The Board of Governors of the Federal Reserve System has recently issued Proposed Guidance on Sound Incentive Compensation (“Proposed Guidance”). While the Federal Reserve’s Proposed Guidance is generally consistent with the principles in the other government initiatives regarding risk management and corporate governance of incentive compensation, the Proposed Guidance is more comprehensive and provides detailed examples of methods, policies, procedures and systems that can be employed to meet a company’s new risk assessment obligations. For example, the Securities and Exchange Commission (“SEC”) and the Department of the Treasury (“Treasury”) have respectively issued proposed rules and interim regulations mandating that public companies and many financial institutions analyze and disclose the state of their risk management and the risk factors affecting any incentive compensation program that could have a material effect on the company.¹ However, neither the SEC nor the Treasury has provided any formal guidance about how to implement their mandates. For that reason, even though the Proposed Guidance is binding only on banking organizations supervised by the Federal Reserve, companies affected by the SEC and Treasury disclosure mandates will benefit from careful consideration of the detailed methods of risk analysis contained in the Proposed Guidance.
The most significant elements of the Proposed Guidance are as follows:
- Supervised banking organizations must immediately review all their incentive compensation programs for executive and non-executive employees that would expose the firm to a “material amount of risk,” and related risk management and corporate governance processes. If they are not consistent with the Proposed Guidance, appropriate action must be taken.The Proposed Guidance discusses not just principles, but provides examples of the policies, procedures and systems a firm should have in place to discourage excessive risk taking and not pose a threat to the safety and soundness of the organization.
- In order to move banking organizations forward in this process, the Federal Reserve is commencing two supervisory initiatives. The first is a review of incentive compensation arrangements at the current 28 large, complex banking organizations to better understand and assess current practices and corporate governance processes, and to identify emerging best practices. The second is a review over 6,800 community and regional banks as part of the Federal Reserve’s regular, risk-focused supervisory process.The Federal Reserve will then incorporate its findings into its examination reports and relevant supervisory rating systems. Where appropriate, the Federal Reserve will bring enforcement actions to rectify any deficiencies in the incentive compensation arrangements or risk-management and governance processes.
The Proposed Guidance applies to incentive compensation arrangements for “covered individuals” and “banking organizations” as described below:
Unlike the TARP Regulations or the proposed Proxy Rules, the Proposed Guidance extends beyond traditional “top” executives, and includes:
- Senior executives and others who are responsible for oversight of the firm-wide activities or material business lines
- Individual employees, including non-executive employees, whose activities may expose the firm to material amounts of risk
- Groups of employees who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, may expose the firm to material amounts of risk, even if no individual employee is likely to expose the firm to material risk
The Proposed Guidance applies to all “banking organizations,” which are defined as “U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations of foreign banks with a branch, agency or commercial lending company subsidiary in the United States.”
Principles of a Sound Incentive Compensation System
The Proposed Guidance contains three main principles that set the stage for its detailed discussion of how to evaluate a bank’s incentive compensation programs and related risk-management and corporate governance processes. A banking organization’s incentive compensation programs should:
- Provide employee incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk
- Be compatible with effective controls and risk management
- Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors
Below is a general summary of the Proposed Guidance regarding the application of these principles. However, the Proposed Guidance is very comprehensive and contains numerous specific examples, a detailed summary of which is beyond the scope of this article.
Principle 1: Balanced Risk-Taking Incentives
- Incentive compensation arrangements should balance risk and financial results in a manner that does not provide employees with incentives to take excessive risks on behalf of the firm.Example: In a balanced incentive compensation arrangement, two employees who generate the same amount of short-term revenue or profit for an organization should not receive the same compensation if the risks taken by the employees in generating the revenue differ materially. The employee whose activities generate materially larger risk should be paid less than the other employee, all else being equal.
- Incentive compensation arrangements should not only be balanced in design, they should also be implemented so that actual payments vary based on risks or risk outcomes.Example: If employees are paid substantially all of their potential incentive compensation even when risk or risk outcomes are materially worse than expected, then employees have less incentive to avoid excessively risky activities.
- Firms should consider the full range of risks associated with the employee’s activities, as well as the time horizon over which those risks may be realized, in assessing whether incentive compensation arrangements are balanced.Example: A firm should consider the cost and amount of capital and liquidity required to support the risks.Example: Where quantitative risk measures are not available, firms should not ignore such issues, but rely on informed judgment to estimate risks and risk outcomes in designing balanced incentive compensation.
- Risks may include credit, market, liquidity, operational, legal, compliance, and reputational risk.
- An unbalanced arrangement can be moved toward balance by adding or modifying features that cause the amounts ultimately received by employees to appropriately reflect risk and risk outcomes.Example: Such features include factoring risk into the determination of the size and payout of an incentive award, deferring incentive payouts by subjecting them to ongoing performance, applying longer performance periods, and flattening the incentive payout curve for higher levels of performance.Example: Where reliable risk measures do not exist, deferring payment may be needed to account for and mitigate potential risk outcomes.
- The manner in which a banking organization seeks to achieve balanced incentive compensation arrangements should be tailored to account for the differences between employees—including the substantial differences between senior executives and other employees—as well as between banking organizations.Example: The use of a single, formulaic approach to making employee incentive compensation arrangements appropriately risk-sensitive is likely to provide at least some employees with incentive to take excessive risk.
- Banking organizations should carefully consider the potential for “golden parachutes” and the vesting arrangements for deferred compensation to affect the risk-taking behavior of employees while at the organizations.Example: The payment of severance compensation or the accelerated payment of deferred compensation at termination without regard to risk or risk outcomes may cause inappropriate risk-taking by employees.
- Banking organizations should effectively communicate to employees the ways in which incentive compensation awards and payments will be reduced as risks increase.
Principle 2: Compatibility with Effective Controls and Risk Management
- A banking organization’s risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements.
- Banking organizations should have appropriate controls to ensure that their processes for achieving balanced incentive compensation arrangements are followed and to maintain the integrity of their risk management and other functions.Example: The organization’s policies and procedures should:
- Identify and describe the role(s) of those involved in the design, implementation, and monitoring of incentive compensation arrangements
- Identify the sources of risk and establish appropriate controls to govern these risks
- Identify those required to approve new arrangements or modify existing ones
- Appropriate personnel, including risk-management personnel, should have input into the organization’s processes for designing incentive compensation arrangements and assessing their effectiveness in restraining excessive risk-taking.Example: This could include:
- Reviewing the types of risks associated with the activities of employees covered by an incentive arrangement
- Approving the risk measures used in risk adjustments and performance measures
- Analyzing risk-taking and risk outcomes related to incentive payments
- Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified personnel and their incentive compensation arrangements should be structured to avoid conflicts of interest.
- Banking organizations should monitor the performance of their incentive compensation arrangements and should revise the arrangements as needed if payments do not appropriately reflect risk.
Principle 3: Strong Corporate Governance
Banking organizations should have strong and effective corporate governance to help ensure sound compensation practices.
- The board of directors of a banking organization should actively oversee incentive compensation arrangements.Example: The board of director’s should review and approve the overall goals and purposes of the firm’s incentive compensation system.
- The board of directors should monitor the performance, and regularly review the design and function, of incentive compensation arrangements, including the use of both look-back and forward-looking analyses.Example: The Board should receive periodic reports that review the incentive compensation awards and payments relative to risk outcomes on a backward looking basis to determine whether the firm’s incentive compensation arrangements may be promoting excessive risk taking.
- The organization, composition, and resources of the board of directors should permit effective oversight of incentive compensation.Example: The board of directors should have the authority to, where appropriate, select, compensate, and use outside counsel, consultants or other experts with expertise in incentive compensation and risk management.
- A banking organization’s disclosure practices should support safe and sound incentive compensation arrangements.
¹ The SEC has issued proposed Proxy Disclosure and Solicitation Enhancements requiring new executive compensation proxy disclosures that includes a discussion and analysis of any compensation policy or practice that has a “material effect” on the company. Treasury has issued interim TARP Standards for Compensation and Corporate Governance that requires all recipients of federal bailout money to have bi-annual meetings of its compensation committee to review risk management of its executive compensation and report the results to the Treasury and the SEC or its principal regulatory agency.