Is the Fed Grandstanding With Its Report Linking Bank Compensation to Risk?

In its new report on compensation practices, the Federal Reserve is charging major U.S. banks are falling behind in their efforts to link incentive pay to the risks they've taken on. But one New York-based recruiter suggests the Fed may be doing a bit of grandstanding.

"England's Financial Services Authority (FSA) has been particularly aggressive and proactive in terms of compensation," says Richard Lipstein of Boyden Executive Search in New York, with UK regulators frowning on performance guarantees in particular.

Margaret Cole of the FSA has said a new body known as the Financial Conduct Authority (FCA) will be even more interventionist when it comes into being at the end of 2012.

There's been some fear on Wall Street that the Fed is trying to compete with those efforts, Lipstein told eFinancialCareers, pointing to some initiatives that in his view are not altogether realistic.

Banks need to tie more employees' compensation to risk

The 27-page Federal Reserve report says that big banks need to tie more employees' compensation to the risks their decisions pose to their institutions, through such things as deferred pay, and that many banks have yet to sufficiently reduce incentive pay when such risks produce losses.

"Most firms still have work to do to implement such arrangements for a larger set of employees and to more closely link such reductions to individual employees' actions, particularly for employees below the senior executive level," the Federal Reserve states.

The New York Times reported that when federal officials began their review in November 2009, they wanted risk managers to be more involved in setting pay. Two years later, the report found "at some firms, risk experts primarily play a peripheral or informal role."

Risk managers still reporting to execs who have influence over bonuses

Moreover, "in letters to the banks documenting the review's preliminary findings sent last spring, Fed examiners found that risk managers at several of the biggest banks still reported to executives who had influence over their year-end bonuses and whose own pay might be constricted by curbing risk," the Times stated.

"Who should they report to?" asks Lipstein. "Who [else] should determine your compensation?

The Times had also reported that not all banks have established separate bonus pools and incentive plans for risk and compliance officials, "not directly tied to the financial performance of their business unit." Lipstein says that the units in question are not profit centers but cost centers which are administrative in nature and not responsible for generating revenue.

"How do you define profitability of a cost center?" asks Lipstein. "You have to wonder whether regulators understand what they're talking about," he adds, wondering "if the Fed is trying to do more than is actually possible in practice."

The Fed report focuses on 25 large banks including Bank of America, The Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, Wells Fargo & Company, the U.S. operations of Barclays, Credit Suisse Group AG, Deutsche Bank AG, HSBC Holdings, Royal Bank of Canada, the Royal Bank of Scotland and UBS AG.

In another report on the findings, Reuters observed that The Fed defended actions taken in the United States compared to Europe, where pay rules are viewed as being particularly tough:

"In its report, the Fed argues that in the United States, more of deferred pay consists of stock, which in turn makes it more closely tied to a bank's long-term performance," Reuters stated.

The report also says that more than 60 percent of senior executives' pay is now, on average, deferred, which is higher than international guidelines.