Healthy banks that agreed to take money from the Troubled Asset Relief Program are beginning to rue their decision. Last fall, as a way to boost lending and stimulate the financial system, the government strongly encouraged several hundred of the country's healthiest banks to tap TARP funds alongside the bigger more precarious national banks deemed too big to fail. Now, these mid-tier bankers complain, the government is tarring them with the same broad brush as the failing institutions and forcing them to accept punitive executive compensation rules.

In February, when President Obama signed the stimulus bill, provisions retroactively changed the rules on compensation for executives at banks that accepted TARP money. The bill limits bonus payments to no more than one-third of annual total compensation, and that bonuses must be in the form of restricted stock that can only vest once the government is repaid. While these restrictions only apply to the top 25 highest-paid people at large institutions, the law doesn't define those 25 people. What's more, the law requires a "say-on-pay" shareholder vote on executive comp.

Several institutions are taking steps to return the federal funding as soon as they can, in part because of the new rules on executive pay. Many others approved for TARP money are declining to take it.

Bankers are concerned that, with the new rules in place, the industry could quickly bifurcate into two tiers of banks: those with pay restrictions and those without. Top talent will shift toward banks without restrictions.

Todd Leone, president of Amalfi Consulting, describes the law as a piece of "hot-tempered" legislation. He points out that several provisions in the law around "luxury expenditures," such as not allowing office renovations or buying airplanes, are slaps at specific institutions (Merrill Lynch and Citi, respectively); he worries that legislators, by reacting angrily to the most egregious behavior of certain institutions, will unfairly penalize healthy banks.

And these new compensation rules are causing confusion and frustration. Bob Atwell, the chief executive of Nicolet National Bank in Green Bay, Wisc., says that the "emotional" response is to want to give the money back to the government and be free of the restrictions. "We believed in the intent of the program as it was originally expressed to us. But the intent of the program is changing continually, and we might reconsider participation in the program."

Besides the pay rules, as troubling for executives is how much further the government might meddle in their business. "We were included because we're part of the solution, part of the stimulus," says John Koelmel, chief executive at the $9 billion-asset First Niagara Bank in Lockport, N.Y. "But the government can't get in our shorts. That's just not going to work. ...The government needs to target restrictions to the losers. They need to take a scalpel to this, not an axe, and if they don't get that right, organizations like us will cut and run."

One such restriction tying up one-third of executive pay in restricted stock until TARP funds get repaid has a reverse incentive - it encourages healthy banks to ignore or exit TARP quickly, negating the stimulative intention of TARP.

But Atwell and Koelmel say that they want to see more details about the new compensation rule before making any decision; those rules should come from Treasury in the next few weeks or months.

The compensation rules cause three distinct problems. First is the retroactive nature of the rules. Many 2008 bonuses were already paid out when the legislation passed. Bankers don't know if they're supposed to ask for that money back from employees, or even if they could legally do so. As Susan O'Donnell, a managing director at Pearl Meyer & Partners in Boston puts it: "The fact that they made these rules retroactive is truly unbelievable."

The second issue bankers must grapple with is the "say-on-pay" provision. The stimulus legislation passed in the midst of proxy season; some banks had already mailed proxies. Nevertheless, Sen. Christopher Dodd, D-Conn., said in a letter to the Securities and Exchange Commission that he expected the rule to apply immediately. The SEC responded in near record time - five days - with guidance, confirming the need for a nonbinding say-on-pay proposal in this year's annual statement.

Thirdly, the stimulus legislation creates uncertainty around how and for whom banks can structure compensation going forward. Without Treasury guidance even the definition of annual compensation is unclear, O'Donnell says. Is annual compensation what is listed on the W-2? Is it base salary only? Should banks be looking at last year's numbers, or this year's?

Yet these questions just scratch the surface of the real dilemma facing bankers, which is how to retain and recruit top talent under these rules. For Koelmel of First Niagara, any rule that inhibits recruiting is unacceptable. "We have to compete for talent and we can't have our hands tied."

Ironically, O'Donnell says, performance pay is what shareholders have demanded for years. With bonuses now restricted, some banks are already raising base salaries to try to make up some of the difference. This stresses balance sheets by guaranteeing the pay of some sales-related employees with no guarantee on performance.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.