Federal Reserve Plans Crackdown on Bank Pay

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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.

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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.

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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.

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