Ethics and Finance—Aligning Financial Incentives with Societal Objectives, Speech by Christine Lagarde, Managing Director of the IMF, delivered at the Event hosted by the Institute for New Economic Thinking: Finance and Society

May 6, 2015

Remarks by Christine Lagarde, Managing Director, International Monetary Fund
At a "Conversation with Janet Yellen, Chair of the Board of Governors of the Federal Reserve System"
May 6, 2015, Washington D.C.


Chair Yellen—again, thank you for being here with us today and for your insightful remarks.

You took us through a vivid “walk down memory lane” of the financial crisis and the role of distorted incentives in fueling excessive risk taking. I fully agree that important progress on the regulatory reform agenda has improved the resilience of financial systems. I also welcome the continued vigilance of the Fed and other institutions.

Yet, as we all know, in too many places, financial stability is still not well-entrenched. Our recent Global Financial Stability Report finds that financial stability risks are rising and rotating—from banks to non-banks, from sovereign and bank solvency to market liquidity, and from advanced countries to emerging countries.1

This suggests to me that there is still work to be done to address distorted incentives in the financial system. Indeed, actions that precipitated the crisis were—mostly—not so much fraudulent as driven by short-term profit motivation. This suggests to me that we need to build a financial system that is both more ethical and oriented more to the needs of the real economy—a financial system that serves society and not the other way round.

So today I would like to focus on how to induce a change in the “culture” of the financial sector—how to better align financial incentives with societal objectives. Clearly, better regulation and supervision play an important role—but so does individual accountability.

I will focus on three topics:
(i) The role of regulation and how remuneration and governance structures can help realign incentives in the financial system;
(ii) How to induce positive change in corporate culture; and
(iii) How good regulation can be consistent with financial deepening, inclusion, and stability.

1. The Role of Regulation—Remuneration and Governance Structures

Let me start with the role of rules and regulation.

Today, six years on, regulatory frameworks still face several challenges that precipitated the crisis. Think of rules that are not tight enough and oversight not strong enough—which is why we need further progress on too-big-to-fail institutions. Think of the culture of compensation based on short-term gains rather than sustainable profits, which induces greater risk-taking and short-termism.

So how can we address these problems? We have done in-depth work in the October 2014 GFSR on how compensation and governance structures can help reduce risk-taking behavior and “re-align” incentives in the financial system.2 Let me highlight two key takeaways on the way forward.

First, on compensation. Incentives related to compensation practices need to change, so that rewards are no longer so much tied to myopic actions and excessive risk-taking.

Our work showed that compensation packages can be structured to favor the long-term performance and soundness of the firm. For example, remuneration could become subject to cancellation and claw-back provisions in cases of misconduct or performance downturn, or where the institution requires the direct support of taxpayers.

Another way is to give shareholders a stronger voice in compensation structures of top executives. And there have been positive steps in this area.

Our analysis covering a sample of more than 800 banks from 72 countries suggests that shareholders’ “say on pay” is becoming more widespread. For example, in 2005, only 10 percent of banks allowed shareholders to cast a non-binding vote on management compensation. Today, 80 percent of banks have instituted this policy.

We have also seen some encouraging steps more recently by the Securities and Exchange Commission. The proposed changes should make it easier for shareholders to determine whether executive compensation is aligned with the firm’s financial performance.

Second, changes in governance structures also matter. A key failure during the crisis was in the internal control and risk management systems of institutions. Think of the recent example of the “London Whale.” In many cases, financial risks were either ignored or underestimated—and in the particular case of systemic risks, they were not well understood. Failure happened at both the management and board levels.

One way to address this failure is to establish clearer separation of the management and the board. We have seen that banks with more independent board members take fewer risks. Another way is to ensure qualification and skills of board members and key technical professionals through rigorous “fit and proper” criteria.

So these are two areas where regulation can help.

2. Corporate Culture and Individual Accountability—Filling the Gaps

Yet, regulation alone cannot solve the problem. Whether something is right or wrong cannot be simply reduced to whether or not it is permissible under the law. What is needed is a culture that induces bankers to do the right thing even if nobody is watching.

Ultimately, we need more individual accountability. Good corporate governance is forged by the ethics of its individuals. That involves moving beyond corporate “rules-based” behavior to “values-based” behavior. We need a greater focus on promoting individual integrity. In the Aristotelian tradition, virtues are molded from habit—developing and nurturing good behavior over time.

One clear solution is to set a strong tone at the top of the institution—establishing a culture where ethical behavior is rewarded and where lapses in ethical integrity are not tolerated. More women leaders would also help. Several studies have shown that female leadership is more inclusive. You may be familiar with a question I have posed in the past: “What would have happened if Lehman Brothers had been Lehman Sisters?”

Against this background, I hope to see more work done on governance and change in risk culture. The Fund has always been a strong supporter of regulators and supervisors and we will continue to do so. But I want to see institutions themselves take up this matter—shareholders and bondholders too. There should be a drive in the private sector for better alignment of risks and incentives.

This applies both to advanced and emerging economies. Indeed, emerging economies can learn a few valuable lessons from the pitfalls of their advanced counterparts.

3. Financial Deepening, Inclusion, and Stability—Mutually Reinforcing Regulation

On this point, we released a study a few days ago that reexamines financial deepening from the viewpoint of emerging markets.3

A key finding is that the gains for growth and stability from financial deepening remain large for most emerging markets, but there are limits on size and speed. When financial sector development outpaces the strength of the supervisory framework, there is excessive risk taking and instability. The experience in many countries, including in the United States, has exposed the dangers of financial systems that have grown too big too fast.

Our analysis shows that regulatory reforms can increase the benefits from financial development while reducing the risks. So fears that changes to global regulatory frameworks would curtail credit, hamper financial development, and stifle growth, may be misplaced.

On the whole, the same set of principles that increases financial depth also contributes to greater stability. Better regulation leads to greater possibilities for development and stability.

Here, let me step back and highlight the important distinction between financial depth and inclusion—especially as we strive this year to deliver on important milestones for the development agenda.

Financial systems around the world are quite sizeable, but they exclude many individuals and firms from financial services. For example, data released during this year’s IMF-World Bank Spring Meetings suggest that 2 billion adults worldwide remain without a bank account. That represents a 20 percent drop in the number of “unbanked” over the last three years, but it is still a massive number.

Moreover, financial exclusion is far from being solely a low-income country or emerging market issue. For example, even here in the United States, surveys find that some 8 percent of U.S. households are “unbanked” and some 20 percent are “underbanked”.

Studies show that broader access to the financial system can boost job creation, increase investments in education, and help people manage risk and absorb financial shocks. Our own analysis that will be released later in the fall finds that financial inclusion is particularly important for women, empowering them economically. Indeed, the numbers suggest much scope for improvement in this area.

Globally, a staggering 42 percent of women lack access to basic financial services, compared to 35 percent for men. This gap is even bigger if we consider the role of women in the provision of financial services. In a world-wide sample of banks, less than 20 percent of board members are women, and only 3 percent of bank CEOs are women. Clearly, we need to do better.

Yet, desirable as it is as an objective, financial inclusion is not without risks, particularly if it leads to excessive financial risk taking. Our forthcoming analysis shows that if supported by good regulation and supervision, financial inclusion can actually go hand in hand with financial stability.


In conclusion, the financial crisis has exposed several fault lines and provided many lessons. An overarching lesson is that building sustainable and inclusive growth hinges on collaborative effort. It requires supervisors and regulators to work on managing risks; it requires building resilience in all countries; and it requires realignment between corporate culture and societal objectives.

We need to work together. There is really no going back from this.

1 International Monetary Fund, Global Financial Stability Report April 2015.

2 International Monetary Fund, Global Financial Stability Report October 2014.

3 Sahay et al, 2015, “Rethinking Financial Deepening: Stability and Growth in Emerging MarketsStaff Discussion Note, International Monetary Fund.


Public Affairs    Media Relations
E-mail: E-mail:
Fax: 202-623-6220 Phone: 202-623-7100