In the wake of the financial crisis — which was driven in large part by Wall Street firms fueling the subprime lending bubble — the Federal Reserve has been looking at ways to rein in Wall Street pay packages, which incentivized bankers and traders to take excessive risk without fear of losing their gargantuan bonuses should their risk-taking backfire. Back in October the Fed began this process, and today it released its final guidelines.
In order to form these guidelines, the Fed looked at what steps banks have taken since the financial meltdown to mitigate riskiness in their pay. To put it mildly, the Fed was not impressed by what it found, announcing that it will “be following up on specific areas that were found to be deficient at many firms”:
— Many firms need better ways to identify which employees, either individually or as a group, can expose banking organizations to material risk;
— While many firms are using or are considering various methods to make incentive compensation more risk sensitive, many are not fully capturing the risks involved and are not applying such methods to enough employees;
— Many firms are using deferral arrangements to adjust for risk, but they are taking a “one-size-fits-all” approach and are not tailoring these deferral arrangements according to the type or duration of risk; and
— Many firms do not have adequate mechanisms to evaluate whether established practices are successful in balancing risk
“Many large banking organizations have already implemented some changes in their incentive compensation policies, but more work clearly needs to be done,” Federal Reserve Board Governor Daniel Tarullo said. “The Federal Reserve expects firms to make material progress this year on the matters identified as we work toward the ultimate goal of ensuring that incentive compensation programs are risk appropriate and are supported by strong corporate governance.”
While the Fed is undertaking this endeavor on its own, the conference committee reconciling the House and Senate financial reform bills also has a role to play in stamping out compensation practices that can ultimately end in systemically risky financial firms going under. The House’s version of the bill gives federal regulators the statutory ability to determine if compensation structures at financial companies (and only financial companies) are aligned with sound risk management. The Senate’s contains no such provision, so the House’s conferees should be fighting for their own chamber’s version.
As Federal Deposit Insurance Corp. Chairman Sheila Bair said, there is “an overwhelming amount of evidence that [compensation structure] is clearly a contributor to the crisis and to the losses that we are suffering.” It’s a good thing that the Fed is acting to prevent a repeat performance by Wall Street, but setting in stone some rules for the regulators to follow would be even better.