Fed Finds Flaws in Big Banks' Pay Packages

WASHINGTON — Even as federal regulators released final guidelines Monday establishing executive compensation restrictions, they made it clear they were already taking action to target flaws in the pay practices of the largest banking companies.

In its horizontal review of the top 25 firms, the Federal Reserve Board found multiple "deficiencies," including a failure to ensure their practices did not encourage risky behavior and to identify which employees can expose the bank to material risk.

Although it did not provide details on which banks fell short, the Fed said it sent notices to firms last month detailing areas that required prompt attention. Some observers said the review proved many firms have failed to properly update their practices.

"Boards have relied on outside consultants to tell them what they wanted to hear, and the Fed comes along and says you have to do more due diligence and they ignore that," said Con Hurley, a former Fed lawyer who is now a financial-law professor at the Boston University School of Law. "How tone deaf can you get? The Fed was giving everybody a heads-up."

Fed officials said Monday that they expect to see improvements soon. "Many large banking organizations have already implemented some changes in their incentive compensation policies, but more work clearly needs to be done," said Federal Reserve Governor Daniel K. Tarullo. "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."

The Fed first issued proposed guidance in October on proper executive pay packages and said it would review the practices at the largest firms to find out how they stacked up. By Monday, the three other regulators had signed on to the final pay guidelines and offered the first details on what the Fed had uncovered.

Although regulators said firms are considering various methods to make incentive compensation more risk sensitive, they said many are not "fully capturing the risks involved and are not applying" new methods to employees.

The agencies also said that while some firms are using deferral arrangements to adjust for risk, they are using a "one-size-fits-all" approach that does not vary according to type and duration of risk.

Overall, the agencies said many firms lack "adequate mechanisms to evaluate whether established practices are successful in balancing risk."

The review is just the first of several that the agencies are planning. Regulators said they will conduct additional cross-firm reviews at large, complex banking organizations to target practices for employees in certain business lines, such as mortgage originators. The regulators are also prepping a report after the end of the year on trends and developments in compensation practices at banking organizations.

Although the pay guidelines finalized on Monday were largely similar to the Fed's proposal last year, their application was much broader. Instead of covering just bank holding companies and state member banks, the final guidance will now apply to all banks regardless of charter and their holding companies.

The final guidelines did make some concessions to smaller banks, who had complained in comment letters that they did not pay the exorbitant bonuses that helped lead to the financial crisis and should be shielded from the proposed regulations.

The final guidance does not exempt community banks, but more clearly defines regulators' different expectations for large and small firms.

"The final guidance makes more explicit the view that the monitoring methods and processes used by a banking organization should be commensurate with size and complexity of the organization, as well as its use of incentive compensation," the guidance says.

Community bank representatives welcomed the change.

"They seem to have followed our advice, which is to focus on the large complex banking organizations and not on the community banks," said Chris Cole, regulatory counsel for the Independent Community Bankers of America, which favored an exemption. "Community banks would find it difficult to have a compensation committee as part of their board, and most community banks don't have a compensation policy at all."

The final guidance requires large banks to follow certain additional steps. For example, large banking companies must form a compensation committee that reports to the board of directors. The board is also required to directly approve compensation arrangements of senior executives, including clawback provisions.

The guidance also directs large banks to consider how golden parachutes and similar arrangements affect risk and employee behavior. Large banks are also required to actively monitor industry, academic and regulatory developments in incentive compensation and be prepared to incorporate those into their systems.

Those requirements were not extended to smaller institutions.

All institutions, however, are required to broadly follow three guiding principles when setting executive pay: providing incentives that appropriately balance risk and financial results and discourage risk taking; matching "effective controls and risk management"; and supporting corporate governance.

As the guidelines were released, analysts were debating their potential impact.

"This guidance is really a significant change from their current practice in many different ways," said Alice Cho, a former Fed official and now a senior principal at Promontory Financial Group. "For example, they now have to define which employees are going to be covered by the guidance … and it's not just top executives. It's going to be in many instances a large number of employees that receive incentive compensation, like stock options or stock grants or bonuses, that are tied to their performances. In large institutions, they can comprise a significant percentage of the employee population."

But others suggested the guidelines would accomplish little.

"I do not believe that these regulations will do very much to change what goes on at the large New York banks," said Peter Morici, a professor at the Robert H. Smith School of Business at the University of Maryland. "This is all about linking compensation to risk … Many of the risks going into this mess were not recognized by the people that would be in a position to curtail compensation."

Steve Balsam, a professor at the Fox School of Business at Temple University, said banks could find ways to justify their existing compensation practices. "These are big companies. They have well-designed programs and they do have answers to the questions, so while there might be an incentive to take risk because of A, factor B mitigates taking excessive risk."