The New York State Department of Financial Services (DFS) recently issued guidance to regulated banking institutions (Institutions) prohibiting them from implementing incentive-based compensation programs unless these programs are accompanied by appropriate mechanisms designed to prevent employees from engaging in over-reaching actions that ultimately harm consumers.

The DFS guidance letter is clear that Institutions are not, by default, barred from implementing incentive programs tied to sales targets or cross-selling. However, Institutions are barred from implementing incentive programs if they do not also implement effective risk management, oversight and control. In other words, without ensuring that employee incentives to cross-sell or meet sales targets are mediated through appropriate controls, Institutions will likely open themselves up to fines, other penalties and lawsuits.

For the regulated community, as is typical when it provides guidance, DFS did not provide any clear directives on how Institutions should manage their incentive compensation programs. Instead, it provided broad principles that Institutions should use as guidance when structuring and monitoring their programs.

DFS directed Institutions, at a minimum, to: (i) appropriately balance risk and financial results in a way so that employees are not encouraged to expose their Institutions to unwise risks; (ii) institute controls that reinforce and support the development and maintenance of incentive compensation arrangements; and (iii) require that these programs are supported by strong corporate governance, including ensuring that the Institution’s board of directors has an active oversight role with regard to incentive compensation programs.

In its letter, DFS stated that it will conduct supervisory review of incentive compensation arrangements during its regular risk-focused examination process, including the ways in which an Institution monitors and implements incentive programs. Additionally, DFS expects Institutions to maintain records that document the structure and approval process of their incentive compensation arrangements.

What is clear is that Institutions should pay particular attention to any cross-selling or referral bonus programs they have in place. Given that DFS has highlighted the inherent risks present in these programs, Institutions should make sure that their programs are being effectively monitored and that any issues that may have already arisen are being addressed. Indicating the seriousness with which DFS is treating incentive compensation arrangements, the DFS letter reminds Institutions that similar tactics and practices led to the 2007 financial crisis.