Federal Reserve presses banks to curb risky pay practices

By Neil Irwin
Washington Post Staff Writer
Tuesday, June 22, 2010

Bank regulators have told the nation's largest financial firms to move faster in changing pay practices that could encourage dangerous risk-taking, officials said Monday.

The Federal Reserve has completed an initial review of compensation policies at 28 large banks it oversees and has been giving them confidential feedback on areas where they must change. On Monday, the Fed and other federal regulators issued final guidelines, stressing the need for policies that do not give executives, traders, and other bank employees incentives to make overly risky investments that might earn them huge bonuses in the short run while leaving the bank exposed to losses in the long term.

Leading bank regulators and many outside analysts have concluded that poorly designed pay practices contributed to irresponsible decisions that caused the financial crisis. Nearly three years after the crisis began, regulators from the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corp. found many large banks to be "deficient" in several areas, according to a news release Monday.

Although the banks have already implemented some changes to their incentive pay, "more work clearly needs to be done," Fed governor Daniel K. Tarullo said in a statement.

"We found that many banks have not modified their practices from what they were before the crisis," Fed Chairman Ben S. Bernanke said in a Capitol Hill hearing earlier this month. "We will be pushing banks to move as quickly as possible to restructure their compensation packages so that they will not be engendering excessive risk-taking."

The government has not told banks to reduce the overall level of compensation paid to senior executives or other employees, though regulators say this could happen if they conclude that the sheer amount endangers a firm.

The regulators did not name the banks that need to make major changes, nor did they detail specific actions. Government officials and sources in the banking industry described many of the demanded changes as focused on how pay decisions are made.

For example, they have instructed banks to reorganize themselves so that the head risk manager for a business line -- investment banking, for example -- reports directly to the corporate chief risk officer rather than the executive running the business line. Regulators' fear is that risk officers might not be aggressive enough if their salaries and bonuses were determined by the very executives whose investment practices might need to be reined in.

Banks have also been told to strengthen their central controls over pay practices. Regulators have been disappointed to find that some large banks with far-flung operations have trouble gathering information about the pay incentives for employees to make risky investments, a senior Fed official said.

And regulators told banks they should tailor bonuses based on the amount and kind of risk that employees take.

Those conclusions are the result of a review, conducted by about 150 regulators from the Fed and other agencies, of information from the 28 biggest and most complex banks. The regulators looked for best practices in pay procedures and for weaknesses that firms have in common.

Each bank was given a 15-to-20-page report identifying areas where pay practices were deemed to be flawed. The banks are now drafting responses, either explaining that they will revise compensation or rebutting the criticism.

The Fed expects to work with banks over the remainder of 2010 and then issue a detailed report on pay practices in the banking system -- and the risks they pose to the overall economy -- early next year.

Banking sources said the industry as a whole is not resisting the new oversight.

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