Fed Releases Guidelines For Bank Compensation — Will They Do Any Good?

AP090722039303Today, on the same day that the administration’s special master for compensation placed significant pay restrictions on the seven companies under his watch, the Federal Reserve released new guidelines regarding compensation practices at all banking organizations.

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” said Federal Reserve chairman Ben Bernanke. “The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system.” According to the Fed, compensation practices should:

– Provide employees incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk;

– Be compatible with effective controls and risk management; and

– Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The guidelines apply to all banks, including regional and community banks, but the Fed will give special scrutiny (and require detailed descriptions of current practices) to 28 “large, complex banking organizations.”

The New York Times noted that the Fed’s principles “are less strict than plans suggested by some European leaders and some members of Congress. They do not impose caps on pay or prohibit multimillion dollar pay packages.” But more than that, they are simply devoid of specifics, and have no teeth behind them. So long as the banks make an attempt to conform with the principles above, it seems like the Fed will be willing to give them a pass.

Remember, as of late the Fed has been scrambling to issue various sets of guidelines, in an attempt to prove it’s taking regulatory reform seriously, as Democrats in Congress advance legislation stripping the Fed of some of its regulatory functions. This could easily be about symbolism, with little intention of following through on the substance.

One interesting aspect of the proposal, though, is that the Fed is soliciting comments on whether “formulaic limits [for compensation] be adopted for some or all banking organizations”:

[Some] have suggested consideration of an approach in which at least 60 percent of all incentive compensation received by senior executives of all large, complex banking organizations be deferred and at least 50 percent of incentive compensation be paid in the form of stock, options, or other equity-linked instruments. Would such formulaic limits on determining and paying incentive compensation likely promote the long-term safety and soundness of banking organizations generally if applied to certain types or classes of executive or nonexecutive employees across all or certain types of banking organizations?

I think the answer is undeniably yes, deferring payment is a smart move, so that pay is linked to the longer-term health of a firm (assuming the length of deferment is long enough to accurately determine how well a banker’s bets are paying off). And if a formula is indeed adopted, the Fed’s proposal will suddenly look a lot better.