Federal Reserve Plans to Manage Risk by Regulating Pay

The Wall Street Journal reported today that the Federal Reserve is planning to begin regulating pay practices at financial institutions that it oversees currently.  The intent of the Federal Reserve is to limit short-term compensation that rewards excessive risk taking.  Here is what the Journal says about the plan.

Details of the Fed's plan aren't final, but the central bank will propose to review pay packages for tens of thousands of bankers to guard against the encouragement of excessive risk, and to allow banks to "claw back" compensation in certain cases. In essence, the Fed is moving to greatly broaden the kind of scrutiny that Obama administration pay czar Kenneth Feinberg has applied to seven firms receiving large amounts of federal aid.

The Fed's move is the latest, and potentially most sweeping, of several efforts to curb risk-taking in the wake of the financial crisis. Congress approved provisions in both the bank-bailout bill last year and the economic-stimulus package in February to restrict some pay. Treasury Secretary Timothy Geithner also addressed the issue in the administration's proposed regulatory overhaul in June.

All of these efforts have had to confront a difficult truth: The relationship between risk-taking and compensation is neither simple nor well understood. Moreover, bankers and many others say it is important to encourage some risk-taking.

Since details of the plan have not yet been released, it is too soon to offer opinions on the effectiveness or impact of such oversight.  However, the Federal Reserve must be careful to avoid micromanaging pay and usurping the authority that is placed in the hands of the Board of Directors at these institutions.