performance art” maybe have been an “unlawful internationally-based prostitution/escort” service. One overseas client sent three wire transfers totaling $44,500. The foreign individual was identified in the Panama Papers, a trove of information about offshore accounts. USAA failed to notify FinCEN about Customer B and other suspicious accounts.[107]
FinCEN did not detail how USAA bankers profited from failing to close these accounts, but the Senate Permanent Subcommittee on Investigations found that bankers that secure new deposits, known in accounting terms as Net New Assets (NNA), is “one of the metrics used for measuring employee performance and compensation.”[108] Further, FinCEN asserted that as its “consumer base and revenue grew,” the bank “willfully failed to ensure that its compliance program kept pace, resulting in millions of dollars in suspicious transactions.”[109] In this case, a prominent factor was the compensation not paid. FinCEN noted that the bank itself determined in 2018 that it needed 178 permanent staff to comply with anti-money laundering compliance, but a year later, there were 62 vacant positions.[110]
Allianz Global Investors
On May 17, 2022, the DOJ announced guilty pleas of bankers at Allianz Global Investors, and an indictment of a third in a securities fraud conspiracy that led to billions in losses for pension fund and other investors “in order to line their own pockets.”[111]
Allianz is a German-based global financial firm that includes subsidiary Allianz Global Investors. Between 2014 and 2020, the Allianz conspirators promoted a set of private funds known as Structured Alpha Funds to “institutional investors, including pension funds for workers all across America,” according to the DOJ. They “misled” these investors into believing that the funds were protected from a sudden stock market crash by engaging in sophisticated trading strategies known as hedges. As the cost of this strategy increased, they “decided to lie and secretly buy cheaper hedges that provided much less protection to investors.” In March 2020, following the crash in the stock market after the COVID-19 pandemic stifled the world economy, the funds lost an excess of $7 billion in market value. These losses fell on more than 100 institutional investors who held savings of more than 100,000 customers. This included pension funds for teachers in Arkansas, laborers in Alaska, bus drivers and subway conductors in New York City, as well as religious organizations, engineers, and other individuals, universities, and charitable organizations across the United States. [112]
Before the 2020 crash, the scheme enhanced the profits of the firm, including the compensation paid to the conspirators. One of the alleged conspirators was “either the highest or second-highest compensated employee” of the firm. In 2019, two of the conspirators received $13 million each. The DOJ concluded, “As a result of this compensation structure, the [conspirators] earned higher pay by taking greater risk with the Funds’ money to generate larger performance fee.”[113] Certainly this should be seen as inappropriate risk-taking behavior.
In addition to prison sentences for the two conspirators who pleaded guilty, the government fined Allianz $1 billion.[114]
First Republic Bank
On May 19, 2022, the SEC fined First Republic $1.8 million for failing to disclose compensation conflicts with its investing clients. Specifically, the bank received compensation from another firm by placing investors’ monies with this second firm, when First Republic could have found more favorable investment opportunities.[115]
In particular, First Republic invested clients’ funds in certain mutual funds and so-called cash sweep products that led to a revenue sharing with an affiliated broker. First Republic might have used a different broker that would have been cheaper for First Republic clients.
Wells Fargo (again)
On May 20, 2022, The SEC charged Wells Fargo for failing to file at least 34 Suspicious Activity Reports (SARs) and the firm agreed to pay $7 million to settle the charges. The SEC said Wells Fargo failed to monitor foreign wire transfers properly, including transfers from foreign countries that it determined to be at a “high or moderate risk for money laundering, terrorist financing, or other illegal money movements.”[116]
Brokers are generally compensated by charging fees on assets they attract and manage, so it is in their interest to attract, and not reject customers’ requests to open an account.[117]
This 2022 fine follows another anti-money laundering fine at Wells Fargo from 2017. In this case, the SEC alleged that a new Wells Fargo manager for anti-money laundering compliance decided the bank was “filing too many” SARS and required that any report contain “proof” of illegal activity, a requirement that naturally led to the bank reporting less suspicious activity. Following this, Wells Fargo suspicious activity reporting declined 60 percent.[118]
Charles Schwab
On June 13, 2022, the SEC fined Charles Schwab $187 million for allegedly misleading investors so the firm could profit from reduced earnings for their clients. From March 2015 through November 2018, the SEC said Schwab told customers in its proprietary Schwab Intelligent Portfolios that the amount of cash was determined through a “disciplined portfolio construction methodology” to generate “optimal return[s].” In fact, the SEC said the firm’s own data showed that under most market conditions, the cash in the portfolios would cause clients to make less money even while taking on the same amount of risk. Schwab failed to tell clients about this drag on their investment. As a result, the firm profited by “sweeping the cash to its affiliate bank, loaning it out, and then keeping the difference between the interest it earned on the loans and what it paid in interest to… clients.”[119] The SEC did not identify specific individuals who many have profited; these profits may have been allocated generally to portfolio managers.
US Bank
On July 28, 2022, the CFPB fined U.S. Bank for a Wells Fargo-like fake-account scam. This allegedly began in 2016. “To increase sales of certain consumer financial products or services, U.S. Bank imposed sales goals on bank employees as part of their job description and implemented an incentive-compensation program that financially rewarded employees for selling those products and services,” according to findings of the CFPB.[120] This activity spanned the years 2010 to 2020.[121] U.S. Bank is the nation’s fifth largest bank and paid a $37 million penalty.[122]
Policy Reform
Bad pay structures led to the massive frauds precipitating the financial crash of 2008 and the resulting Great Recession. Historically, compensation structures that incentivize bending the rules to line one’s pockets have caused crises in American history.” Bad pay structures led to other bank-caused crises in American history, most notably the Crash of 1929 that precipitated the Great Depression. And since 2008, bad pay structures have led to major bank losses, bribery, money laundering, fraud, investor and consumer abuse.
Clearly, Washington rule-makers must use the available tool approved by Congress in 2010 to combat future injuries.
Public Citizen believes that a well-structured rule under Section 956 can help reduce the potential for recurrence of the types of problems this report documents.
We believe any final rule should contain the following.
Implement A Ban On Stock Options At Wall Street Banks
Risk-taking can become volatile at a bank when mixed with stock options.[123] Stock options promise executives all the benefits of share price increases with none of the risk of share price declines. In other words, stock options provide executives with asymmetric incentives to shoot for the moon. On Wall Street in the mid-2000s, this meant relaxing the underwriting standards on mortgage lending to generate fees for the bank while inflating the housing bubble. As long as massive stock option jackpots — often worth seven-, eight-, and even nine-digits — are sitting on the table, with little or no downside risk, Wall Street executives and traders have a powerful incentive to make outrageous gambles that put us all at risk. Many of the senior executives in cases above profited when they or their subordinates engaged in fraudulent activity because that raised the stock price. For example, pressure by Wells Fargo’s executives on the line clerks to fabricate fake accounts for customers yielded growth numbers that pleased Wall Street, driving up the stock price.
Some firms, including JP Morgan and Citigroup, have already voluntarily stopped issuing executive stock options.[124] They should be banned for all bankers. We note that rules from the European Union introduced in 2014 limit banker bonuses to no more than annual salary, or up to 200 percent of annual salary with shareholder approval.
A requirement that significant compensation be deferred for 10 years to pay potential misconduct fines
The fraud perpetrated by bankers leading up to the 2008 crash resulted in tens of billions of dollars in fines. But prosecutors failed to imprison any senior banker or assess fines on any of the responsible individuals. Instead, bank shareholders effectively paid those fines. We advocate that a significant portion of senior banker annual pay be deferred for ten years.[125] These collective funds would then be used to pay fines that a company might incur for misconduct settlements. William Dudley, then president of the New York Federal Reserve Bank, advanced this proposal as a way to change the dangerously reckless, individualistic culture on Wall Street.[126] In concept, it returns investment firms to their pre-public partnership model, where fines were effectively deducted from the profits that might be distributed to partners.
Many of the frauds discussed above must have been understood by at least some senior executives who nevertheless kept quiet lest their lack of loyalty jeopardize their job security. If their own pay were jeopardized, they might have spoken up. If executives knew that the tsunami of fraudulent mortgage-making leading to the 2008 financial crash would lead not to shareholder-funded fines, but elimination of their own bonus, they may have bridled this behavior.
A Ban On Executive Hedging Of Bonus Pay
Any effort to reduce inappropriate risk-taking will be ineffective if employees can use hedging strategies to reduce their risk from poor company performance. In 2005, AIG CEO Hank Greenberg bought insurance to hedge about $300 million worth of stock, allowing him to avoid millions of dollars in losses when the firm collapsed in 2008.[127] The Bank of England already imposes a hedging ban on executives of the banks it supervises, and several major U.S. banks have voluntarily instituted such anti-hedging policies.[128] The U.S. rule should do so as well.
Conclusion
Financial institutions play a pivotal role in our economy, matching savers and users of capital. America’s great industries grew with the financing of banks, from the railroads, automobiles and airplanes, to pharmaceuticals, technology, food and more. These businesses, in turn, can provide good jobs. Homebuyers can live in greater comfort with sound loan-making. Consumers can access credit for needed purchases.
But when bankers seek to maximize their compensation by any means, the devastation can be equally bleak, as attested by the Great Depression, the Great Recession, money-laundering that fuels drug lords and tyrants, bribery that undermines government development programs and public trust, consumers paying fees on accounts they didn’t open, abused shareholders and investors, and other harms to consumers due to inappropriate behavior by bankers.
Washington’s regulators must propose a strong rule to implement Section 956. The time is now.