On June 21, 2010, the Federal Reserve, Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS) and Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) issued new Guidance on Sound Incentive Compensation Policies. The Guidance is designed to ensure that incentive compensation arrangements at banking organizations properly account for risk and are consistent with safe and sound practices. Originally proposed by the Federal Reserve in October 2009, the Guidance has now been issued jointly by the Agencies in final form.
The three key principles underlying the Guidance are that incentive compensation arrangements should:
- Provide employees incentives that appropriately balance risk and reward;
- Be compatible with effective controls and risk management; and
- Be supported by strong corporate governance, including active and effective oversight by the board of directors.
The Guidance applies to all banking organizations supervised by the Agencies, including national banks, state member and nonmember banks, savings associations, U.S. bank holding companies, savings and loan holding companies, the U.S. operations of foreign banks and Edge and agreement corporations (collectively, banking organizations).
The remainder of this Update discusses the scope and application of the Guidance to the banking organizations.
Scope of Incentive Plan Participants Covered
The Guidance applies to incentive compensation arrangements for certain Covered Employees. Covered Employees are:
- Senior executives and others who are responsible for oversight of firm-wide activities or material business lines;
- Individual employees, including non-executive employees, whose activities expose the organization to material amounts of risk (e.g. traders with large position limits relative to overall risk tolerance); and
- Groups of employees who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, may expose the organization to material amounts of risk, even if no individual employee is likely to expose the organization to material risk (e.g., loan officers who, as a group, originate loans that account for a material amount of the organization's credit risk).
The Guidance permits exclusion of certain categories of employees, on a facts and circumstances basis, whose compensation arrangements are believed unlikely to pose material risks (such as tellers, bookkeepers, couriers or data processing personnel). While this provides some relief to banking organizations, this relief is fairly minor.
Internal Review of Incentive Compensation Practices
The Agencies expect banking organizations to regularly review their incentive compensation arrangements for Covered Employees. Banking organizations are also expected to regularly review the risk management, control and corporate governance processes related to these arrangements. The analysis and methods for ensuring that incentive compensation arrangements take appropriate account of risk should be tailored to the size, complexity, business strategy and risk tolerance of the organization.
For purposes of the Guidance, Large Banking Organizations (LBOs) are all "large, complex banking organizations" as identified by the Federal Reserve, the "largest and most complex national banks" as defined by the OCC, "large, complex insured depository institutions" as defined by the FDIC and the "largest and most complex savings associations and savings and loan holding companies" as identified by OTS.
Because of the size and complexity of their operations, LBOs should have and adhere to systematic and formalized policies, procedures and processes. Conversely, the policies, procedures and systems of smaller banking organizations that use incentive compensation arrangements are not expected to be as extensive, formalized, or detailed as those of LBOs.
In that regard, LBOs should expect close regulatory reviews of incentive compensation while little, if any, additional examination work is expected for smaller banking organizations that do not use incentive compensation arrangements. Regardless, prudence suggests that all banking organizations should be prepared to address these issues with regulators as part of the supervisory and examination process.
For all banking organizations, supervisory findings related to incentive compensation will be included in the relevant report of examination or inspection. These findings will also be incorporated into the organization's component and composite ratings, as applicable. An organization's appropriate federal supervisor may take enforcement action against a banking organization if its incentive compensation arrangements or related risk management, control or governance processes pose a risk to the safety and soundness of the organization.
As a practical matter, all banking organizations should be very careful to document compliance steps taken in accordance with the Guidance and should create mechanisms for automatic periodic reviews and adjustments to incentive compensation arrangements.
Please note that in addition to the new Guidance, the requirements of the Interagency Guidelines Establishing Standards for Safety and Soundness (Appendix A to 12 C.F.R. Part 364) still apply, prohibiting the payment of compensation, fees and benefits that are excessive or could lead to material financial loss to the organization.
Principle 1: Balanced Risk-Taking Incentives
- Incentive compensation arrangements should balance risk and financial results in a manner that does not encourage Covered Employees to expose their organizations to imprudent risks. An incentive compensation arrangement is considered balanced for purposes of the Guidance when amounts paid to a Covered Employee appropriately take into account the risks and financial benefits of the Covered Employee's activities and the impact of those activities on the organization's safety and soundness. For example, assuming two Covered Employees generate the same revenue for an organization, a balanced incentive compensation arrangement will provide less compensation to the employee whose activities create materially larger risk for the organization. Plans that provide for awards based solely on overall organization-wide performance are unlikely to provide Covered Employees, other than senior executives and individuals who have the ability to materially affect the organization's overall risk profile, with unbalanced risk-taking incentives.
- In assessing whether incentive compensation arrangements are balanced, banking organizations should consider the full range of risks associated with an employee's activities and the time horizon over which these risks may be realized. The activities of Covered Employees may create a wide range of short- and long-term risks for a banking organization, such as credit, market, liquidity, operational, legal, compliance and reputational risks. Banking organizations should consider the full range of current and potential risks associated with Covered Employees' activities (including the cost and amount of capital and liquidity needed to support those risks) in developing balanced incentive compensation arrangements. Reliable quantitative measures of risk and risk outcomes may be particularly useful; however, the absence of reliable quantitative measures does not mean that banking organizations should ignore such risks or outcomes. In the absence of reliable quantitative risk measures, banking organizations should rely on informed judgments, supported by available data, to estimate risk and risk outcomes. LBOs should assess, in advance of implementation, whether such arrangements are likely to provide balanced risk-taking incentives. For example, LBOs may use simulation analysis to assess such arrangements in advance of implementation.
- An unbalanced arrangement can be moved toward balance by adding or modifying features that cause the amounts ultimately received by Covered Employees to appropriately reflect risk and risk outcomes. The following four methods are frequently used to make compensation more sensitive to risk: (1) risk adjustment of awards (the amount of an award is adjusted based on measures that take into account the risk the Covered Employee's activities may pose to the organization); (2) deferral of payment (the actual payout of an award is delayed significantly beyond the end of the performance period and the amounts paid are adjusted for actual performance); (3) longer performance periods; and (4) reduced sensitivity to short-term performance. These methods for achieving balance are not intended to be exclusive. LBOs should actively monitor developments in the field and incorporate new or emerging methods or practices.
- The manner in which a banking organization seeks to achieve balanced incentive compensation arrangements should be tailored to account for the differences between Covered Employees within a banking organization and different banking organizations. Activities and risks may vary significantly both across a banking organization (e.g., based on the scope or complexity of activities and the business strategies pursued by the organization) and across Covered Employees within a particular banking organization (e.g., between different groups of non-executive Covered Employees or between executives and non-executive Covered Employees). Incentive compensation arrangements for senior executives at LBOs should be structured to involve (i) deferral of a substantial portion of the executive's incentive compensation over a multi-year period in a way that reduces the amounts received in the event of poor performance, (ii) substantial use of multi-year performance periods, or both.
- Banking organizations should carefully consider the potential for "golden parachutes" and the vesting arrangements for deferred compensation to affect the risk-taking behavior of Covered Employees. The Agencies believe that incentive compensation arrangements with these features may expose the banking organization to undue risk because "golden parachutes" typically consist of payments upon departure or upon a change of control irrespective of future risk outcomes. Banking organizations should carefully review any such existing or proposed arrangements and their potential impact on the organization's safety and soundness taking into account, where possible, potential issues raised by new hire payments by other organizations to the departing executive (golden handshakes). Balancing features may be included to mitigate the potential for the arrangements to encourage imprudent risk-taking. LBOs should monitor whether golden handshake arrangements are materially weakening the organization's efforts to constrain the risk-taking incentives of Covered Employees.
- Banking organizations should effectively communicate to Covered Employees the ways in which incentive compensation awards and payments will be reduced as risks increase. Employee communications should, where possible, explicitly link the relationship between projected or actual risk outcomes and be sufficiently tailored to the sophistication of the incentive plan participants in order to ensure their effectiveness.
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. Covered Employees may try to evade the processes established by a banking organization. Traditional risk management controls alone do not eliminate the need to identify Covered Employees who may expose the organization to material risk, nor do they obviate the need for the incentive compensation arrangements for these Covered Employees to be balanced.
- Banking organizations should have appropriate controls to ensure that their processes for achieving balanced compensation arrangements are followed and to maintain the integrity of their risk management and other functions. All banking organizations should create and maintain documentation sufficient to permit an audit of the effectiveness of their processes for establishing, modifying, and monitoring incentive compensation arrangements. LBOs should have and maintain policies and procedures (i) identifying and describing the roles of the personnel, business units, and control units authorized to be involved in the design, implementation, and monitoring of incentive compensation arrangements; (ii) identifying the source of significant risk-related inputs into these processes and establishing appropriate controls governing the development and approval of these inputs to help ensure their integrity; and (iii) identifying the individuals and control units whose approval is necessary for the establishment of new incentive compensation arrangements or modification of existing arrangements. LBOs should also conduct regular internal reviews to ensure compliance with policies and procedures.
- 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 imprudent risk-taking. For instance, risk managers might review the types of risks associated with the activities of Covered Employees, approve the risk measures used in risk adjustments and performance measures, and analyze risk-taking and risk outcomes relative to incentive compensation payments.
- Compensation for Covered Employees in risk management and control functions should be sufficient to attract and retain qualified personnel and should avoid conflicts of interest. In addition, incentive compensation received by risk management and control personnel should not be based substantially on the financial performance of the business units they review.
- 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. This highlights the need for the implementation of the Guidance to be done on a continual basis.
Principle 3: Strong Corporate Governance
- Banking organizations should have strong and effective corporate governance to help ensure sound compensation practices, including active and effective oversight by the board of directors. The board of directors should directly approve and monitor the incentive compensation arrangements for senior executives, including any material exceptions or adjustments to incentive compensation arrangements. The board of directors is ultimately responsible for ensuring that the organization's incentive compensation arrangements are appropriately balanced. The board of directors of an LBO and any banking organizations that uses incentive compensation to a significant extent should actively oversee all incentive compensation policies, systems and related control processes.
- The board of directors of any banking organization should monitor the performance, and regularly review the design and function, of incentive compensation arrangements. The board of directors of an LBO or any other banking organization that uses incentive compensation to a significant extent should receive and review, at least annually, an assessment by management, composed with appropriate input from risk management personnel, of the effectiveness of the organization's incentive compensation system. The board of such an organization should also receive periodic reports reviewing incentive compensation programs relative to risk outcomes on a backward-looking basis.
- The organization, composition, and resources of the board of directors should permit effective oversight of incentive compensation. The board of directors of an LBO or any other banking organization that uses incentive compensation to a significant extent should consider establishing a separate compensation committee, to the extent one does not already exist, for this purpose.
- A banking organization's disclosure practices should support safe and sound incentive compensation arrangements. Shareholders should be provided with sufficient information to allow them to monitor and take action, if appropriate, to restrain the potential for incentive compensation arrangements and processes to encourage imprudent risks. It is unclear from the Guidance what disclosure is meant to be included by publicly-traded institutions in addition to that already required by the Securities and Exchange Commission.
- LBOs should follow a systematic approach to developing a compensation system that has balanced incentive compensation arrangements. This approach should be supported by robust and formalized policies, procedures and systems to ensure that arrangements are appropriately balanced and consistent with safety and soundness.