WASHINGTON — The Federal Reserve Board and the other banking regulators finalized guidance governing executive compensation practices on Monday and announced its review of pay at the largest holding companies had turned up significant flaws.

The final guidance is similar to what the central bank proposed in October, but would now apply to the entire banking industry. Previously, its efforts targeted only holding companies and state-member banks.

But the other three banking agencies have now signed on to the guidance, which explicitly says it is applicable to all institutions and their holding companies.

The guidance also makes 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. "In addition, the final guidance highlights the types of policies, procedures, systems and specific aspects of corporate governance that [large banking organizations] should have and maintain, but that are not expected of other banking organizations."

Additionally, the final guidance requires large banks to follow certain 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.

The final guidance did not change the three initial goals of the Fed's proposal: providing incentives that appropriately balance risk and financial results and discourage risk taking; matching "effective controls and risk management"; and supporting corporate governance.

The Fed also announced the results of its first round of a horizontal review of the compensation practices of the largest 28 financial companies.

The central bank found many of the banks had "deficiencies" such as identifying which employees, either individually or as a group, can expose the bank to material risk; not fully capturing risks for incentive compensation; taking a "one-size-fits-all" approach to deferral arrangements; and inadequate mechanisms to evaluate whether practices balance risk.

The Fed announced that it will conduct an additional cross-firm, horizontal review at the largest banking organizations for employees in certain business lines, such as mortgage originators.

The final guidance applies to not only top-level executives, but also other managers who have the ability to "materially" affect the risk profile of the firm.

The Fed, along with the other federal banking agencies, will prepare a report after the end of the year on trends and developments in compensation practices at banking organizations.

The guidance comes in addition to pending pay proposals part of the regulatory reform bill and separate actions being contemplated by the Federal Deposit Insurance Corp. and Treasury Department.

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