Federal Reserve Plans Crackdown on Bank Pay

wall st/ABC News
The Federal Reserve is expected to announce expansive new rules on bank employee compensation.

The Federal Reserve is working on a proposal to crack down on incentive structures for bank employees as part of an effort to avoid excessive risk-taking, a Federal Reserve source confirmed to ABC News Friday.

The reviews will not focus solely on executive compensation but rather on the pay structure for employees across entire financial institutions.

One of the factors in the current financial crisis, the source noted, was incentives that encouraged employees to take too many risks. Now the Fed is moving toward a plan that would give the central bank the power to reject any compensation structures deemed unsatisfactory.

VIDEO: Steve Forbes on the conflict between salaries and government bailouts.Play

In the coming weeks, the Fed intends to move toward a vote by the full Board of Governors on this proposed guidance, the source said. If the board approves the proposal, it would then go to a period of public comment for around 30 days.

However, immediately after the board approves the proposal, the source said, the Fed could launch a horizontal review of compensation structures at the nation's biggest banks, numbering around 25.

Anyone in a position to take risks would be subject to examination. The 25 banks would have to submit to the Fed their current compensation practices. By comparing practices across a wide swath of institutions, the Fed would then determine what practices are acceptable and what are not.

VIDEO: Government plans to regulate compensation at companies that received bailout.Play

Practices that fall into the latter category would have to be changed. Unlike the stress tests last spring, the results of the Fed's review would not be released to the public.

The Fed, the source noted, possesses the authority to enforce their decisions on compensation by using any one of a number of methods, from written agreements to cease-and-desist orders to even an interim policy that could be put in place until a bank alters its compensation plan.

The overall goal, the source said, is to ensure that employees are not rewarded in the short-term for practices that can lead to firms taking excessive risks. One firm taking excessive risks can produce a domino effect, thereby placing the larger financial system in jeopardy, as in the current crisis.

Smaller banks would also be subjected to the Fed's scrutiny. The central bank -- which oversees around 5,000 bank holding companies -- would also examine smaller institutions as part of the regular exam cycle.

As part of this stepped-up supervision, the Fed is also examining "clawbacks" -- ways to recoup pay from staffers who took harmful risks. But, the Fed source cited, the central bank views this issue more as one of principle rather than a one-size-fits-all approach.

Bank employees could see their compensation come in the form of restricted stock with a view toward longer-term incentives instead of short-term rewards.

The Fed's move toward examining compensation structures is just the latest in a flurry of moves by Washington to home in on pay policies at financial institutions. In July, the House of Representatives passed a bill to give federal regulators the power to restrict pay practices that prompt "inappropriate risk" at financial firms.

In June, the Obama administration appointed a pay czar, Ken Feinberg, to oversee compensation at seven firms receiving what the administration calls "exceptional assistance": AIG, Bank of America, Citigroup, General Motors, Chrysler, GMAC and Chrysler Financial.

There has been no communication with Feinberg about the Fed's possible review of pay at these 25 banks, the Fed source said.

The possible compensation plan by the central bank is not a surprise. In recent months, Fed officials have previewed on numerous occasions that compensation changes were coming.

"I should let you know that the Federal Reserve is going to be proposing later this year guidance on executive compensation that will attempt to clarify that compensation packages should be structured in such a way as to tie reward to performance and to be such that they don't create excessive amounts of risk for the firm," Fed Chairman Ben Bernanke told lawmakers July 21 at a House Financial Services Committee hearing.

Weeks later, Federal Reserve Board governor Dan Tarullo echoed that statement.

Feds to Review Bank Compensation Structures

"The crisis has newly highlighted the potential for compensation practices at financial institutions to encourage excessive risk-taking and unsafe and unsound behavior -- not just by senior executives but also by other managers or employees who have the ability, individually or collectively, to materially alter the risk profile of the institution," Tarullo said at an Aug. 4 hearing.

"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.

"The Federal Reserve expects to issue soon our own guidance on this important subject to promote compensation practices that are consistent with sound risk-management principles and safe and sound banking," he stated.

Perhaps because the Fed's compensation crackdown was expected, the financial industry wasted no time in voicing its opposition.

"The industry has already eliminated certain pay practices and has strengthened reliance on longer-term pay incentives," said Scott Talbott of the Financial Services Roundtable.

Some steps taken by the industry, Talbott noted, include the use of clawbacks, deferments, restricted stock options and reduced pay packages at the corporate level. This year Citigroup chief executive Vikram Pandit is earning a salary of $1.

The industry has also halted the use of certain practices that lead to excessive risks, such as yield-spread premiums. If a borrower qualified for a 5 percent mortgage, a salesperson would receive a bonus for getting the borrower to take a 6 percent mortgage instead, leading to greater interest revenue for the bank.

If the Fed crackdown goes too far, the industry fears, employees could opt to find work elsewhere, such as at hedge funds or foreign firms.

"Our concern is that the Fed rules will be too restrictive for salespeople," Talbott said. "That, in turn, would weaken the institution. That's what we're worried about."