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Banks reduce bonus pay

April 25th, 2013

Regulators of financial services firms, such as the Federal Reserve, are making progress in their quest to lower risk in the banking system. The Wall Street Journal reported earlier this week that seven large U.S. financial services firms have stated that they are “scaling back” the maximum bonuses awarded to their executives. These maximum bonuses are awarded to executives when they beat their pre-determined performance targets.

The performance programs typically work by promising to give top executives a certain number of shares if they meet their targets over several years. If targets are exceeded by the executives, they receive even more of a payout. The maximum payout amount is commonly set at limits of 200 percent of the target bonus.

Since the financial crisis, the Federal Reserve has grown concerned that the performance-based pay programs for executives that beat their financial targets are “way too sweet for banks,” according to The WSJ. The WSJ also reports that the Federal Reserve has urged banks to “cap bonuses” in cases where they could encourage executives to “take too much risk.”

Mark Williams, a former Federal Reserve bank examiner who now teaches at Boston University, said, “The Fed wants to ensure that excessive risk-taking is not encouraged in these structures.”

U.S. firms BB&T Corp, KeyCorp, U.S. Bancorp, SunTrust Banks Inc., Capital One Financial Corp., PNC Financial Services Group and Discover Financial Services Inc. have cut their maximum performance-based bonuses recently, according to a study conducted by pay-consulting firm Compensation Advisory Partners that examined 23 of the largest financial services firms. The WSJ reports that some shareholder groups “question the trend” of regulators interfering with the private pay practices of banks.

The argument proposed by these shareholder groups is that executives’ incentives “should be aligned with those of investors, who want companies to perform as strongly as possible.”

Carol Bowie, a senior research executive for the advisory firm Institutional Shareholder Services, stated, “There is some tension between the Fed’s focus, which is on risk mitigation, and the focus of investors.”

The “reasonable risks” that banks take are an important ingredient in what makes the stocks of banks rise.

There is a trade-off between executive compensation plans of the banks having risk-balancing features, such as the maximum payout caps, and aligning with the interests of their shareholders. The Federal Reserve seems like they will continue to guide banks to mitigate risk, in order to keep them from focusing too much on short-term profits and too little on risk when designing their bonus plans.

Information from The Wall Street Journal was used in this report.