Fed Proposing to Take a Hard Line on Bank Executive Pay

The Federal Reserve is considering regulating banks’ pay policies to make certain they discourage employees from making the irresponsible gambles that led to 2008’s financial meltdown.  The Fed’s proposal would apply to thousands of banks, including some that did not receive bailouts.

Under the Fed’s proposal, the central bank would review – and could say “no” – to pay policies that might result in excessive risk-taking by executives, traders or loan officers.  The move marks the Fed’s most recent response to critics who say it didn’t crack down on lax lending, reckless risk taking and other practices that led to the great recession.  If the proposal is adopted, the 28 largest banks would develop internal plans to assure that compensation doesn’t start a new round of disproportionate risk taking.  Although the Fed declined to identify which banks would be required to submit plans, it’s safe to say that Citigroup, Inc., Bank of America Corporation and Wells Fargo & Company will be on that list.

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

The key concept here is that of moral hazard – creating a correlation between performance and remuneration so that people are always compelled to act in the general interest.