Introduction

Today, the Federal Reserve published in the Federal Register proposed guidance on incentive compensation policies at banking organizations (the "Guidance"). The Guidance is based on three key principles that attempt to ensure that incentive compensation arrangements at banking organizations do not encourage excessive risk taking and are consistent with the safety and soundness of the organization. This guidance applies to incentive compensation not only for senior executives, but also for individual employees, or groups of employees, who may expose the institution to material amounts of risk. The three principles are:

  • Banking organizations should provide employees incentives that do not encourage excessive risk taking beyond the organization's ability to effectively identify and manage risk;
  • Incentive compensation arrangements should be compatible with effective controls and risk management; and
  • Incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the organization's board of directors.

The Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements for consistency with these principles and to take immediate actions to address any deficiencies. The Federal Reserve will, on an ongoing basis, also assess whether banking organizations' incentive compensation arrangements are compliant with these principles.

Furthermore, the Federal Reserve has announced two new supervisory initiatives designed to encourage and monitor the banking industry's progress towards implementing safe and sound compensation arrangements, identify emerging best practices and advance the state of practice generally. These supervisory initiatives are:

  • A special "horizontal review" of incentive compensation practices at large complex banking organizations ("LCBOs"); and
  • A review of incentive compensation practices at non-LCBOs as part of the risk-focused examination process for these organizations.

This memorandum briefly outlines the Federal Reserve Guidance and supervisory programs.

I. Incentive Compensation Guidance

The Federal Reserve's goal is for incentive compensation arrangements to be consistent with principles of soundness and safety, and for such arrangements to take into account potential risk and risk outcomes. To that end, the Federal Reserve has developed three key principles which structure the Guidance, as noted above.

1. Balanced Risk-Taking Incentives

Incentive compensation arrangements should balance risk and financial results so that employees are not given incentives to take excessive risks on behalf of the banking organization. This includes:

  • Considering the full range of risks associated with an employee's, or a group of employees', activities, including the likelihood and severity of risks under multiple scenarios and the time horizon over which those risks may be realized.
  • Balancing arrangements by adding or modifying features that cause the amounts ultimately received by employees to appropriately reflect risk and risk outcome, such as by adjusting the amount of an award depending on the level of risk, deferring payment to allow for the realization of any potential risk and longer performance periods.
  • Tailoring incentive compensation arrangements to account for differences between employees (as well as banking organizations), rather than applying a single, formulaic approach.
  • Reconsidering whether the use of "golden parachutes" and vesting arrangements for deferred compensation affects the risk-taking behavior of employees.
  • Communicating clearly to employees the manner in which incentive compensation awards will be reduced as risks increase.

2. Compatibility with Effective Controls and Risk Management

Balanced incentive compensation arrangements should be reinforced and supported by risk-management processes and internal controls. This includes:

  • Ensuring that appropriate controls are followed and the integrity of risk-management functions is maintained, such as by keeping sufficient documentation and conducting regular internal reviews.
  • Having appropriate risk-management personnel provide input into the design of incentive compensation arrangements, and in assessing such arrangements' effectiveness in restraining excessive risk taking.
  • Compensating employees in risk-management positions in a manner that avoids any conflict of interest and that is sufficient to attract and retain qualified personnel.
  • Monitoring incentive compensation arrangements and revising when necessary.

3. Strong Corporate Governance

To ensure sound compensation practices, banking organizations should have strong and effective corporate governance. This includes:

  • Having the board of directors actively oversee incentive compensation arrangements, approve the overall goals and purposes of the incentive compensation system, monitor performance and regularly review the design of such arrangements. The board of directors should directly approve the incentive compensation arrangements for senior executives and document any material exceptions or adjustments to those arrangements.
  • Organizing and composing the board of directors in such a way as to permit effective oversight of incentive compensation arrangements, and providing enough resources to the board of directors to enable them to accomplish this goal.
  • Creating disclosure practices that support safe and sound incentive compensation arrangements by providing the appropriate amount of information to shareholders concerning the incentive compensation arrangements.
  • For LCBOs, following a systematic approach to developing balanced incentive compensation systems which, among other aspects, identifies particular employees and the types and time horizon of the relevant risks posed by those employees, assesses the potential risks inherent in performance measures and communicates the effect of risk on employees' awards and payments.

II. Principles-Based Guidance and Implementation

As the foregoing suggests, the Guidance is principles-based and therefore seems flexible in the types of incentive compensation arrangements that will continue to be permitted. While banking organizations are required to ensure compliance with the principles described in the Guidance, it has yet to be seen how the Guidance will actually affect incentive compensation arrangements in detail. However, the Guidance does offer some specific examples of how it should be implemented, such as the following:

  • Under a balanced incentive compensation arrangement, two employees who generate the same amount of short-term revenue should not receive the same amount of incentive compensation if the risks taken differ materially between the two employees. The employee whose activities create materially larger risks should receive less incentive compensation, all else being equal.
  • The size of an employee's incentive compensation in relation to the employee's total compensation can affect the likelihood that the incentive compensation portion could induce the employee to take excessive risks. When the portion of incentive compensation is a smaller percentage of total compensation, it can act as a deterrent to risk-taking behavior.
  • Equity-related deferred compensation may be ineffective in restraining the activities of lower-level employees, as such employees are likely to believe that their actions will not materially affect the organization's stock price.
  • Golden parachutes and certain vesting arrangements for deferred compensation are generally discouraged and organizations are exhorted to review such existing or proposed arrangements.

III. Supervisory Initiatives

In addition to the Guidance, the Federal Reserve has also announced two supervisory initiatives designed to spur and monitor the banking industry's progress towards implementing balanced, safe and sound inventive compensation arrangements, as well as to identify emerging best practices.

1. Program for Large, Complex Banking Organizations

The Federal Reserve will conduct a formal "horizontal review" of incentive compensation at LCBOs. This review is designed to enhance supervisory understanding of current practices, to assess the strength of controls and whether actual payouts under incentive compensation arrangements are effectively monitored, to understand the roles played by various parties and to identify emerging best practices. LCBOs will be expected to provide to the Federal Reserve information and documentation on the structure of their current incentive compensation arrangements, their existing processes to oversee these arrangements and the organization's future plans to improve risk sensitivity. If the LCBO fails to submit or develop effective plans, the Federal Reserve may take enforcement or supervisory action, such as limiting the LCBO's incentive awards.

2. Program for Community and Regional Banking Organizations

Incentive compensation arrangements will be examined as part of the regular review of community and regional banking organizations, in connection with a review of the organization's risk management, internal controls and corporate governance. If examiners find incentive practices that may be of concern, the Federal Reserve may take supervisory action to address deficiencies.

Conclusion

The Federal Reserve has made its first foray into attempting to constrain excessive risk taking motivated by incentive compensation. Although the Guidance is proposed, the Federal Reserve expects banking organizations to promptly start taking action to address deficiencies in their incentive compensation arrangements and their related risk-management, internal control and corporate governance processes. The Guidance is open to comments, which must be submitted by November 27, 2009.

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