Executive compensation has been a hot button issue in the ongoing debate on regulation of the financial sector. Since the 1980’s and the days of “Reganomics,” financial regulation has been avoided like the plague, but all of this has changed in lieu of the recent economic turmoil. With increased public support for a Consumer Financial Protection Agency and other safeguards against excessive risk-taking in the financial sector, the government appears poised to begin imposing new regulations. One of the first steps towards redefining the financial industry came in mid-October with the announcement that the Fed will begin to take measures to regulate executive pay.

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” said Federal Reserve chairman Ben Bernanke.

In the aftermath of last fall’s financial crisis, experts pointed to executive compensation packages that promoted excessive risk taking as being one of the main culprits. Incentive packages that encouraged high-risk business ventures were ubiquitous among financial institutions, particularly those that were forced to come to the government for aid.

In a move that surprised many on Wall Street, the Federal Reserve announced that they would be imposing certain restrictions on executive pay and bonus packages. The newly proposed pay restrictions are still more lax than many members of Congress and leaders from overseas would have liked. Rather than mandating reform, the Fed has simply instituted guidelines for banks to follow. The new policy will not impose caps on pay, but rather establish rules and stipulations on how companies can incentivize their employees. All organizations supervised by the Fed will be subject to the new regulations, including bank holding companies, state member banks and the US operations of foreign banks.

“The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system,” Bernanke said.

The main goal of this new regulation is not necessarily to end high pay for executives, but rather to promote more responsible investing and business ventures. The new system will review the compensation packages at 28 of the nation’s largest and most complex banking organizations and employ a “horizontal review” to compare them to one another. Despite the changes being announced this month, it will likely be months before there is a quantifiable effect.

Companies that received the most funds from the TARP will be subjected to even harsher restrictions. These companies will be forced to comply with these constraints until they have repaid all of their government loans. The Obama administration’s “pay czar,” Kenneth Feinberg, recently released his plan to cut the pay of the top 25 earners at the seven companies that received the lion’s share government aid: Citigroup, Bank of America, A.I.G., GM, Chrysler, as well as the financial companies of the two automakers. Feinburg’s plan will cut executive pay from these companies’ top earners by half, limiting cash salaries to $500,000 and requiring government permission for any “special benefits” that exceed $25,000.

While these restrictions will only be effective until the end of 2009, Feinburg will have the opportunity to impose new regulations for 2010. On average, 90 percent of the cash portion of executives’ salaries will be eliminated and replaced by stock that will have to be held for a designated amount of time. Part of Feinburg’s proposal is a reiteration that A.I.G. must fulfill its commitment to cut the $198 million that it had previously promised to employees in the financial products division.

There has been public outcry as of late, with Goldman Sachs, JPMorgan Chase and Morgan Stanley expected to dole out billions of dollars in bonuses at the end of this year. Although these companies received government aid through the TARP, they have already repaid all of their loans and are no longer under the stipulations of the program. Goldman Sachs is poised to set a record for their compensation packages this year, already having set aside $16.7 billion for bonuses.

As always, there are two sides to the debate. Those on Wall Street contend that without high executive pay they risk losing their most talented employees to their competitors. Although this argument has merit, many feel that it is being overemphasized by opponents of financial reform. Without a clear definition of “excessive risk” or “excessive compensation,” many are concerned that the new restrictions will be too vague. The bottom line is that it is difficult to find a level of compensation that doesn’t reward risk and adequately attracts talent concurrently.

“These people are considered the brains of the machine. They are who can pull you through the tough times,” said Steven Hall, the manager of an executive compensation firm. “This will give them reason to leave.”

The White House is currently considering other revisions to executive pay policy as well, such as giving shareholders a nonbinding vote on the pay of the company’s top executives. This appears to be the first step in a larger mission to completely reform the financial industry and impose regulations that have been nonexistent for the last several decades.

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