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Compensation curbs announced yesterday by the Treasury Department and the Federal Reserve thrust the U.S. government into decisions about pay and performance traditionally reserved for corporate boards.

The Treasury’s special pay master, Kenneth Feinberg, slashed the salaries of the most highly paid executives at seven companies that received taxpayer aid, including Citigroup Inc. and Bank of America Corp. The Fed’s action came in the form of guidance that would apply to more than 6,000 banks, with a focus on the 28 largest.

Both the Treasury and the Fed are seeking to rein in the excessive risk-taking blamed for triggering a recession that has cost 7.2 million American jobs. The danger is that the oversight once exercised by shareholders and directors will now be replaced by the government, economists said.

“The Fed through its policies has virtually eliminated the incentives of board members, equity holders or debt holders to exert sound corporate governance,” said Ross Levine, an economist and author of a book on bank regulation who teaches at Brown University in Providence, Rhode Island. “The only mechanism left is official oversight.”

The Obama administration and Congress are drafting the biggest overhaul of financial regulation since the 1930s. Congressional leaders are debating whether the Fed should be the lead agency with responsibility for setting standards on capital, liquidity, and risk-management for the entire financial system.

“Regulatory reform is really up for grabs right now,” said Richard Sylla, a financial historian at New York University’s Leonard N. Stern School of Business. The Fed’s announcement, coming on the same day as the Treasury’s, “is almost a part of their campaign to say ‘Yes, we can do this.’”

Surveillance Role

House Financial Services Committee Chairman Barney Frank said last month that the authority over systemic risk will reside within a council of regulators. The Fed may still be the most important agency within that council because of its large staff and financial-market surveillance role.

The differences between the approaches taken by Feinberg and the Fed are stark. Feinberg capped most cash salaries at $500,000 a year and demanded that bonuses be in the form of restricted stock, to be paid after three years and only if government aid has been returned.

Feinberg’s rules tie the hands of board members by preventing companies that received bailouts from using those funds to pay large bonuses. American International Group Inc. in March ignited a backlash after giving about $165 million in bonuses to its derivatives staff, a decision that President Barack Obama called “an outrage.”

‘Witch Hunt’

“This is a clear triumph of the mentality of a political witch hunt over reason,” said Peter Wallison, a former general counsel at the Treasury and a member of the commission set up by Congress to investigate the financial meltdown.

Overall, the total compensation for the top 25 executives at the seven companies will be cut by an average of 50 percent. Feinberg’s rules only apply to compensation earned by employees in November and December; he will revisit pay practices at the seven companies at the start of 2010.

The rules have triggered a debate about the role of corporate boards in setting compensation.

‘Compensation Bureaucracy’

“It’s the responsibility of the board and the investors to appropriately police pay practices,” said Charles Elson, director of University of Delaware’s Weinberg Center for Corporate Governance. He said the government rules create a “compensation bureaucracy.”

Nell Minow, co-founder of the Portland, Maine-based Corporate Library, which focuses on governance issues, disagreed.

“Boards of directors cannot fix this,” she said in a Bloomberg Television interview. “They don’t have the courage.”

The Fed’s guidelines, while less rigid than Feinberg’s rules, are more far-reaching, applying even to banks like Goldman Sachs Group Inc. and JPMorgan Chase & Co. that have returned government aid.

The central bank doesn’t impose pay caps or bans on particular practices. The guidance is aimed instead at discouraging banks from adopting practices that might endanger the federal deposit insurance fund or the larger financial system.

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” Fed Chairman Ben S. Bernanke said in a statement yesterday.

Delayed Bonuses

One method banks can use to align their pay practices with the Fed’s proposed guidelines is by “significantly” delaying the payout of a bonus, the Fed said. Banks could also extend from one year to two the period covered by performance measures.

The Fed suggested that employees who expose a firm to large amounts of risk might receive smaller bonuses than those whose activities are less risky, even if both types generate the same revenue or profit.

The Fed’s rules will not take effect for months while the agency considers public comments and makes revisions. Banks won’t have the luxury of waiting. The Fed expects them to start reviewing their pay practices immediately. It also plans to launch a review of compensation at the 28 largest banks, which it didn’t name.

One area where the Fed’s guidelines are stronger than Feinberg’s is in so-called clawbacks, or adjustments to bonus payments for any actual losses that become clear during the deferral period. The Fed guidelines encourage banks to take back compensation from employees whose risk-taking causes losses in later years.

Seven Firms

Feinberg isn’t seeking to recover any compensation that executives have already received. The seven firms whose pay Feinberg oversees are Bank of America, Citigroup, American International Group, Chrysler Group LLC, Chrysler Financial Corp., General Motors Co. and General Motors Acceptance Corp.

Kenneth Raskin, head of the global executive compensation practice at New York-based law firm White & Case, said it’s unclear whether either the Fed or Feinberg have sufficient expertise to make compensation decisions.

“Many companies go to outside compensation consultants to advise them on what is proper,” Raskin said. “If the companies themselves don’t always know how best to set performance standards, is the federal government going to be able do that better?”

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Filed under: finance by Finance Boss