Unlike a Treasury plan to slash pay at certain companies that were bailed out with large sums of taxpayer money, the Fed proposal would cover thousands of banks, including many that never received a bailout.
The Fed would not actually set compensation. Instead, the central bank would review - and could veto - pay policies that could cause too much risk-taking by executives, traders or loan officers.
It's the Fed's latest response to criticism that it failed to crack down on lax lending, irresponsible risk taking and other practices that many blame for contributing to the worst financial crisis since the 1930s.
The Fed's goal is to make sure banks' pay policies don't encourage top managers or other employees to take gambles that could endanger the company, the broader financial system or the economy.
"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. "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."
Under the proposal, the 28 biggest banks would develop their own plans to make sure compensation doesn't spur undue risk taking. If the Fed approves, the plan would be adopted and bank supervisors would monitor compliance.
To get a broad picture of industry pay, the Fed also will internally compare and contrast results across the big banks. It is not anticipated that the central bank will make public the results of this so-called "horizontal review," Fed officials said.
The Fed refused to identify the 28 banks that will have to submit plans. But Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. are usually included among the largest banks.
Compensation arrangements for senior executives at big banks are likely to be better balanced if they involve deferral of a "substantial portion" of compensation over a multiyear period in a way that reduces the amount received due to poor performance, the Fed suggested.
At smaller banks - where compensation is typically less - Fed supervisors will conduct reviews. Those banks don't have to submit plans.
All told, nearly 6,000 banks regulated by the Fed would be covered.
Because of differences between large and small banks and the various ways compensation can be structured, the Fed said it decided against a "one size fits all" approach.
The Fed did suggest that banks, among other things, carefully review "golden parachutes," which typically provide senior executives with large payments without regard to outcomes, to ensure they don't encourage undue risk-taking.
Banks too often rewarded employees for increasing the firm's short-term revenue or profit, without adequate recognition of the risks posed for the company, one of the many factors feeding into the financial crisis, the Fed said.
"Aligning the interests of shareholders and employees ... is not always sufficient to protect the safety and soundness of a banking organization," according to the Fed proposal.
The public, industry and other interested parties will have an opportunity to weigh in on the Fed's proposal.
After a 30-day comment period, the proposal could be revised before a final plan is adopted. Fed officials said they want to move quickly but wouldn't commit to a final plan being adopted this year.
Still, the Fed said it expects banks to immediately review their compensation arrangements and implement "corrective programs where needed."
The Fed also may ban certain practices if "further experience" reveals a problem. The central bank said it will ask the public, industry and others to provide feedback on this point.
The findings from the Fed's compensation reviews will be included when supervisors rate a bank for financial soundness. Bank ratings are usually kept confidential.
The Fed also will put together a report - sometime after next year - on trends and developments in compensation practices at banks.
Although Fed officials said they were confident that supervisors would have the necessary expertise to assess compensation practices, outside experts thought the Fed might have to hire additional people to do so.