Fed Plans to Vet Banker Pay to Discourage Risky Practices

WASHINGTON — The Federal Reserve announced Thursday that it would crack down on pay packages that encouraged bankers to take excessive risks, but officials acknowledged that the plan might not reduce the biggest paychecks on Wall Street.

While unlikely by itself to end the practice of lavish compensation, the Fed’s plan is one of the most far-reaching responses yet to last year’s financial crisis. It will subject executives, traders, deal makers and other employees of the biggest banks to regulatory scrutiny of their compensation and represent another increase in government intervention in the marketplace.

The announcement was choreographed to coincide with the decision by the Obama administration this week to cut the pay of many high earners at the seven companies that received the most taxpayer help. Both decisions were announced amid growing public outrage over large pay packages at many of those companies.

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” said Ben S. Bernanke, the Fed chairman. “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.”

In one sense, the announcements by the Fed and the Treasury are a sharp departure from the hands-off approach to regulation that had dominated this city for decades. The abiding principle of both announcements was the same — companies that make a lot of money over a sustained period will be allowed to reward their executives handsomely, while those who put the economy, the financial system, shareholders and the taxpayer at risk may not.

But the effectiveness of the new policies — and whether they will curtail irresponsible business decisions designed to inflate bonuses — will ultimately be dictated by how the new rules are enforced. Even in Washington, there was skepticism about whether the government would be able to keep ahead of practices that have allowed top executives and others to reap huge financial rewards while their banking companies turned in poor or unsustainable performances.

The principles proposed by the Fed for the nation’s 28 largest banking companies are less strict than those from some European leaders and some members of Congress. They do not impose caps on pay or prohibit multimillion-dollar packages. One senior official predicted that they would do nothing to curtail the lucrative pay at firms like Goldman Sachs and Morgan Stanley, both regulated by the Fed since becoming bank holding companies last year during the financial crisis.

Instead of pay limits, the Fed rules are intended to discourage pay packages that may encourage risky practices. The government wants to encourage pay packages that reward executives for long-term performance.

Officials acknowledged that it could be months before they would be able to tell whether the Fed’s changes would have the intended effect. Bank examiners will have to be trained on the ties between compensation and risk management. Moreover, compensation consultants have been adept at finding ways to get around pay restrictions.

The officials emphasized that the plan was not intended to make pay packages more socially equitable but was part of a broader effort by the Fed to shore up the stability of the banking system. That effort has included tighter supervision of lending and trading practices and higher requirements for capital held as a cushion against losses.

Even as the Fed was unveiling its plan, Kenneth R. Feinberg, the Treasury official in charge of overseeing pay practices at the companies that received the biggest government bailouts, was providing details about his decision to curb the compensation of the 25 top employees of each of those firms.

At those companies — which include Citigroup, Bank of America, the American International Group, General Motors and Chrysler — future bonus payments will be awarded only after senior executives set corporate performance goals in consultation with Treasury. The bonuses will have to be in the form of restricted stock that cannot be sold until the company repays the government. Executive perks of more than $25,000 for country clubs or corporate cars will need approval from Washington.

But, bowing to concerns that too heavy a hand could lead to a mass exodus of executives, both the Treasury and Fed policies will permit top earners to reap millions of dollars.

Mr. Feinberg said that all the companies had made unacceptable requests. In most cases, he restricted the cash salary to $500,000 and imposed new restraints on stock grants and bonuses tied to company performance over several years.

“I found that the numbers that were submitted by the companies were almost without exception to have been not in the public interest,” Mr. Feinberg said. “They were both too high and the wrong mix of stock and cash.”

Mr. Feinberg said he had made one significant exception to his policy of slashing compensation — for three senior executives at A.I.G. who had signed contracts long before his appointment for multimillion-dollar bonuses. And if Citigroup and Bank of America manage to heal, 22 of the top 34 earners could each wind up making more than $5 million over the next year.

The Fed’s plan, which will take effect some time after a 30-day comment period, will create a two-tier system of supervising pay, using different approaches for the nation’s 28 biggest institutions and the thousands of smaller banks, which would be subjected to a review with their regular bank examinations.

The money center bank holding companies, like JPMorgan Chase, Goldman Sachs and Morgan Stanley, would have to present their compensation plans to bank regulators, who would then evaluate whether pay incentives properly balance goals of short-term growth and long-term stability. Bank regulators could demand changes, and would monitor pay practices as part of their regular examinations.

The plan would apply to senior executives and others, like loan officers and traders, whose individual or collective decisions could expose the firm to significant losses.

But the review, including discussions between regulators and the companies, would remain confidential, making it difficult for outsiders to glean any changes prompted by regulators

At Citigroup’s investment banking offices, traders shrugged off the pay rules imposed by Mr. Feinberg as affecting only a handful of the company’s 275,000 employees.

Eugene A. Ludwig, a former Comptroller of the Currency who runs a consulting firm that specializes in regulatory issues, said banking regulators had been reluctant to look at pay practices, thinking it is the province of management. Now, it is rising to the top of their agenda.

“That will change behavior,” he said.