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Karla Reyerson

Karla L. Reyerson Bank & Finance

kreyerson@fredlaw.com
612.492.7418
Printable Version

Regulators Take Steps to Curb Incentive Compensation

By: KARLA L. REYERSON

June 2010

As bank regulators work to identify the causes of and solutions to the financial crisis that crippled the country, one area of focus has become the payment of certain “risky” forms of incentive compensation to bank employees. Both the Federal Reserve and FDIC have taken steps to change some bank practices with regard to incentive compensation, though each agency has taken a somewhat different approach.

Federal Reserve’s Proposed Guidance


On October 27, 2009, the Federal Reserve published proposed guidance on sound incentive compensation policies to help ensure banking organizations (including state member banks and bank holding companies) do not encourage excessive risk taking and that they compensate in ways consistent with safe and sound banking practices.

The proposal contains two initiatives. The first is directed at “large complex banking organizations,” which is defined to include the 28 largest U.S. banking organizations. The Federal Reserve plans to perform a comprehensive review of these organizations’ incentive compensation arrangements and work with these organizations to improve the risk sensitivity of incentive compensation programs.

The second initiative involves reviewing compensation practices at all other banking organizations as part of their regular risk-based examinations. The Federal Reserve will review the incentive compensation plans of senior executive officers, as well as any other individuals or groups of individuals within a banking organization whose activities may expose the organization to material amounts of risk. In reviewing incentive compensation, the Federal Reserve intends to adhere to three principals.

Principle 1: Balanced Risk-Taking Incentives


The first principle is that incentive compensation arrangements should balance risk and financial results so as to avoid giving employees incentives to take excessive risks on behalf of the organization. The Federal Reserve warns against having incentive pay tied to short-term gains which may not reflect the long-term risk of the employee’s activities. For example, where two employees generate the same short-term revenue for the organization but one employee creates materially larger long-term risk for the organization, that employee should receive less incentive compensation than the employee who did not create that long-term risk.

The proposal sets forth certain methods organizations may use to make incentive compensation more sensitive to risk, including the following:

  1. Risk Adjustment of Awards: Adjust the incentive compensation award to take into account the risk the employee’s activities pose to the organization.
  2. Deferral of Payment: Delay payment of the incentive compensation until the compensation may be adjusted to reflect any actual losses.
  3. Longer Performance Periods: Extend the time period used to measure the employee’s performance.
  4. Reduced Sensitivity to Short-Term Performance: Reduce the rate at which incentive awards increase as an employee achieves higher levels of performance, thus lowering the incentive to take risks.

The proposed guidance encourages institutions to account for the differences between employees when designing incentive compensation packages and instructs organizations to consider the potential for “golden parachutes” and deferred compensation vesting arrangements to affect employees’ risk-taking behaviors. Finally, the Federal Reserve encourages organizations to communicate to employees the ways in which incentive compensation awards will be reduced as risks increase.

Principle 2: Compatibility with Effective Controls and Risk Management


Banking organizations are directed to utilize their risk-management processes and internal controls to reinforce and support the development and maintenance of balanced incentive compensation arrangements. Banks should use internal controls to monitor the effectiveness of their incentive compensation programs and to make sure that those who benefit from these programs do not have undue influence over a program’s design or implementation.

The proposal emphasizes the importance of involving risk-management personnel in the design and review of incentive compensation programs, including the identification of the risks these programs may pose to the organization. Organizations are encouraged to compensate those in risk management and control functions sufficiently in order to attract and retain qualified personnel and avoid conflicts of interest.

Principle 3: Strong Corporate Governance


The proposed guidance calls for strong and effective corporate governance to help ensure sound compensation practices. The board of directors of the organization should actively oversee incentive compensation arrangements because the board is ultimately responsible for ensuring these arrangements are appropriately balanced with risk and do not create safety and soundness concerns. Also, the organization is directed to inform its shareholders of its incentive compensation practices and controls so that shareholders can monitor these activities.

The proposed guidance emphasizes that the scope of an organization’s processes and procedures surrounding incentive compensation will depend on the size of the organization, its use of incentive compensation, and the strength of its risk management and internal controls. If the proposal is finalized as written, banking organizations will be required to take immediate action to identify and correct deficiencies in their incentive compensation arrangements. Those organizations that are determined to have unduly risky incentive compensation programs may face downgrades in their supervisory rating and possible supervisory action.

FDIC’s Notice Of Proposed Rule-Making


On January 12, 2010, the FDIC issued an advance notice of proposed rulemaking (ANPR) seeking comment on how the FDIC can revise its risk-based deposit insurance assessments to account for the risk level of banks’ employee compensation programs. The FDIC stated its goal of better aligning employees’ interests with the long-term interests of the organization and its stakeholders.

The ANPR indicates that the FDIC would focus on the compensation of “senior management, among others” and that compensation programs meeting the FDIC’s goals may include the following features:

  1. Provide that those employees who receive incentive compensation and whose business activities present risk to the institution receive a significant portion of their incentive compensation in restricted, nondiscounted company stock, which would become available to the employee over a period of years.
  2. Provide that significant awards of company stock vest over multiple years, subject to a clawback designed to account for the results of risks assumed in earlier periods.
  3. Administer the compensation program through a committee of the board of directors composed of independent directors with input from independent compensation professionals.

The FDIC proposes to require institutions to attest that their compensation programs include the identified features; those that cannot would face a higher risk-based assessment rate. The ANPR also includes a list of questions for commenters to respond to regarding how these adjustments to risk-based assessments should work, including how to measure whether boards are effectively overseeing these programs, whether to implement quantifiable measures of compensation related to the institution’s health or performance, and what amount of adjustment would be needed in order to influence compensation practices.

Takeaway


Although the form of incentive compensation restrictions may not be set yet, it is almost certain that one or more government initiatives related to incentive programs will be implemented. In order to avoid having to significantly revise compensation arrangements in the future, organizations should become familiar with the goals and principals of the regulators’ current proposals and attempt to remove risk incentives. Also, risk-management personnel and the board should become involved in the compensation arrangements of the organization and be ready to implement changes if necessary.