Incentive-based compensation at financial institutions have come under increasing scrutiny and regulation, and the scrutiny will only increase due to recent issues involving cross-selling. Avoiding or reducing the risks associated with incentive-based compensation is preferable to investigations, fines, and legal actions. A well-structured compliance program can help mitigate the risks related to cross-selling incentives, and reduce the penalties imposed in the event of a legal violation.
Incentive-Based Compensation Creates Risk.
Six federal agencies (the Office of the Comptroller of the Currency, the Federal Reserve System, The Federal Deposit Insurance Corporation, the National Credit Union Administration, the Federal Housing Finance Agency, and the Securities & Exchange Commission) are in the process of issuing a rule that would “prohibit incentive-based compensation arrangements that encourage inappropriate risks” at financial institutions with assets over $1 billion https://www.federalreserve.gov/newsevents/press/bcreg/20160516a.htm.
Incentive-based compensation has a role in financial institutions. As the proposed rule explains: “incentive-based compensation arrangements are critical tools in the management of financial institutions.” https://www.gpo.gov/fdsys/pkg/FR-2016-06-10/pdf/2016-11788.pdf. Bonuses, for example, “serve several important objectives, including attracting and retaining skilled staff and promoting better performance of the institution and individual employees.” Id.
But, there are risks, as the proposed rule explains: “poorly structured incentive-based compensation arrangements can provide executives and employees with incentives to take inappropriate risks that are not consistent with the long-term health of the institution . . . .” Id. The proposed rule cites Washington Mutual as an example of a “flawed incentive-based compensation” system because loan officers were compensated largely on volume, irrespectively of the quality of the loans originated.
Cross-selling - the practice of selling existing customers on multiple products – can expand a relationship with a customer, provide valuable services, and increase firm revenues. http://www.wsj.com/articles/how-cross-selling-can-help-hurt-consumers-1474037775. As recent news reports and enforcement actions indicate, cross-selling incentives, like any incentive-based compensation, carries risks. http://www.consumerfinance.gov/policy-compliance/guidance/supervision-examinations/institutions/; https://www.occ.gov/topics/consumer-protection/index-consumer-protection.html.
Are there ways to mitigate cross-selling risk?
Fall is a good time to review existing efforts and consider how a compliance program can reduce those risk. Every fall Americans are urged to inoculate themselves against the flu. Inoculation reduces the chances of either catching the flu or experiencing severe symptoms. A compliance program is like a flu shot; it can diminish the risk of infection and reduce the severity of the consequences if an outbreak occurs.
The risks associated with incentive-based compensation for cross-selling can addressed by creating a program, or by revising existing programs, to address the potential risks created by the incentives in the compensation system. Tailoring a program to address cross-selling is the first step. The government typically looks for compliance programs that feature:
- Clear and understandable standards of conduct;
- Require that management be knowledgeable about operations and ensure compliance;
- Give specific individuals responsibility for day-to-day implementation and monitoring;
- Take practical steps to communicate the standards to frontline employees;
- Engage in active monitoring and auditing to detect improper behavior;
- Allow for reporting of violations, anonymously or confidentiality; and
- Respond to violations by taking reasonable action.
The next, and key, step after establishing a compliance program is “implement[ing], and enforc[ing]” the program. Id. The implementation of a compliance program usually includes employee training, oversight by managers, and internal and external audits. See In re Caremark Int’l Inc. Derivative Litigation, 698 A.2d 959, 962-63 (Del. Ct. Ch. 1996).
Applying some of these features to address cross-selling, might, for example, suggest that a department or group, other than the originating team, confirm orders with customers. Another possible feature of a cross-selling compliance program might be periodic audits on new accounts to confirm active usage.
Like a flu shot, even the most robust compliance program cannot reduce risk to zero, and regulators recognize that: “[t]he failure to prevent or detect the instant offense does not necessarily mean that the program is not generally effective in preventing and detecting criminal conduct.” http://www.ussc.gov/guidelines-manual/2015/2015-chapter-8#8b21. But, like a flu shot, a compliance program can reduce the severity of consequences in the event an issue arises. Id. This fall, financial institutions should consider whether some additional inoculation would reduce risks that regulators are becoming increasingly focused on before an outbreak occurs.