Wall Street Is Losing Its War With the Fed Over Bonuses

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Photo: NICHOLAS KAMM/AFP/Getty Images

Cutting bonuses for bankers is all the rage these days. The European Union is doing it. The Pope is doing it. And now, our very own Federal Reserve is doing it to Wall Street, too. Yesterday's Wall Street Journal had a front-page story about how the Federal Reserve has been quietly prodding large financial institutions to reduce the "the maximum bonuses awarded to executives who beat their performance target."

The Journal's report leaves some questions unasked, though. Namely: Why is the Federal Reserve, a central bank whose job is promoting price stability and full employment, giving banks advice about pay? Are bankers mad that the Fed is trying to dictate the size of their bonuses? And how binding are the Fed's suggestions, anyway?

I started asking these questions to a few Wall Street sources, and as it turns out, I stepped in a snake pit.

The first problem is that Wall Street banks generally won't talk about what they discuss with the Federal Reserve, ever.

"We never say shit about the Fed," one bank official told me. "Our practice is not to discuss our regulators," another bank official said, phrasing it more delicately.

So it's not clear what, exactly, the Fed has said to Wall Street about compensation or any other issue. But there are reasons to suspect that there has been a quiet, behind-the-scenes war over the issue of pay that is just now spilling into public view.

According to the WSJ (and an earlier report by Reuters), the Fed has been actively trying to change Wall Street's pay practices for years. The Fed began looking into banker pay in 2009 and 2010, and in 2011 released a "horizontal report" on all of Wall Street's compensation policies, and the ways in which they represent risks to the stability of the financial system. And now, according to reports, Fed officials are reaching out to banks directly and having secretive discussions about how to reform Wall Street's bonus culture to make it less risky. These discussions are kept tightly under wraps, according to my sources, because the Fed doesn't want to appear to be too heavy-handed in laying out rules about executive pay. But make no mistake: They're happening.

The biggest issue the Fed has these days is that banks routinely pay high-performing executives as much as twice the amount of a "target bonus" they set out at the beginning of the year. The Fed believes these bonus multipliers can cause executives to overshoot, taking on too much risk and behaving irresponsibly in order to meet their year-end targets, and endangering the financial system as a result. So, according to the WSJ, the Fed went to banks and demanded a fix:

Last year, it urged certain financial-services firms to cap bonuses at a lower multiple of the target payouts, usually 125% or 150% instead of 200%, according to a person briefed on the Fed's work.

That kind of direct government involvement was routine during the financial crisis, when the Treasury Department appointed a special regulator ("pay czar" Kenneth Feinberg) to set rules about banker pay after the massive TARP bailouts of 2008. But it's rarer in the years since TARP was paid back. And not all bankers are happy that the Fed is continuing to stick its nose into their bonus discussions.

"I was under the impression that after TARP, we were outside the rule of the pay czar," one bank official told me.

But the Fed is getting results. In fact, as this chart shows, a number of banks dropped their incentive caps from 200 percent of a target bonus to 125 percent or 150 percent, in keeping with the central bank's wishes:

Eric Hosken, a partner at Compensation Advisory Partners, the firm whose new report [PDF] on compensation formed the basis of the Journal's story, told me that even though the Fed's comments about Wall Street pay aren't iron-clad rules, banks often feel like they have to obey them anyway.

"The Fed is their regulator," Hosken said. "You’ve got to address their concerns."

Bankers, too, seem to be acknowledging that while they may not like the Fed's input on their pay practices, they have no choice but to listen.

"It’s not iron-clad," a bank official told me, referring to the Fed's guidance on pay. "But no bank is going to want to create a comp structure outside of what the regulators expect."

Of course, Wall Street banks, being Wall Street banks, are already finding loopholes in the caps the Fed wants them to impose. For example, one bank that was contacted by the Fed about its bonus caps, PNC Financial, got creative and decided to put extra money in a side pot at the beginning of the year, then distribute it among executives based on performance at the end of the year.

PNC reduced the payout to 125% of the target award, then approved $2 million for an additional compensation pool to be divided among the affected executives.

That pool means that many PNC executives will end up getting paid what they would have before the Fed stepped in, but with fewer angry calls from Ben Bernanke's office.

I'm on record as opposing the EU's bonus restrictions, since they are hard caps that are easily circumvented. But the Fed's efforts to reform Wall Street's pay seem more likely to work, because they're more holistic. Ben Bernanke and his team want banks to change not just the amounts of banker bonuses, but the way banks think about paying out bonuses.

"This move is less about stopping banks from paying a particular amount of money, and more on not having comp programs that encourage short-term behavior over long-term thinking," Hosken says. 

Wall Street may wish the Fed would leave banks alone, when it comes to setting their executive pay. But most of the insiders I spoke to admitted that the Fed is probably just getting started. They think that the central bank has latched onto compensation as a practice it can reform in order to prevent the types of excessive risk that caused the financial crisis. And until it believes that Wall Street is paying its employees in a way that encourages them to think about long-term risks over short-term gains, the central bank isn't likely to let up.

"This is an industry that has had a lot of issues," Hosken said, speaking of Wall Street. "A lot of those issues are about risk."

So while Wall Street banks might not like Ben Bernanke meddling in their bonus discussions, there's probably nothing they can do to stop it. Between the Fed's supervisory authority and banks' unwillingness to offend their most powerful regulator, the compensation war is looking like one Wall Street just can't win.