By Yali N'Diaye

WASHINGTON (MNI) - In an effort to discourage excessive risk taking and ensure banks' safety and soundness, the Federal Reserve Thursday proposed to conduct a review of compensation practices at small banks and at 28 "large, complex banking organizations."

The Fed is proposing to incorporate the findings into the institutions' supervisory ratings, which help identify institutions that raise concern or require special attention and include a risk management component.

The central bank is also proposing to report on "on trends and developments in compensation practices" in the banking industry "after the conclusion of 2010."

While the proposal will be submitted for comment for 30 days, the Fed is expecting firms to start taking actions immediately on their compensation policies and practices.

"Flaws in incentive compensation practices were one of many factors contributing to the financial crisis," the Fed notes. "With that in mind, the Federal Reserve's guidance and supervisory reviews cover all employees who have the ability to materially affect the risk profile of an organization, either individually, or as part of a group."

And where appropriate, the central bank could require institutions to take "develop a corrective action plan."

The examination at the 28 large institutions -- not named by the Fed -- would be coordinated in a "special horizontal review," the announcement reads.

"The policies and implementing practices adopted by these firms in response to the final supervisory principles will become a part of the supervisory expectations for each firm and will be monitored for compliance," it adds.

At smaller banks, the "reviews will be tailored to take account of the size, complexity, and other characteristics of the banking organization."

Under the proposal, the results of the findings would be incorporated in the banks' supervisory rating "component(s) and subcomponent(s) relating to risk management, internal controls, and corporate governance under the relevant supervisory rating system, as well as the organization's overall supervisory rating."

Those two supervisory initiatives were announced as the largest recipients of TARP funds -- AIG, Citigroup, Bank of America, Chrysler, GM, GMAC and Chrysler Financial -- were reported in the press to be expected to be required by Treasury to slash the compensation of their highest paid employees.

"The Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements and related risk management, control, and corporate governance processes and immediately address deficiencies in these arrangements or processes that are inconsistent with safety and soundness," the notice of proposed guidance says.

It stresses that firms' compensation practices have been encouraging short term performance over longer term considerations, leading to excessive risk taking contributing to the financial crisis.

To address the shortfall, "supervisors can provide a common prudential foundation for incentive compensation arrangements across banking organizations and promote the overall movement of the industry toward better practices."

The Fed describes three core principles on which its proposed guidance is based. First the compensation policy should not encourage excessive risk taking but be based on "balanced risk-taking incentives." Second, it should be "compatible" with effective risk management. Third, it should be supported by "strong corporate governance."

In its notice, the Fed is asking whether those principles are "appropriate and sufficient" or, "Should additional or different principles be included to achieve this goal?"

It is also asking whether a "formulaic" approach to executive compensation should be favored to determine pay limits and incentives.

In particular, the Fed is encouraging banks to look at policies such as the "golden parachutes" to assess their effectiveness.

** Market News International Washington Bureau: 202-371-2121 **