Behind the Fed's move to regulate Wall St pay

WASHINGTON/NEW YORK (Reuters) - Before the financial crisis erupted a little over a year ago, executive pay was hardly on the Fed’s front-burner.

Former U.S. Federal reserve Chairman Alan Greenspan, who ran the institution from 1987 to 2006 and was regarded during much of that period as a financial deity, didn’t consider it the central bank’s business.

Neither did his successor, Ben Bernanke. As recently as this past May, seven months after Lehman Brothers’ collapse, Bernanke gave a speech entitled “Lessons from the Financial Crisis.” Banker pay was never mentioned.

A Reuters review of Federal Reserve speeches over the last 13 years reveals that the term “executive compensation” came up just three times, and only beginning in March 2009, when anger over bonuses to a bailed-out AIG was engulfing the nation.

Yet today, the Fed and Treasury announced a coordinated effort that will put the central bank at the heart of the rush to regulate pay on Wall Street. The regulations, which will try to align the financial incentives of managers with the longer-term performance of their firms, will give the Federal Reserve direct oversight over the pay of tens of thousands of executives, bankers, and traders.

What accounts for this newfound interest?


Earlier this month, Bernanke said the Federal Reserve now considers short-term incentives to be among the potential risks to the financial system, making the Fed’s oversight only natural.

“We view this as a safety and soundness issue,” he said in Congressional testimony. “That is what we have heard from the institutions themselves. They believe that the incentive structure affects safety and soundness.”

But interviews with dozens of lobbyists, banking industry insiders, and high-level regulators suggests that the Fed incursion into excessive pay stems more from political expediency than financial concerns. This, many say, raises serious questions about the central bank’s independence.

“If the Fed is fundamentally opposed to this idea but is going along because of politics, that’s a very bad sign,” said William Poole, former president of the St. Louis Federal Reserve.

Many seasoned Fed watchers, including a number of high-ranking officials from the central bank itself, say the clampdown on compensation constitutes a striking shift in policy for an organization that has consistently exhibited a non-interventionist impulse.

“It’s a sharp and rather surprising break with Fed tradition,” said Bill Cheney, chief economist at John Hancock Financial Services.

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To many, it is also a sign that the White House and Congress have become increasingly involved in directing central bank policy, a potential blow to the Fed’s independence that may be rooted in past misjudgments that made it appear too close to Wall Street.

For their part, Fed officials deny the White House or lawmakers had any hand in nudging the central bank in this direction. They say the push for greater oversight in executive compensation has been long in the making, and is part and parcel of the central bank’s mandate to ensure the safety and soundness of the banking system.

“I don’t see this as somehow suggesting that the Fed has lost its independence,” said Randall Kroszner, who stepped down from the Federal Reserve’s Board in January to return to a teaching post at the University of Chicago’s Booth School of Business. “If there are compensation polices seen as inconsistent with safety and soundness then regulators should intervene.”


On most issues identifying the top concerns of policy-makers is easy: they repeat their views on everything from regulatory policy to the macroeconomic outlook over and over in speeches around the country and the world. During the dot-com bubble for instance, a mere utterance from Greenspan turned “irrational exuberance” into a household expression.

In financial circles, such frequent pronouncements have even earned the central bank’s policy-setting group, the Federal Open Market Committee, a nickname: “Federal Open Mouth Committee.”

The speeches and testimony of the Fed’s top members offer a useful window into their thinking. And their radio silence on the subject of executive compensation speaks volumes, Fed watchers say.

The issue is first broached by Bernanke and his number two, Donald Kohn, who addressed pay fleetingly in testimony, addressing concerns about the Fed's role in American International Group AIG.N.

Never once did they signal this would eventually lead to a systematic policy on pay. That idea was not raised publicly until the Fed’s legal counsel, Scott Alvarez, spoke to Congress on June 11, 2009. He was the first to overtly make the case that the issue, long thought to be outside the scope of regulatory policy -- much less direct central bank intervention -- should now come under the Fed’s umbrella.

“Bernanke has never indicated any interest in this issue whatsoever,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “It would be a huge, albeit possibly warranted, departure for the Fed to get into compensation in a big way.”

Poole, of the St. Louis Fed, said the topic was not on the agenda while he was in office. “I never remember hearing anything about it,” he said.

Before the financial crisis, the one time the Fed seems to have weighed in on the matter, it signaled that all was well with executive compensation. In a 2007 paper published by the Federal Reserve Board, central bank economists concluded that sky-rocketing compensation was simply a reflection of improved firm performance, serving to “align managerial incentives with those of shareholders.”

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If the White House and Federal Reserve had a matchmaker, it was the near market meltdown. Since the first rumblings of crisis back in the summer of 2007, the U.S. Treasury Department has been working closely with the Fed to stem the most severe financial panic in generations.

In September 2008, a turbulent month that saw the fall or near-death experience of industry giants like Fannie Mae, Freddie Mac, AIG, Merrill Lynch and Lehman Brothers LEHMQ.PK, Paulson met with Bernanke numerous times.

At the time, Bernanke eagerly backed a proposal by Henry Paulson, then Secretary of the Treasury, that was widely criticized for being way too thin on details, weighing in at a mere three pages -- and with nary a mention of Wall Street pay.

Bernanke’s backing was borne of a serious concern for the economic outlook as the financial crisis appeared to spiral out of control. As a long-time student of depressions, he was eager to apply his scholarship to real world policy. Sources say he threw the Fed’s weight behind the plan because he truly believed that getting the money from Congress was an imperative.

As aftershocks from Wall Street’s meltdown continued, the emerging nexus between the White House and the Fed was intensified, according to people close to the matter.

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The Fed even agreed to buy Treasury bonds directly in an effort to revive the housing market, a controversial decision that was opposed by a number of regional Fed officials.


Fed policy-makers are well-aware of the need to stress their independence on setting interest rates. It must also convince both investors and the public that the central bank can and will withdraw its multi-trillion dollar emergency lending programs when it considers the time is right, not when the White House and Congress say it is time to do so.

But the renewed tendency of government to intrude into the central bank’s affairs is likely to make the eventual Fed’s policy exit more complicated.

Forced to resort to unconventional forms of monetary stimulus, like outright asset purchases, to stem the crisis, the Fed must now grapple with how to eventually pull the plug.

The phrase “political risk,” normally reserved for emerging economies, is increasingly being bandied about in reference to the U.S. central bank, whose reputation for independence was once pristine.

“The uncertainty that surrounds the conduct of future monetary policy will be extreme,” said Eric Lascelles, chief economics and rates strategist at TD Securities, who cites an “increased risk of political interference.”

In a sense, the Fed is trying to salvage a reputation tarnished by the financial implosion. Some of its pre-crisis actions, like touting the benefits of arcane financial derivatives that proved to be highly destructive when asset values fell, contributed to an erosion of its credibility, critics say.

The Fed’s big misses in the housing arena also damaged its reputation. The central bank could have been more assertive about reining in predatory mortgage lending but failed to do so.

“The Fed needs a greater regulatory backbone,” argued RGE Monitor’s Nouriel Roubini and Ian Bremmer of Eurasia Group in a recent newspaper editorial. “The Fed had the power to regulate mortgage markets but failed to use this power out of a misplaced deference to laissez faire attitudes and Wall Street.”

All of this added to the impression that the Fed had simply gotten too close to Wall Street, a suspicion bolstered by direct links to the banking sector among so many of its top members.

In the most egregious example, Stephen Friedman, chairman of the New York Federal Reserve Bank’s board of directors, resigned in May amid accusations of impropriety regarding his purchase and sale of stock in Goldman Sachs, the investment giant he once chaired.

Friedman traded Goldman stock even as the firm benefited from the very rescue plans he helped draft. He was also in charge of finding a replacement for Timothy Geithner, who was leaving the New York Fed to become Treasury Secretary.

Friedman’s eventual pick to succeed Geithner, former Goldman partner William Dudley, did little to quiet the controversy.

These stains on the Fed’s record have left it politically vulnerable, say analysts.

One school of thought posits that the central bank’s dive into executive pay may simply a bid to improve its battered image. In a recent poll, the Fed outdid even the Internal Revenue Service on the list of agencies Americans love to hate.

“My sense is that they saw this as an area in bank regulation that has a lot of popular support,” said Michael Feroli, an economist at JP Morgan and former Fed staffer. “They are going for the lower-hanging fruit.”

Editing by Jim Impoco