Financial Institutions & Executive Compensation Client Alert – Summer 2010

Announcement of Final Guidance on Incentive Compensation Practices

As we previously advised, in October 2009 the Federal Reserve issued proposed guidance and requested comments concerning incentive compensation by banks and financial institutions. On June 21, the process concluded with the announcement of final guidance. The Federal Reserve was joined by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision in issuing the final guidance. Note that “guidance” represents policy concerning safety and soundness examinations and differs from formal regulations in that guidance is typically less formulaic and leaves more room for interpretation by examiners.


Summary

The guidance is centered around three core principles: First, incentive compensation programs should balance the incentives for risk taking. Put simply, if two employees generate the same level of revenue or profits, but, in doing so, one incurs greater risk, this employee should earn less incentive compensation. Second, institutions should have strong controls in place to create and monitor the effectiveness of incentives. Third, the board of directors or the compensation committee must be fully informed and actively involved in creating and monitoring incentive compensation programs. The end result of this guidance should be incentive compensation that is more weighted toward equity incentives, longer performance periods, strong clawbacks and continuous monitoring by management with the active supervision of an informed board of directors or compensation committee.


Analysis

Applicability

The final guidance will be applicable to all banks, thrifts, bank and financial holding companies and other banking organizations supervised by any of the adopting agencies, including state member banks of the Federal Reserve, FDIC insured banks, Edge and agreement corporations and the U.S. operations of foreign banks. The guidance will be effective upon publication in the Federal Register, which should happen shortly. The guidance includes special provisions applicable to largest most complex institutions. This Client Alert focuses on the aspects of the guidance which are most applicable to regional and community financial institutions.

Scope

The guidance covers incentive compensation for both senior executives and non-executive employees who, individually or as part of a group, have the ability to expose an institution to material risks. Obvious examples are bonus programs for personnel who expressly control enterprise risk, such as loan officers and traders. However, the institution must also look at incentive pay for personnel who are tasked with internal controls and risk management, such as the controller, CFO and their respective staff.

Three Core Principles

The final guidance retains the same three core principles outlined in the October 2009 proposal, with adjustments and clarifications to address matters raised in the public comments. The guidance remains principles-based, rather than formula-based, and thus does not mandate or prohibit the use of any specific forms of payment for incentive compensation or establish mandatory compensation levels or caps.

Principal 1 (Balanced Risk-taking Incentives): Incentive compensation arrangements should provide incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk.

Put simply, incentive compensation should be sensitive to risk. As an example, two employees who generate the same amount of short-term revenue or profit should not receive the same amount of incentive compensation if the risks taken by the employees differ materially. The employee whose activities create materially larger risks should receive less than the other employee, all else being equal.

  • Institutions should consider the full range of risks associated with an employee’s activities, as well as the time horizon over which those risks may be realized.
For example, future revenues that are booked as current income may not materialize, and short-term profit-and-loss measures may not appropriately reflect differences in risks (e.g., the higher credit or compliance risk associated with subprime loans versus prime loans). Institutions should use formal analysis of the risk arising from the activities of an employee or group of employees. Quantitative analysis is preferred, but if this is not possible or practical, the organization should engage in a qualitative analysis. The incentive compensation outcome should be in line with the risk outcome.
  • Unbalanced arrangements should be modified so that the amounts ultimately received by employees appropriately reflect risk and risk outcomes.

    The guidance outlines four methods that may be used to make compensation more sensitive to risk, although this is not intended to be an exclusive list.
    • Reducing the amount of an incentive compensation for an employee to take into account higher risks posed by the employee’s activities.
    • Deferring payment of an earned award beyond the end of the performance period, so that the earned amounts can be adjusted for actual losses or other aspects of performance that become clear only after the performance period.
    • Longer performance periods (such two years, instead of one year), which, similar to deferral of payment, allow awards or payments to be made after some or all risk outcomes are realized or better known.
    • Reducing sensitivity to short-term performance, such as reducing the rate at which awards increase as an employee achieves higher levels of the relevant performance measure(s).

The appropriate measures will vary from case to case. For example, if risks are difficult to quantify, deferral of awards or extension of the performance period may be more effective measures than adjusting an award based on risk. Clawbacks are also an effective way to ensure that compensation outcomes match the actual financial performance of an employee.

  • The characteristics of a balanced incentive compensation arrangement vary based on differences between employees—including the substantial differences between senior executives and other employees—as well as between banking organizations.
For example, the CEO’s incentive compensation arrangement should take into account the enterprise-wide risk level of the organization, which may involve analysis which is more difficult to quantify compared to the risks posed by the activities of the institution’s loan officer group. The guidance specifically recommends the use of equity compensation and deferral of payment of incentive compensation for senior executives as an effective means of balancing their risk incentives.
  • Banking organizations should carefully consider the potential for “golden parachutes” and the vesting arrangements for deferred compensation to affect the risk-taking behavior of employees while at the organizations.
Severance payment arrangements, sometimes referred to as “golden parachutes,” are specifically targeted by the adopting agencies for careful review. The final guidance clarifies that organizations should consider including balancing features, such as risk adjustments or deferral requirements, in golden parachutes and severance arrangements to mitigate the potential for the arrangements to encourage imprudent risk-taking.
  • Banking organizations should effectively communicate to employees that incentive compensation awards and payments will be reduced as risks increase.

Principle 2 (Compatibility with effective controls): An institution’s risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements.

  • Institutions should have appropriate controls to ensure that their processes for achieving balanced incentive compensation arrangements are followed and to maintain the integrity of their risk-management and other functions.
Institutions should create and maintain sufficient documentation to permit an audit of the effectiveness of these controls. Smaller banking organizations should incorporate reviews of these processes into their overall framework for compliance monitoring (including internal audit).
  • Appropriate personnel, including risk-management personnel, should have input into the design of incentive compensation arrangements and the assessment of their effectiveness in restraining excessive risk taking.
The guidance specifically points out that it is appropriate that a number of functions, such as control, human resources, and/or finance, be involved in the process of designing and reviewing performance measures used in compensation arrangements or supplying data used as part of these measures.
  • Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified personnel and should avoid conflicts of interest.
  • Institutions should monitor the performance of their incentive compensation arrangements and revise the arrangements as needed if payments do not appropriately reflect risk.

In response to public comments, the final guidance has clarified that the monitoring methods and processes used by an institution should be commensurate with its size and complexity, as well as its use of incentive compensation. Thus, a smaller institution that uses incentive compensation only to a limited extent may find that it can appropriately monitor its arrangements through normal management processes.

Principle 3 (Strong corporate governance): Incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

  • The board of directors should monitor the performance, and regularly review the design and function, of incentive compensation arrangements.
The board, or the compensation committee, needs to docket annual, or more frequent, review of the design and effectiveness of incentive compensation arrangements. If the arrangements are not in line with risk profile of employees’ activities, the arrangements should be modified. The board of directors or compensation committee should seek to stay abreast of significant emerging changes in compensation plan mechanisms and incentives in the marketplace as well as developments in academic research and regulatory advice regarding incentive compensation policies.
  • The organization, composition, and resources of the board of directors should permit effective oversight of incentive compensation.
The board, or the compensation committee, needs to have the authority, resources and expertise to design, implement and evaluate effective incentive compensation arrangements. The requisite level of expertise may be present collectively among the members of the board, may come from formal training or from experience in addressing these issues, including as a director, or may be obtained through advice received from outside counsel, consultants, or other experts with expertise in incentive compensation and risk-management.
  • A banking organization’s disclosure practices should support safe and sound incentive compensation arrangements.
The institution should provide shareholders with an appropriate amount of information concerning its incentive compensation arrangements for executive and non-executive employees and related risk-management, control, and governance processes. This will allow shareholders to monitor and, where appropriate, take actions to restrain the potential for such arrangements and processes to encourage employees to take imprudent risks. Publicly traded institutions should comply with the disclosure requirements of applicable securities laws.

Next Steps

We recommend that all covered financial institutions promptly begin reviewing their incentive compensation arrangements in light of the guidance. The guidance will be a part of all covered institutions’ next supervisory examination. Therefore, institutions should prepare for an evaluation of incentive compensation practices just as they would prepare for other aspects of the examination. The smallest community lenders may not need formal policies or risk analysis, but certainly many large community lenders and regional institutions will need to approach this area with new written policies, formal sets of controls and new systems that implement the guidance.

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