WASHINGTON — Though the Federal Reserve Board's proposed guidance governing executive compensation could potentially affect thousands of banks in all corners of the United States, the true test of its success will probably be determined by whether it actually changes the way bankers are paid.
The proposal was praised Thursday for its breadth and restraint — the Fed did not move to cap salaries or dictate how compensation packages should be structured — but doubts arose that it will lead to fundamental changes.
"It's a game changer only if it is eventually married with the say-on-pay proposal that's floating out there," said Cornelius Hurley, a former Fed lawyer who now directs the Morin Center on Banking and Financial Law at the Boston University School of Law. "The Fed talks at great length about how shareholders have an incentive to encourage compensation practices that are too risky. There's some truth to that, but the bigger issue is, shareholders have been excluded from the discussion."
As part of its push for regulatory reform, the Obama administration has proposed giving shareholders a nonbinding vote on compensation issues. This provision was not included in the Fed's proposal, but others said the central bank's plan would lead to significant changes by directly linking pay with risk management.
"It's a huge deal," said Dan Borge, a director at the LECG consulting firm. Compensation committees at banks "will be on the spot to demonstrate they've chosen a compensation system that will not incentivize risk. Doing that requires knowing who is taking the risk."
The Fed's proposal comes at a time of heightened awareness in Washington of the paychecks being doled out to bankers. Also on Thursday, the Treasury Department's pay czar, Kenneth Feinberg, released standards that tied salary for the 25 highest-paid executives at Bank of America Corp. and Citigroup Inc. — both companies that have gotten exceptional government assistance — to stock rather than cash.
Feinberg said he hopes his action will help set industry standards, but the broader impact is likely to come from the Fed's moves.
For starters, the guidance applies to all bank holding companies, where many compensation decisions are made. It also affects foreign banks operating in the United States and state member institutions.
The guidance is designed to help banks develop proper pay practices. It tells them to avoid structures that lead to big paychecks in the short term but do not take into account longer-term goals and stability.
More specifically, banks should consider three goals: providing incentives that discourage risk taking, matching "effective controls and risk management" and supporting strong corporate governance.
The Fed expects its guidance to be applied far beyond the executive suites.
It targets individuals or groups who could expose the bank to risk, a category that could include traders and loan officers, the Fed said, but would exclude tellers, bookkeepers and couriers.
"Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability," Fed Chairman Ben Bernanke said in a press release. "The Federal Reserve is working to ensure that compensation practices appropriately tie rewards to longer-term performance and do not create undue risk for the firm."
As part of the proposal, which is open to public comment for 30 days, the Fed also plans to thoroughly review existing pay standards at financial institutions.
The Fed plans to split the job into two pieces: one review for 28 unnamed "large, complex banking organizations" and another for all other banks.
At the large banks, the Fed plans to do a "horizontal review" of compensation practices and policies, meaning the companies would be compared to each other. The Fed did not give a timeline but said the review is designed to help supervisors better understand compensation trends in the industry and identify companies whose practices fall outside the norm.
During the review, the Fed said large banks would give it documentation describing compensation plans and efforts to improve them. Some observers said the bar for banks to defend their pay structures would be set high.
"Given the public attention on this whole issue of pay, … that tells me the Fed is serious about transmitting that pressure to the banks," Borge said.
In a conference call with reporters on Thursday, a senior Fed official said the results of the review will not be made public.
Smaller banks are also facing greater oversight, but the Fed was careful to point out that its process for these institutions would be far less formal and intensive, and it requested comment on ways to further decrease the burden.
Compensation at regional and community banks will not be compared against competitors'. Instead, the Fed will supervise pay practices at these companies as part of the regular examination process.