The Federal Reserve expects the largest U.S. banks to make progress this year in overhauling their pay practices, while acknowledging that more dramatic changes may take longer to implement, a Fed official said on Thursday.

Wall Street pay has been a frequent source of controversy in the wake of a financial meltdown that brought global markets to the brink of collapse and prompted multibillion-dollar taxpayer bailouts for individual financial firms.

Scott Alvarez, general counsel of the central bank, said the Fed expects to issue final guidance shortly on the pay guidelines it issued in October to combat excessive risk-taking at banks.

He said the Fed is also working on a two-tier system after public comments said smaller banks may face a heavier regulatory burden as supervisors increase scrutiny of pay practices.

Compensation practices were not the sole cause of the financial crisis, but they were a contributing cause, Alvarez said in prepared remarks for a House Financial Services Committee hearing on pay at financial firms.

Public anger has simmered as Wall Street firms have returned to paying executives huge bonuses at a time when many Americans are still struggling with joblessness brought on as the financial crisis sparked the worst recession since the 1930s.

New York's Attorney General said on Tuesday that Wall Street bonuses rose 17 percent last year to $20.3 billion and jumped 30 percent at three of New York's largest banks -- Goldman Sachs Group , JPMorgan Chase & Co and Morgan Stanley . The increases sparked strong rebukes from the Obama administration and U.S. lawmakers.

AIG ANGER

But no single firm has unleashed more anger than bailed-out insurer American International Group Inc , which this month paid out another $100 million in bonuses to employees of the unit that made bad bets on credit default swaps and brought the firm to the brink of collapse.

Kenneth Feinberg, the Obama administration's pay czar, told the panel that renegotiation of pay contracts at AIG has been a unique challenge.

As a result of officials' refusals to restructure their cash retention payments, I refused to approve cash salary amounts proposed by the company, which, in light of the retention payments, would have resulted in an excessive level of cash compensation, Feinberg said.

AIG fell short of a target to reduce the payments by $26 million, achieving only $20 million in reductions.

Lawmakers also questioned the size of pay packages at government-controlled mortgage finance companies Fannie Mae and Freddie Mac , which could allow the top executive at each firm to earn up to $6 million.

Edward DeMarco, acting director for the Federal Housing Finance Agency, the regulator for Fannie and Freddie, multimillion-dollar pay packages were necessary to retain talented managers.

But he also said that during the housing boom years, badly constructed compensation incentives contributed significantly to excessive focus on near-term earnings reports to the serious detriment of the enterprises.

Feinberg told lawmakers that he thought the Fannie compensation was high compared to the $500,000 cash salary cap that he has imposed but said the two housing enterprises had challenges attracting talent and making long-term stock incentive pay arrangements due to questions over their future structure.

It's difficult to say, 'We will pay you four or five years out' when there's a question over what Fannie and Freddie will look like four or five years out.

Nonetheless, Feinberg said he saw as rather dubious claims that executives were leaving bailed out firms facing pay restrictions. We don't see an exit from these companies.

SELF CONTROL

Alvarez said financial firms are taking it upon themselves to review their pay structures to ensure that the interest of managers and other employees is better aligned with the long-term health of their firms.

Some changes are already in place, he said, noting that firms have been converting cash bonuses to deferred stock and instituting clawbacks which allow companies to recoup bonuses that were awarded for decisions that did not result in adequate returns.

Alvarez said the Fed is still reviewing the pay practices at the 28 largest banking firms, including Goldman Sachs and Morgan Stanley.

He said it is clear that a shift in philosophy is occurring at the firms. But he said it will take time for them to put in place systems needed to make bonuses appropriately risk-sensitive and to figure out ways to determine if certain pay structures do indeed lead to excessive risk.

(Editing by Kenneth Barry)

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