Fed Proposes Incentive Compensation Policies for Banking Organizations

This post is based on a Sullivan & Cromwell LLP client memorandum. The approach followed by the Federal Reserve was advocated in Regulating Bankers’ Pay, a discussion paper by Lucian Bebchuk and Holger Spamann issued by the Program on Corporate Governance last spring, which was described in a post on the Forum here.

On October 22, 2009, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a comprehensive proposal (the “Proposal”) on incentive compensation policies that is intended to ensure that these policies do not undermine the safety and soundness of banking organizations by encouraging excessive risk-taking. The Proposal applies to all banking organizations supervised by the Federal Reserve (U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations (including securities subsidiaries) of foreign banks with a branch, agency, or “commercial lending company” subsidiary in the United States (each a “banking organization”)). It covers executive and non-executive employees who receive any current or potential compensation that is tied to achievement of one or more performance metrics, as well as “golden parachute” and “golden handshake” arrangements.

The Proposal is based on three key principles that are designed to govern incentive compensation arrangements. There are no prescriptive requirements, such as “caps” or “claw backs”, but there is extensive guidance as to the development, implementation and relevant considerations for these arrangements.

The Proposal imposes immediate obligations on banking organizations to review their incentive compensation arrangements. In addition, the Proposal includes two supervisory initiatives. The first applies to 28 large, complex banking organizations (“LCBOs”), and the second applies to all other banking organizations. In each case, the Federal Reserve will review the banking organization’s policies and practices to determine their consistency with the principles established by the Federal Reserve for risk-appropriate incentive compensation. Deficiencies will be factored into the organization’s supervisory ratings. Compliance with the Proposal is likely to require a significant dedication of resources to develop and implement the requisite internal reviews, policies, reports, systems and controls.

The Federal Reserve requests comments on the Proposal within 30 days after publication in the Federal Register.

I. Background

The Proposal represents, as described by Federal Reserve Governor Daniel Tarullo, “one part of a broad program by the Federal Reserve to strengthen the supervision of banks and bank holding companies in the wake of the financial crisis”. It reflects the Federal Reserve’s view that “[f]laws in incentive compensation practices were one of many factors contributing to the financial crisis”. In the words of Federal Reserve Chairman Bernanke, “[c]ompensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability”.

The Proposal explains that supervisory action is also necessary to address the “first mover” problem. The Federal Reserve is concerned that individual firms will be reluctant to act alone to deal with misaligned incentive programs due to concern about losing valuable employees.

The Proposal is designed to be consistent with the Financial Stability Board’s (“FSB”) Principles for Sound Compensation Practices issued in April 2009 and the FSB’s Implementation Standards issued in September 2009. The Proposal notes the Federal Reserve’s intention to work with other nations to achieve a “level playing field”.

II. Proposal

A. Incentive Compensation Principles

The Proposal sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation policies do not encourage excessive risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should:

  • Provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks.
  • Be compatible with effective internal controls and risk management.
  • Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The Proposal indicates that the Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements based on these three principles. Where there are deficiencies in the incentive compensation arrangements, they must be immediately addressed.

The Proposal explicitly rejects a “one size fits all” approach, and specific limits or requirements, such as pay caps, “claw backs” or allocation between cash and equity, are not included. The Proposal distinguishes supervisory guidance from a formal rule, but the practical effect in individual cases is likely to be similar.

B. Covered Employees

The Proposal covers all employees “who have the ability to materially affect the risk profile of an organization, either individually, or as part of a group”. It explicitly notes that “problematic compensation practices were not limited to the most senior executives”. Covered employees are divided into three segments:

  • Senior executives and other employees who are responsible for the oversight of a banking organization’s firm-wide activities or material business lines.
  • Individual employees, including non-executive employees, whose activities may expose the banking organization to significant amounts of risk. (An example cited in the Proposal is traders with large positions relative to the banking organization’s overall risk tolerance.)
  • Groups of employees who are subject to similar incentive compensation arrangements and who, in the aggregate, may expose the banking organization to significant amounts of risk, even if no individual employee is likely to expose the banking organization to a significant amount of risk. (An example cited in the Proposal is loan officers who, as a group, originate loans that account for a material amount of the organization’s credit risk.)

C. Balanced Risk-Taking Incentive Compensation Arrangements

The Proposal provides that incentive compensation arrangements should “balance risk and financial results in a manner that does not provide employees incentives to take excessive risks”. A balanced incentive compensation arrangement is described as an arrangement that takes into account the risks and financial benefits from the employee’s activities and the impact of those activities on the banking organization’s safety and soundness. As an example, the Proposal states that two employees who generated the same amount of short-term revenue should not receive the same amount of incentive compensation if the risks taken to generate that revenue differ materially.

To determine whether incentives encourage risk-taking beyond a banking organization’s ability to identify and manage the risk and to implement balanced risk-taking incentives, the Proposal provides a number of guidelines:

  • Banking organizations should consider the full range of risks (including, credit, market, liquidity, operational, compliance and reputational) associated with an employee’s activities, as well as the time period over which the risks may be realized.
  • The relevant time horizon for a risk outcome may extend beyond the stated maturity of an exposure, and special concern should be directed to “bad-tail” risks, i.e., those that have a low probability of being realized but have highly adverse effects if they are.
  • There is an important distinction between “reliable” quantitative measures that are available for some risks and “informed judgment” that is used for other risks. In the latter case, there is a “need for strong internal controls and ex post facto monitoring”.
  • Banking organizations, particularly LCBOs, should consider using “scenario analysis”.
  • Unbalanced incentive arrangements may be moved toward balance by a variety of methods: risk-adjusting the payments, deferring payment so as to adjust actual payments based on actual outcomes, lengthening performance periods, and reducing sensitivity to short-term performance, including reducing the rate at which awards increase as higher levels of performance are achieved. The Proposal cautions against over-reliance on judgment in determining deferrals, as compared to determining deferrals formulaically, because “extensive use of judgment might make it more difficult to execute deferral arrangements in a sufficiently predictable fashion to influence employee behavior”.
  • Incentive arrangements should take into account differences among employees, particularly the difference between senior executives and other employees. In this regard, the Proposal notes that equity compensation may not be expected to be as effective in restraining risk incentives for lower level employees as for senior executives; that for senior executives at LCBOs incentive compensation arrangements are likely to be better balanced if they involve deferral of a “substantial portion” of incentive compensation over a multi-year period and payment of a “significant portion” in equity-based instruments vesting over multiple years; and that a single formulaic approach is likely to encourage at least some employees to take excessive risk.
  • Careful consideration should be given to how “golden parachutes” and the vesting of deferred compensation may affect risk-taking behavior. For senior executives, the Proposal notes that forfeiture provisions may be counterproductive, especially in a competitive marketplace where sign-on bonuses are prevalent.
  • Banking organizations should effectively communicate to employees the ways that incentives will be reduced as risks increase.

D. Compatibility with Effective Control and Risk Management

The Proposal states that a banking organization’s internal risk-management processes and controls should reinforce and support the development and continuation of balanced incentive compensation arrangements. The Proposal suggests:

  • Appropriate controls should be in place, such as regular internal audits (or other review), to ensure that the processes for achieving balanced incentives are followed and to protect against evasion by maintaining the integrity of the risk management function. A banking organization should create and maintain sufficient documentation to permit an audit of the banking organization’s processes for establishing, modifying and monitoring incentive compensation arrangements.
  • Risk management employees and other appropriate personnel should have input into the organization’s processes for designing incentive compensation arrangements and assessing effectiveness in limiting excessive risk-taking.
  • Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified employees and should avoid conflicts of interest (including by not having their incentives based predominantly on the financial performance of the units that they review).
  • Incentive arrangements should be monitored and modified to the extent necessary to provide balanced incentives. The Proposal explains that the design and implementation of effective incentive compensation arrangements “is a complex task” and requires the “commitment of adequate resources”.

E. Effective Corporate Governance

The Proposal states that banking organizations should have strong and effective corporate governance to help ensure sound compensation practices. This requirement primarily relates to a banking organization’s board of directors and board committees but also includes guidance related to processes for designing incentive compensation and disclosure to shareholders of pay practices. The Proposal states that directors should:

  • Actively oversee incentive compensation arrangements. The Proposal provides that the board is “ultimately responsible” for ensuring that a banking organization’s incentive compensation arrangements do not jeopardize its safety and soundness. Among the board’s responsibilities are “review and approv[al] of the overall goals and purposes” of the incentive compensation arrangements, “clear direction” to management, “ensur[ing] that the compensation system” will “achieve balance”, direct approval of incentive compensation arrangements for senior executives, and approval and documentation of material exceptions.
  • Monitor the performance, and regularly review the design and function, of incentive compensation, including on both a backward and forward-looking scenario basis. In this connection, the board should receive, at least annually, assessments by management.
  • Have the organization, composition and resources in order to achieve effective oversight of incentive compensation. At least one member of the compensation committee should have a level of experience and expertise in risk management and compensation practices in financial services that is appropriate for the organization’s activities. The board should also have the authority to select and compensate outside counsel and executive compensation and risk management consultants as needed, and, in that connection, the board should be sensitive to independence issues.

LCBOs should use a systematic approach to developing a compensation system supported by formal internal policies and procedures.

Disclosure to shareholders of incentive compensation arrangements should appropriately describe such arrangements and related risk management, control and governance processes to allow them to “monitor and, where appropriate, take actions to restrain the potential for such arrangements and processes to encourage employees to take excessive risks”. The last statement may be an implicit endorsement of “say-on-pay”. The Proposal notes that the Federal Reserve will work with the Securities Commission to improve disclosure regarding incentive compensation arrangements.

F. Implementation Initiatives and Consequences

Although the Proposal is subject to comment for 30 days, banking organizations are instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-taking and implement corrective programs as needed. This review should be based on the Proposal’s three key principles. It is intended to help prepare banking organizations for the Federal Reserve’s two supervisory initiatives, which are intended to spur and monitor the financial industry’s progress toward implementing the Proposal.

The first initiative is a special, coordinated “horizontal” review of the incentive compensation policies and practices of the 28 LCBOs, which will “commence promptly”. In the Federal Reserve’s view, these organizations are significant users of incentive compensation arrangements and flawed arrangements at these organizations are more likely to have a more serious effect on the broader financial system. The horizontal review, which appears to be similar in form to the recently conducted “stress test” at 19 large bank holding companies, will be led by Federal Reserve staff, who will work with relevant Reserve Bank supervisors. As part of this initiative, LCBOs will be expected to provide the Federal Reserve with information and documentation that describes (i) the structure of the banking organization’s current incentive compensation arrangements, (ii) the current processes used by the organization to oversee the arrangements and help ensure that they do not encourage excessive risk and (iii) the organization’s plans, including timetables, for improving risk sensitivity and related risk management, controls and corporate governance practices. The policies and implementing practices of each LCBO will become part of supervisory expectations for it and will be monitored to ensure “full implement[ation] in a timely manner”. The objectives of the horizontal review are to:

  • Enhance supervisory understanding of the details of current practices, as well as the steps taken or proposed to be taken by organizations to improve the balance of incentive compensation arrangements.
  • Assess the strength of controls and whether actual payouts under incentive compensation arrangements are effectively monitored relative to actual risk outcomes.
  • Understand the role played by boards of directors, compensation committees, and riskmanagement functions in designing, approving, and monitoring incentive compensation systems.
  • Identify emerging best practices through comparison of practices across organizations and business lines.

Second, the Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations that are not LCBOs. These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements.

The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, “which can affect the organization’s ability to make acquisitions”. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Both supervisory initiatives will aid the Federal Reserve in identifying best practices for incentive compensation for banking organizations.

G. Foreign Banks

In the case of the U.S. operations of foreign banks, the U.S. incentive compensation policies are to be (i) coordinated with the bank’s group-wide policies, (ii) developed in accordance with the rules of the bank’s home country supervisor, and (iii) consistent with the bank’s overall corporate and risk management structure and controls.

H. Comment

The Proposal invites comment on all its aspects, including the guiding three principles, legal and regulatory issues, burden, exceptions (such as for firm-wide profit sharing plans) and formulaic limits (referring to suggestions that at least 60% of all incentive compensation be deferred and at least 50% be equity-linked). The Proposal also inquires as to what statutory, regulatory or private sector actions might mitigate market forces.

III. Conclusion and Observations

The general approach of the Proposal does not depart materially from previous broad statements of policy by the Administration and Federal Reserve. It does, however, provide considerable detail regarding the types of internal processes that are expected to be implemented by banking organizations to monitor risk associated with incentive compensation arrangements throughout the organization. Substantial resources will be needed for banking organizations to align their incentive compensation policies with the Proposal and demonstrate such alignment to Federal Reserve examiners. The Proposal and the Federal Reserve’s oversight are likely to result in greater uniformity of incentive compensation arrangements across organizations with similar risk profiles.

One fundamental question raised by the Proposal is whether banking organizations are being encouraged to weight compensation more heavily to fixed salaries. Although the Proposal acknowledges that incentive compensation has numerous benefits, the attendant risks identified by the Federal Reserve may prove determinative. Such a change, however, would be inconsistent with other compensation initiatives that promote greater focus on performance.

Finally, the Proposal stresses that the development of incentive compensation arrangements will be an evolving process extending over many years. The Federal Reserve will prepare a report after 2010 on trends and developments.

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