WASHINGTON -- In a frontal assault on the U.S. banking system, the Federal Reserve proposed Thursday to review the pay practices of America's largest banks, while the Treasury Department outlined why it slashed executive pay at financial institutions that are receiving substantial taxpayer bailouts.
The moves potentially point to a new era of tough love for a sector that's long influenced what does -- and what doesn't -- get done in Washington.
The Treasury Department, part of the executive branch, had already moved assertively for months to press the issue of misaligned incentives for pay and bonuses in the financial sector, both through proposed legislation and high-profile pronouncements.
The newfound assertiveness, however, was striking from the independent Federal Reserve, which the Obama administration wants to arm with new powers to police the financial sector more broadly for system-wide risks to the economy.
"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 statement. "The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to the longer-term performance and do not create undue risk for the firm or the financial system."
In a three-page statement explaining how it will review compensation practices at 28 large banking organizations, the Fed made clear that it intends to have a say in how financial executives receive pay and bonuses.
"Because of the federal safety net, shareholders of a banking organization may be willing to tolerate a degree of risk that is inconsistent with the organization's safety and soundness," the Fed said — accusing boards of directors at major financial institutions of assessing and managing risk improperly because they think they have a federal safety net. "Thus aligning interests of employees and shareholders may not be sufficient to protect the safety and soundness of the organization or financial stability."
At the heart of the Fed's planned review of pay practices at the nation's biggest, most globally interconnected banks is a concern that in the run-up to last year's near meltdown of global finance, big financial firms were rewarding executives for short-term, unsustainable profits without regard for the long-term consequences.
Briefing reporters on the condition of anonymity, a senior Fed official said that the goal is to ensure that all major banks think of compensation over the long term, providing rewards across a horizon well beyond three months or even two or three years.
Fed critics were wary of Thursday's announcement.
"I'm impressed, but I am skeptical . . . What is new is the Fed seems to be interested in doing anything about it," said Dean Baker, an economist and co-director of the Center for Economic Policy Research, a liberal group. "I'm glad to see it, but it's a story of which you have to be skeptical."
Bernanke and other Fed officials have long known how well compensated top Wall Street executives have been, Baker said, questioning what makes the issue a top concern at the Fed just as some Democratic lawmakers want to weaken the central bank while the Obama administration tries to strengthen it.
The bank sector pleaded guilty to the Fed announcement.
"From a banking standpoint, their proposal is correctly focused on eliminating compensation practices that cause employees to take excessive risk," said Scott Talbott, the senior vice president of government affairs for the Financial Services Roundtable, the lobby for big financial firms. "The institutions did not manage their compensation risks, they were focused on the short term . . . and not over the longer-term horizon."
Compensation is front and center in the Washington debate after reports suggested that Wall Street banks are on track to pay salaries and bonuses exceeding what they paid in 2007, before the financial crisis began.
Many of the institutions paying bonuses received taxpayer bailout money. Even if some have repaid the government aid with interest, they still continue to enjoy loan guarantees and other federal subsidies designed to thaw a deep freeze in credit markets.
The Fed's compensation review, which can't begin until after a 30-day comment period, doesn't aim to equalize pay structures or cap them, but to end with a best-practices approach for the industry.
That complements actions detailed Thursday by Kenneth Feinberg, the Treasury Department's special pay czar for companies that now have significant government ownership. Feinberg announced that he's capping at $500,000 the cash pay for the 175 executives at seven large institutions receiving taxpayer support, and cutting their bonuses in half. These executives will be compensated with shares of company stock for the salaries and bonuses they're losing.
"We gave him the difficult task of cutting excessive pay, striking a balance between compensation and risk taking, and keeping strong management teams in place to help the companies recover -- all in the public interest." Treasury Secretary Timothy Geithner said in a statement welcoming Feinberg's action.
The seven institutions were Citigroup; Bank of America; American International Group; General Motors and its finance arm, GMAC Inc.; and Chrysler LLC and its finance arm, Chrysler Financial.
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