washingtonpost.com
Fed Preparing to Step Up Regulation of Banks' Pay
Goal Is to End Unwise Incentives

By Neil Irwin and Tomoeh Murakami Tse
Washington Post Staff Writers
Saturday, September 19, 2009

The Federal Reserve is moving to restrict compensation practices at the nation's banks, expanding its regulatory reach to oversee how tens of thousands of bank employees ranging from chief executives to loan officers are paid.

The Fed, acting under its existing powers as a bank regulator, aims to curtail pay practices that can encourage bank employees to take the kinds of irresponsible risks that may have led to the financial crisis. It is not seeking to set caps on the amount any individual employee can be paid, said sources familiar with the plans.

Fed officials and many private analysts have concluded that pay practices emphasizing short-term performance contributed to the near-collapse of the financial system last year.

For example, a trader who receives bonuses based solely on one year's performance might make bets that pay off in the short run but cause vast losses in the long run. A loan officer paid only based on the volume of loans issued might not pay enough attention to the quality of those loans. Under the approach envisioned by the Fed, the two dozen or so largest banks would have to explain these pay practices to their regulator, and adjust them if examiners think they endanger the safety and soundness of the bank, said the sources, who spoke on condition of anonymity because the policy is not yet final.

Some critics viewed the expected new regulations as a form of mission creep by the central bank, as it is being undertaken without explicit authorization from Congress. It comes as the Fed is facing extreme political pressure, under fire for its efforts to stabilize the financial system and for regulatory failures in the years before the crisis -- and as Chairman Ben S. Bernanke is up for Senate confirmation for a second term.

The banking industry has reservations about the scope of the policy.

"I don't think there's any objection to the concept of compensation policies being better aligned with risk," said Ed Yingling, chief executive of the American Bankers Association. "The concern is that it ends up being too wide a net, affecting every bank branch manager in the country when what they're really trying to get at is out-of-line incentives on Wall Street."

Other parts of the government are also addressing pay at financial firms. The Treasury Department is looking to prevent multimillion-dollar bonuses at firms that received government bailouts. And Congress is moving toward legislation aimed at giving shareholders more say over what senior executives are paid.

But regulatory guidance being considered at the Fed in many ways goes further than either effort. It would apply to all the nation's banks, not just those that received bailout money. And it would apply to a wide range of employees beyond executives, including anyone whose actions could threaten the financial stability of a bank.

Still, it was unclear Friday whether the Fed's proposal would result in any major changes in how compensation works in the financial sector. Many banks have already reworked their pay practices to try to prevent the excesses of recent years from recurring. A source familiar with the Fed's plans said that officials are not yet in a position to judge whether the regulations will require major changes.

Fed critics were wary of the proposals. "I'm not convinced they even have the power to do this," said Rep. Jeb Hensarling (R-Tex.), a member of the House Financial Services Committee. "It seems like sweeping, draconian powers."

In particular, Hensarling argued that the Fed was taking on some of the powers of a "systemic risk" regulator, overseeing risks posed by large financial firms, without having been granted such powers by Congress. "It appears that the Fed is unilaterally taking a significant step toward assuming powers Congress hasn't given them," Hensarling said.

The Fed Board of Governors is slated to approve proposed guidance on the new regulatory approach in the coming weeks, after which there would be a public comment period, followed by final approval. But bank regulators are already gathering information about pay practices from the institutions they oversee.

"Bonuses and other compensation arrangements should not provide incentives for employees at any level to behave in ways that imprudently increase risks to the institution, and potentially to the financial system as a whole," said Fed Governor Daniel Tarullo in congressional testimony last month. He added that the Fed expects to issue its guidance on compensation "soon."

The Wall Street Journal reported on the proposed guidance in Friday's editions.

On Friday, a number of banks said the Fed's plan was consistent with signals they had been receiving from Washington regulators and the Obama administration for much of the year, and none expressed outright opposition -- only reservations about the execution of the policy.

"Our view is that it's entirely appropriate to have compensation policies that actively discourage inappropriate risk-taking," said Lucas Van Praag, a spokesman for Goldman Sachs. "Compensation should be directly linked to the performance of the company and senior employees should receive the bulk of any bonus in equity that is subject to deferred vesting."

"Everyone's big concern is whatever they do, they do it for everybody so it's an even playing field," said one executive at a large bank who spoke on condition of anonymity because of the sensitivity of the subject matter.

Each of the more than two dozen "large complex banking organizations" that the Fed regulates would be required to present information about their pay practices to regulators, who could then demand changes. That includes such major institutions as Citigroup, J.P. Morgan Chase and Goldman Sachs. Thousands of smaller banks regulated by the Fed would not go through that process, but their examiners would be expected to monitor pay practices as part of their overall oversight of safety and soundness.

View all comments that have been posted about this article.

© 2009 The Washington Post Company