Incentive Compensation: The Federal Reserve Speaks

By Casey M. Nault
November 17, 2009

Overview

On October 22, 2009, the Federal Reserve Board issued proposed guidance designed to ensure that incentive compensation practices and policies at Fed-regulated institutions, including U.S. bank holding companies, state member banks and certain other categories of institutions, do not undermine the safety and soundness of those institutions. The Fed explained its action in part by noting that corporate governance structures related to compensation practices may not be sufficient to protect the safety and soundness of institutions, since the federal “safety net” may lead shareholders to tolerate a degree of risk that is inconsistent with safety and soundness. Like the Treasury rules applicable to institutions participating in the Troubled Asset Relief Program (TARP) and recent proposed rules from the Securities and Exchange Commission (SEC), the proposed Fed guidance focuses on identifying and eliminating compensation practices that may encourage employees to take excessive risks. The Fed guidance does not impose pay caps or limit the forms of compensation, but rather imposes a framework of key principles within which Boards and management must design incentive compensation programs. In addition to the guidance, the Fed also announced two new supervisory initiatives to drive progress toward compensation practices that are better aligned with safety and soundness and to identify and spread best practices.

The proposed guidance is subject to a 30-day comment period, with final guidance potentially several months away. However, the Fed expects institutions covered by the guidance to immediately begin reviewing their incentive compensation policies and practices in light of the proposed guidance. In this regard, although the TARP rules and the Fed guidance are not entirely duplicative, there are substantial areas of overlap and institutions that have participated in TARP and are undertaking required risk assessments under the TARP rules should be able to leverage some of that work for purposes of beginning to implement the Fed guidance. In addition, although many banking institutions are not technically subject to the Fed guidance (e.g., state-chartered non-member banks whose federal regulator is the FDIC), we believe all banking organizations should become familiar with and prepare to implement the key tenets of the guidance in anticipation that their regulators will soon require similar measures. Further to this point, the Corporate and Financial Institution Compensation Fairness Act of 2009, recently passed by the House of Representatives, would require all federal banking regulators to regulate compensation with a focus on avoiding excessive risk.

Proposed Guidance

Key Principles

The guidance introduces three key principles designed to ensure that incentive compensation does not encourage employees to take excessive risks.

Incentives in compensation arrangements should be appropriately balanced with related risks. The guidance requires institutions to consider the full range of risks inherent in incentive compensation arrangements, including remote but potentially catastrophic risks, to ensure that the potential financial rewards from an employee’s activities are appropriately balanced against the related risks. Examples of appropriate balance include (a) adjusting payouts for related risk, (b) aligning the risk horizon with the payout through deferred payments, clawbacks and/or longer performance periods, and (c) reducing the sensitivity of payouts to increases in short-term financial results. As a means of testing whether arrangements are appropriately balanced, the Fed encourages institutions, particularly large, complex institutions where incentive compensation is a major portion of total compensation, to employ both a backward-looking analysis of payments relative to risk outcomes, and a forward-looking “scenario analysis” to assess potential payments and risk outcomes under various scenarios. The Fed also suggests that safety and soundness concerns are lessened where, as is often the case at regional and community banks, incentive compensation comprises a relatively small portion of total compensation, since employees are less likely to take excessive risk when the corresponding payout is less significant.
Incentive compensation arrangements should be compatible with effective controls and risk management. The guidance requires institutions to develop and maintain appropriate controls around the design, implementation and monitoring of incentive compensation programs. Those controls should be subject to internal audit and designed by appropriate personnel (e.g., risk management, human resources, finance) whose incentive compensation should be tied primarily to the objectives of their work and not the financial performance of the institution or the business unit they review.
Programs should operate within a framework of strong corporate governance, including active Board oversight. The guidance encourages each institution’s Board to exercise active oversight through a compensation committee of independent directors, which should work closely with the risk and audit committees (or the full Board if those functions are not delegated to a committee). The Fed expects at least an annual review of management’s assessment of the effectiveness of the programs and related controls in providing balanced risk-taking incentives.

Covered Employees; Broad Scope

The preamble to the guidance states that problematic incentive compensation practices at all levels of financial institutions contributed to the financial crisis. Accordingly, the guidance applies not just to senior executives or other most highly-compensated employees, but also to employees who, either individually or as a group, may expose the institution to material risk. However, the guidance also acknowledges that the scope and complexity of each institution’s business as well as the scope and prevalence of incentive compensation arrangements will be important factors in evaluating whether incentive compensation arrangements raise safety and soundness concerns. For example, it should be much simpler for community banks whose incentive compensation programs are neither rich nor weighted toward risky activities to implement and satisfy the Fed guidance than for large, diversified, global investment banks with thousands of employees deriving the majority of their compensation from incentive compensation tied to risky activities.

Supervisory Initiatives

The Fed is commencing two supervisory initiatives to promote better incentive compensation practices.

Large Complex Institutions. The first initiative involves a “horizontal” review of the incentive compensation arrangements at 28 large, complex banking organizations, designed to (a) better understand the arrangements, (b) assess the effectiveness of controls and whether payouts are balanced with related risks, (c) better understand the corporate governance framework around incentive compensation and (d) identify emerging best practices. Each institution will be required to submit a report detailing its practices and outlining its plans to enhance the effectiveness of controls and ensure their programs are consistent with safety and soundness and do not encourage excessive risk-taking.
Other Institutions. Incentive compensation programs and controls at other institutions will be reviewed as part of the regular, risk-focused supervisory process. These reviews will be tailored appropriately to reflect the scope and complexity of the institution’s business and compensation programs. Findings will be incorporated into supervisory ratings and, where deficiencies exist, may result in supervisory action against the institution.

What Should Banks Do Now?

Clearly, as a starting point, both management and the compensation committee (or full board, if appropriate) of any bank holding company or Fed member bank should immediately review and become familiar with the guidance.

Consider consulting with counsel and/or compensation advisors for suggestions on incentive compensation plan design and approach.

Watch for guidance similar to the Fed guidance from the FDIC and/or the OCC for state non-member banks and national banks.

If you are an SEC-reporting company, coordinate your efforts with your other corporate governance practices and be mindful of how compliance with the guidance may trigger additional proxy disclosure.

If you are a participant in the TARP Capital Purchase Program, reconcile your actions under the TARP rules with those under the Fed guidance. In particular, consider how your work in connection with required risk assessments under the TARP rules can be leveraged for compliance with the Fed guidance.

Conclusion

These developments reflect the current political climate and represent a continuation of recent trends toward broader and more restrictive regulation of compensation practices at financial institutions. Institutions not subject to Fed regulation should carefully review the guidance as their regulators are likely to adopt similar requirements in the near term. We expect to publish further updates on these issues as developments warrant. In the meantime, please contact your usual Graham & Dunn attorney or Casey M. Nault (206.903.4808 or cnault@grahamdunn.com), Stephen M. Klein (206.340.9648 or sklein@grahamdunn.com), or Kumi Yamamoto Baruffi (206.340.9676 or kbaruffi@grahamdunn.com) should you have any questions or wish to discuss these issues further.