Should the Federal Reserve regulate bank pay practices?

News leaked out late last week that the Federal Reserve was considering adopting a new policy that would allow it to regulate the pay policies of banks. The rules are vague, to say the least. There would not be a cap on pay or bonuses, but the Fed would look at issues such as how long should deferred compensation be deferred and whether banks can reclaim bonuses and stock grants in certain situations.

As my MBA 505 students know from our discussion last week, there are serious concerns that pay practices have contributed to excessive risk taking. However, those practices have been put in place for a good reason -- to align the incentives of bank executives, traders and other high-level employees with the incentives of stockholders. I can somewhat understand the Fed and the Treasury asserting themselves in banks where taxpayers hold significant stakes -- but for all the banks all of the time?

Many economists maintain that the real agency problem is the Fed's implicit commitment to bail out virtually all failed financial institutions (except Lehman). It will be interesting to see how this plays out.