Federal Banking Agencies Issue Final Guidance on Incentive Compensation Arrangements
June 28, 2010
On the assertion that bank incentive compensation practices are among the factors contributing to the current financial crisis, the OCC, Federal Reserve Board , FDIC and OTS (“Agencies”) have issued final guidance (“Guidance”) on bank incentive compensation policies and practices.
Incentive compensation is defined as the portion of compensation where the amount varies with and is tied to a metric such as sales. Thus, it does not include regular salary or to 401(k) plans. The purpose of the Guidance is to ensure that such policies do not encourage imprudent risk-taking and that they are consistent with principles of safety and soundness. The Guidance does not apply to banks that do not use incentive compensation. 
The Guidance adopts a principles-based approach rather than establishing prohibitions on the type and amount of compensation permitted. It recognizes that different compensation arrangements are appropriate for different institutions depending their size, complexity, and level of usage of incentive compensation. The three broad principles are that incentive compensation arrangements (1) should provide incentives that balance risk and financial results without encouraging imprudent risk-taking; (2) should be subject to effective controls and risk-management; and (3) should be supported by strong corporate governance, including board oversight.
The Guidance applies to executive and non-executive employees “who, either individually or as part of a group, have the ability to expose the organization to material amounts of risk.” These include senior executives  with company-wide or major business line responsibilities, other executive or non-executive employees whose activities may expose the organization to material risks, and groups of employees whose compensation arrangements, in the aggregate, may pose such risks even if they might not do so individually. Employees who are likely to be outside the scope of the Guidance include tellers, bookkeepers, couriers, and data processing personnel because they do not have the ability to expose the organization to material risks.
Much of the Guidance is targeted at “large banking organizations” or “LBOs” which are institutions that are identified as such or a similar designation by the respective banking agencies. These are “large, complex banking organizations” designated by the Federal Reserve for supervisory purposes; the largest and most complex national banks designated in the Large Bank Supervision booklet of the Comptroller’s Handbook; large complex insured depository institutions (IDIs) designated by the FDIC; and the largest and most complex savings associations and savings and loan holding companies as designated by the OTS. “Smaller banking organizations” are those institutions that are not LBOs. 
LBOs are expected to adopt “systematic and formalized” policies, procedures, and processes because they are considered to be more likely to use incentive compensation arrangements. While practices at smaller banks are not expected to be as extensive, all banks’ incentive compensation activities will be subject to supervisory review as part of their regular evaluation of risk-management, internal controls, and corporate governance (to the extent that they use such arrangements). Supervisory findings related to incentive compensation will be included in banks’ examination reports and incorporated in the relevant supervisory ratings. The Agencies may employ the usual measures to enforce compliance with the Guidance, including requiring banks to take corrective actions to rectify safety and soundness deficiencies.
Balancing risks and incentives
A balanced incentive compensation arrangement is one that focuses both on revenue generation and risk to the organization. For example, two employees who generate the same amount of revenue or profit should not receive the same amount of incentive compensation if the resulting risks to the organization differ materially. All else being equal, the employee generating the materially larger risk should receive less compensation. Generally, the kind of incentives that are less likely to encourage employees to take imprudent risks are those based solely on organization-wide performance (except for senior executives and individuals who actually have the ability to materially affect the organization’s overall risk profile). In an example provided in the Guidance, an employee who works with positions that close at year-end should not have incentives under an arrangement to take large risks prior to closing without factoring how such positions may perform over a longer period of time.
Institutions must consider a full range of risks associated with employees’ activities and when those risks may be realized. Quantitative measures are preferable, but the Agencies recognize that such measures are not always available. Risks to consider include credit, market, liquidity, operational, legal, compliance, reputational, and other risks that affect the viability or operation of the organization. Banks must further consider the cost and amount of capital and liquidity needed to support identified risks. No details in this regard are provided. LBOs are further expected to consider employing “simulation analysis,” which uses forward-looking projections of incentive compensation awards and payments based on a range of performance levels and risk outcomes.
The Guidance identifies four methods to make compensation more sensitive to risk:
- Adjust awards based on risk. Such measures may be quantitative or based on qualitative assessment and made subject to appropriate oversight.
- Defer payment. The actual payout of an award is delayed and then adjusted in accordance with actual realized losses or other aspects of performance known only later (e.g., “clawback”).
- Extend performance periods. Extend the time period covered by the performance measures to permit the organization to identify realized losses and risks.
- Reduce incentives for short-term performance. This method is intended to reduce the distorting effects of focusing on short-term profits and help the organization take a longer view.
These methods for achieving balance are not intended to be exclusive or to be used in every instance.
Generally the higher the likelihood that incentives will increase risks, the more attention must be given to achieving balance. Where judgment is exercised with respect to incentive compensation arrangements, banks are expected to ensure that their policies and procedures describe how managers should exercise that judgment and that they receive information about employees’ risk-taking activities as necessary to make informed judgments. LBOs are expected to stay abreast of emerging methods and practices for making compensation sensitive to risk and to incorporate them into their incentive compensation programs.
Flexibility based on type of employees.
The Guidance recognizes the difficulty of designing incentive compensation arrangements that meet the needs of different kinds of employees and business lines within the same organization. But this kind of challenge is to be expected, and it would be inappropriate for an organization to employ a single, formulaic approach that would achieve the necessary sensitivity to risk as required in the Guidance. Balancing incentive compensation arrangements may account for differences between employee groups based on the scope or complexity of their duties and the organization’s business strategies.
As for arrangements for senior executives at LBOs, the Guidance expects use of substantial deferral of incentive compensation over multi-year periods and use of equity-based compensation in the form of instruments that vest over multiple years. These practices may not be appropriate with respect to employees at lower pay scales, but nevertheless, these practices are intended to help the organization avoid the pitfalls of overly pursuing short term results.
The Guidance specifically warns against golden parachute arrangements that fail to consider the effect on risk-taking behavior of employees during their tenure at the bank. Guaranteed payments, for example, could offset the effect of those arrangements that appropriately balance incentives with risk control. A bank is encouraged to consider, with respect to golden parachute arrangements, including the same kind of balancing that is applied to incentive compensation arrangements in order to make them more consistent with the bank’s overall goals.
The Guidance also takes aim at “golden handshake” arrangements, which the Agencies believe could weaken whatever controls, incentives, and balancing that had been incorporated in the newly-hired employee’s incentive compensation arrangement at the prior employer.  This is seen as a particular concern for LBOs in the hiring of skilled employees whose services are in high demand. LBOs are also encouraged to monitor such arrangements for evidence that they weaken the organization’s efforts to constrain undue risk-taking.
The Agencies consider it necessary for an organization’s incentive compensation arrangements to be subject to its risk-management processes and internal controls. This means that management at the highest levels are engaged in all phases, including designing, implementing, and monitoring of the arrangements. Documentation is necessary to permit audits of each of these processes. The Guidance includes specific expectations in this regard, particularly for LBOs, which include identifying and describing the roles of responsible parties, conducting regular internal reviews, monitoring, and reporting to management including, as appropriate, the board of directors.
Risk management personnel are expected to be involved in all aspects of incentive compensation arrangements, and organizations need to provide them with adequate compensation to attract and retain qualified personnel who can perform the needed review, approval, and analytical work. Conflicts of interest should be avoided by ensuring that their compensation is not substantially based on the financial performance of the business units that they review, but rather on such objectives as adherence to internal controls.
The general level of the board’s involvement in incentive compensation arrangements depends on the scope of those arrangements. The boards of LBOs that are significant users of incentive compensation are expected to be closely involved in overseeing the development and implementation of the arrangements, as well as in the control and review processes. Closer oversight is expected with arrangements for senior executives, including any material exceptions or adjustments, which must be documented and separately approved. Another component of effective governance is appropriate disclosure to shareholders to allow them to monitor and perhaps take actions to restrain arrangements and processes that encourage undue risk-taking.
An LBO’s board is expected to review incentive compensation arrangements at least annually. It should receive periodic reports that review incentive compensation payments on a backward-looking basis to determine whether the appropriate balance is achieved. It should also consider periodically reviewing simulation analysis of compensation on a forward-looking basis based on a range of performance levels, risk outcomes, and the amount of risks taken. Particular attention must be paid to clawback provisions, and boards are expected to stay abreast of developments in compensation issues. The Agencies expect banks to take prompt action to address any deficiencies.
The board should have, or have access to, expertise and experience in risk-management and compensation practices in the financial services industry. However, outside parties should not exercise undue influence on the organization. If the board does not have a separate compensation committee composed solely or predominantly of non-executive directors, it should ensure that non-executive directors of the board are actively involved. Attention should be paid to conflicts of interest in dealings among directors, outside parties, and management. The audit committee should be involved where compensation issues overlap with its responsibilities.
LBOs cannot expect that an ad hoc approach in developing compensation arrangements would make them balanced and consistent. The Guidance encourages LBOs instead to adopt a systematic approach that features formalized policies and procedures. The approach should identify eligible employees, identify the risks that their activities pose, incorporate appropriate balancing adjustments, include effective communications to the employees, and implement monitoring and any necessary modifications if payments are not appropriately sensitive to risks.
The Guidance is effective as of last Friday, June 25, 2010, when it was published in the Federal Register.
- The Agencies note that smaller banks will not be considered a significant user of incentive compensation arrangements simply because it has a bank-wide profit sharing or bonus plan that is based on the bank’s profitability, even if it covers all or most of the bank’s employees.
- Senior executives include, at a minimum, “executive officers” within the meaning of the Federal Reserve’s Regulation O (see 12 CFR 215.2(e)(1)) and, for publicly traded companies, “named officers” within the meaning of the Securities and Exchange Commission’s rules on disclosure of executive compensation (see 17 CFR 229.402(a)(3)). Savings associations should also refer to OTS’s rule on loans by saving associations to their executive officers, directors, and principal shareholders. (12 CFR 563.43).
- With respect to U.S. operations of foreign banks, incentive compensation policies, including management, review, and approval requirements for a foreign bank’s U.S. operations should be coordinated with the bank’s group-wide policies developed in accordance with the rules of its home country supervisor. These policies and practices should be consistent with the foreign bank’s overall corporate and management structure and its framework for risk-management and internal controls, as well as with the Guidance.
- Golden handshakes are arrangements that compensate an employee for some or all of the estimated, non-adjusted value of deferred incentive compensation that would have been forfeited upon departure from the employee’s previous employment.
The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.
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