Did Compliance Programs Fail During the Financial Industry Meltdown?


Most people would say yes to this question. I think the answer is more complex. A stand alone compliance program could not prevent the over-exuberance, excessive risk taking, and ethical lapses that lead to the meltdown.

The inspiration for this post came from an article by David Hechler, Risky Business: Did compliance programs fail the test during the financial industry meltdown? for the April edition of Corporate Counsel. Hechler focused on Countrywide Financial Corporation and Tim Mazur, who was an ethics officer at Countrywide. Hechler comes up with three lessons from

  1. Misaligned Compensation Mangles Companies
  2. You Don’t Build an Ethical Culture in a Day (or Year)
  3. Empowerment Is More than a Nice Word

The real problem was a failure of compliance at the structural level, not the program level.

Top-level executive compensation for public companies will be linked to stock performance. There are many people discussing the pros and cons of this approach and how it affects compliance. The more important place to look for misalignment of compensation is front-line employees and mid-level managers.

The examples in the story about Countrywide are a great example. Loan officers at Countrywide were paid higher commission for sub-prime loans than traditional loans. Wrong compensation. Those loans are riskier to the company so they should be less valuable and be subject to a lower commission. (You should also question why commissions would change from one loan product to another.)

The compensation to the loan officer is tied to origination of the loan with no compensation tied to the repayment of the loan. So of course, underwriting standards are going to deteriorate as the pool of good borrowers shrinks and you need to find less qualified borrowers to take on loans.

The managers of these loan officers were also similarly compensated based on origination of the loans so they were going to push for more and more loans regardless of the likelihood of repayment. There is a similarity to this structure and the the structure at Enron. In The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, the authors paint a picture of Enron focused on origination of deals with little resources or focus on managing the deals.

You can’t build an ethical culture if the structure is not in place. Mazur contends that he did not have enough time to build an ethical culture at Countrywide. Unless he would have been able to change that front-line employee compensation model, I do not think he could have prevented the problems at Countrywide.

You need to align the institutional incentives of your company for a compliant and ethical company. You also need to align the personal incentives for employees throughout the company to match those institutional incentives.


Update: fixed some typos

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