US Regulators’ Bonus Compensation Proposal

Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, Mike Alix, Adam Gilbert, and Armen Meyer. Related research from the Program on Corporate Governance includes Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann; The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann; How to Fix Bankers’ Pay by Lucian Bebchuk; and Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried.

[On April 21, 2016], the National Credit Union Administration (NCUA) became the first of six federal regulatory agencies to repropose the long-awaited bonus compensation rule that will apply to banks, asset managers, broker-dealers, and other financial institutions. [1] The issuance follows an earlier joint proposal released in April 2011 to establish limitations on the timing—but not the size—of bonus payouts. [2] Compared to the 2011 proposal, the reproposal establishes generally stricter bonus requirements (e.g., longer deferral periods and clawbacks) [3] and applies these requirements to a larger subset of the institutions’ employees. The reproposal also differentiates many of the requirements for institutions with total consolidated assets of over $250 billion, and with between $50 and $250 billion (i.e., “Level 1” and “Level 2” institutions, respectively). [4]

The bottom line is that the reproposal ended up being a less important event than was anticipated—at least for the biggest banks—and is hardly front page news. The reality is that industry practice and prior interagency guidance already call for bonus deferrals for three or four year periods. However, implementation of the reproposal will be challenging: banks must ensure processes are in place to fully comply while meeting record keeping requirements. Furthermore, regulators could choose to use bonus compensation as an enforcement (or public shaming) tool down the road. As the recent negative feedback to the largest banks’ resolution plans demonstrated, [5] the regulators have broad enforcement discretion.

1. More employees are subject to bonus regulation. The reproposal’s deferrals and clawbacks apply to “senior executive officers” and “significant risk takers”—a significant expansion of scope compared to the 2011 proposal.

  • Senior executive officers include the President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, or head of a major business line. In an expansion from the 2011 proposal, this category now also includes executives who are not traditionally seen as major risk takers, such as the chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, and heads of control functions.
  • Significant risk takers include those whose annual bonus is at least equal to 50% of base salary, and either (a) are among the top 5% (for Level 1 institutions) or 2% (for Level 2 institutions) highest compensated employees or (b) have the authority to commit or expose over 0.5% of the institution’s capital as determined based on institution type (e.g., CET1 for most bank holding companies). The 5% threshold for Level 1 institutions is particularly stark in its difference from the Level 2 requirement, and will cause significantly more employees to be impacted. This expansion of scope from the 2011 proposal to include “significant risk takers” makes the US’s approach more consistent with approaches in the EU and UK (as further described below).

2. The reproposal’s main features are bonus deferral periods and clawback requirements. For Level 1 institutions, the reproposal requires that at least 60% and 50% of bonuses payable to senior executive officers and significant risk takers, respectively, be deferred for at least four years. For Level 2 institutions, these amounts are reduced to 50% and 40% respectively, for at least three years. [6] In addition, the reproposal introduces a new measure that would require clawback of 100% of bonuses within seven years of vesting in cases of employee misconduct. [7] Although these provisions go beyond the 2011 proposal’s deferral requirement (i.e., 50% of bonuses for at least three years) and add the clawback requirement, the impact of these provisions for banks will likely be less significant than it appears. At least for the biggest banks, bonuses are already largely being deferred for three or four year periods. Furthermore, the reproposal’s clawbacks are only triggered by a high bar (i.e., employee misconduct), so they are unlikely to be often used (i.e., clawbacks are not required to be used to recoup bonuses for risk-taking that resulted in large losses). The impact will also be mitigated for most asset managers, since the proposal’s asset threshold for being labeled as a Level 1 or Level 2 institution does not include client assets.

3. The codification of bonus terms offers benefits to the CEOs and boards of the largest US banks. Because the reproposal’s deferral periods and clawbacks are consistent with practices at several of the major US banks, CEOs and boards may benefit from the reproposal’s codification of standardized industry compensation practices because it will limit employee opportunities to shop for better terms. This codification also simplifies the supervisory review process for these firms, by providing more specificity around regulatory requirements that until now lacked full clarity. [8] Smaller Level 1 and Level 2 institutions, however, are far less likely to view the reproposal as beneficial, since their compensations practices vary more widely. Furthermore, FBOs that are within the reproposal’s scope will have to balance the reproposal’s requirements with those of their home jurisdictions. [9]

4. No bonus caps in the US—a global banking advantage. The reproposal does not cap bonuses at any predetermined level. Instead, and consistent with the 2011 proposal, the reproposal prohibits “excessive” bonuses, determined by considering a number of relatively flexible factors [10] and requires bonus arrangements to appropriately balance risk and reward, among other qualitative measures. This approach is different from that taken by EU regulations which limit bankers’ bonuses to 100% of their base salary (or 200% subject to shareholder approval). [11] This difference benefits US banks versus their EU peers with respect to their ability to attract the most qualified employees. We suggested that the reproposal would not cap bonuses like the EU in our recent publication entitled, Bank culture: It’s about more than bad apples (November 2015).

5. Compensation: the final thematic piece of post-crisis reform. In the years since 2010, US regulators have prescribed how much capital and liquidity banks can hold, [12] how much equity they can return to shareholders, [13] and to some extent what businesses they can be in. [14] Therefore, the reproposal not only marks the nearing of the end of new rulemakings, but is also noteworthy for its relatively deferential approach—likely indicating US regulators’ view of the most important areas for effective risk management. However, compensation will remain on the front burner as part of the supervisory process, particularly with a focus on how risk taking is rewarded in bonus decisions.

What’s next?

Following the NCUA issuance, we expect substantially identical reproposals from the remaining five agencies, starting with the OCC and FDIC next week. [15] The reproposal will remain open for comments until July 22nd (perhaps longer if the other agencies do not follow suit soon) and conformance would be required 18 months after a final rule is published in the Federal Register.

Endnotes:

[1] Dodd-Frank requires that this rule be jointly proposed by the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA), and the NCUA. Although the other agencies have yet to officially repropose the rule, we expect these upcoming reproposals (led by the FDIC’s and OCC’s anticipated issuance next week) to be substantially identical to the NCUA’s.
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[2] For more information on the 2011 joint proposal that was never finalized, see PwC’s A closer look, Incentive-based compensation requirements for certain firms (April 2011).
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[3] The reproposal defines bonuses broadly to include any variable compensation (cash or otherwise), fees, or benefits that serve as an incentive or reward for performance.
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[4] The regulators’ text explaining the reproposal indicates that there are 15 Level 1 bank holding companies in the US. However, it is our view that more entities will ultimately be included in this group—e.g., the largest US operations of foreign banking organization (FBOs)—since the proposal calls for FBOs’ inclusion when their total US consolidated assets exceed $250 billion (adding up the assets of their US branches, agencies, and subsidiaries).
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[5] See PwC’s First take, Ten key points from Agencies’ resolution plan feedback (April 14, 2016).
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[6] However, recognizing the risk-mitigating effect of long-term incentive plans (i.e., bonuses calculated based on a performance period of at least three years, as opposed to the more customary one year), the reproposal reduces the bonus deferral period to at least two years for Level 1 institutions and at least one year for Level 2 institutions.
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[7] These cases include engagement by a senior executive officer or significant risk taker in (a) misconduct that resulted in significant financial or reputational harm to the institution, (b) fraud, or (c) intentional misrepresentation of information used to determine the individual’s bonus compensation.
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[8] Regulatory issuances on the topic until now have been generally limited to high-level standards such as the 2010 Interagency Guidance on Sound Incentive Compensation Policies, which includes similar measures to the reproposal’s (e.g., around deferrals) but lack the reproposal’s specificity.
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[9] For example, see PwC’s First take, Key points from the UK’s final bonus compensation rule (June 26, 2015) (discussed on the Forum here), which indicates that the UK requires vesting periods of up to seven years on a pro-rata schedule for UK banks’ operations in the US. Making things more complicated, the reproposal also applies to the foreign operations of US banks, so US banks will also have to balance the reproposal’s requirements with those of foreign jurisdictions.
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[10] These factors include bonuses paid to individuals with comparable expertise, the institution’s financial health, and compensation practices at peer institutions.
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[11] See PwC’s Regulatory brief, EU bonus cap: The net widens (March 2015).
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[12] See PwC’s Regulatory brief, Basel III capital rules finalized by Federal Reserve: But much more to come for the big banks (July 2013) and First take, Ten key points from the final US liquidity coverage ratio (September 9, 2014).
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[13] See PwC’s First take, Ten key points from the 2015 Comprehensive Capital Analysis and Review (“CCAR”) (March 13, 2015) (discussed on the Forum here).
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[14] See PwC’s A closer look, Volcker rule clarity: Waiting for Godot (May 2014) (discussed on the Forum here), and Regulatory brief, Volcker shrugged (December 2013).
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[15] It is noteworthy, however, that the NCUA was the first regulatory agency to vote on the reproposal, and some other agencies including the Federal Reserve are yet to schedule public meetings to do so.
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