Fed & Treasury Pitch Pay Rules, But Will They Work?

Call it pay day in Washington: The Federal Reserve and Treasury made a splash by unveiling sweeping compensation rules, mostly for executives at banks and other financial companies.

The Fed’s proposals are broad — reaching every bank, with special attention for the biggest, and potentially touching every facet of the pay structure. The Treasury’s rules only apply to the seven companies that have gotten extraordinary taxpayer aid — including AIG, Bank of America, GM and Chrysler — but dig deep into the minutiae of compensation for as many as 175 executives and top earners at those firms.

But both efforts, while ambitious, illustrate what may prove to be the key shortcomings of their approaches: The Fed’s guidelines count on the agency to succeed where it failed before, and the Treasury’s dictates fall back on some of the old assumptions about pay and performance that lay behind pre-crisis compensation practices. 

Let's take the Fed first. Fundamentally, its proposals -- which the Fed will consider formalizing after a 30-day comment period -- tell bank holding companies just how the agency intends to assess their pay practices. The idea is to ensure that bonuses and other incentives don't encourage bankers to take outsize risk, thus putting their banks in jeopardy -- and perhaps the entire U.S. financial system in the process.

The proposed guidelines don't, however, contain any hard-and-fast rules -- no pay caps, no bonus formulas; Fed officials figure every institution is different, and pay practices should reflect that. Ultimately, then, the rules are about judgment -- judgment by bank boards in setting pay wisely, and judgment by the regulators looking over their shoulders in spotting practices that unwittingly reward unwanted risk.

But that, by many accounts, is where the Fed slipped up before: It failed to notice the burgeoning risks on bank balance-sheets, underestimated the perils posed by subprime lending and exotic housing securities -- and all the while, didn't realize that pay practices helped encourage bankers to take on ever-bigger risks. Indeed, in briefing reporters Thursday, a senior Fed official noted that the agency has always, in fact, been responsible for ensuring that pay doesn't threaten a bank's soundness. Now, it seems, they really mean it.

That's not to say the Fed's rules are hollow. Among other features, it notes prominently that it will examine not only the pay of top executives and employees whose individual actions could threaten the institution (senior traders, for example), but also "groups of employees ... who, in the aggregate, may expose the firm to material amounts of risk."

In other words, this time, when volume-based commissions begin to encourage platoons of junior employees to originate or acquire ever-shoddier mortgages, the Fed means to prevent it. The real question is whether its bank examiners will recognize the next such diffuse threat when they see it, and whether regulators will have the political will to keep it from spinning out of control.

The Treasury's new rules, by contrast, are firmly anchored in the top echelons of the corporate org chart. That's not entirely the fault of Kenneth Feinberg, the "special master" with the massive task of enforcing compensation rules that Congress passed amid public outrage over the pay practices of firms bailed out during the financial crisis.

Feinberg's mandate under federal law and regulations was to police pay only for the top five executives and 20 highest-paid other employees at each of the firms getting extraordinary government bailouts. It's a tricky endeavor, requiring a delicate balance between his main job -- trying to ensure that pay doesn't jeopardize the chance that taxpayers get their money back -- with factors like retaining key executives and avoiding excessive risk.

But his main focus seems to have been swapping big chunks of cash salary for stock, and replacing annual bonuses with restricted stock. It's a start, to be sure -- a far cry from guaranteed bonuses (he's nixed those entirely) and the stock options that give executives hefty upside and virtually no downside (they're verboten for TARP babies under federal law). But it's still the kind of pay that stands to encourage top executives to shoot for the stars, and leaves lesser managers at the mercy of a market they don't control.

"It's one size fits all, with stock-holding being the ultimate solution," says Pearl Meyer, a longtime comp consultant and co-founder of Steven Hall & Partners. In her eyes, Feinberg has his finger on the problem, but not the solution. As others have, she points out that Bear Stearns and Lehman Brothers executives scooped up tons of stock as compensation before those firms failed spectacularly. "Having wealth tied up in stock does not necessarily change one’s perspective," she says. "These people lost most of their wealth." (Not that many of them were sent to the poorhouse.)

Feinberg's scheme has some twists missing from those old-time stock-based compensation plans, of course. Stock in lieu of salary -- "salarized" shares, in Feinberg's words -- belongs to execs immediately, but they can only cash it out over the course of three years. To keep stock paid as bonuses, executives have to stick around for three years, and they can cash it out only when Uncle Sam is paid back. That should help keep execs' eyes on the horizon, instead of making a quick buck come bonus season.

Still, a better approach might have been to fine-tune each exec's pay package to his duties -- especially for those responsible for specific business units rather than the firm as a whole -- and to establish specific operational goals for receiving or keeping the pay. "You’ve got to focus people on what they’re responsible for –- you can’t ignore the power of individual responsibility and accountability," Meyer says.

Now that would take a lot of work.