On October 22, 2009, the Federal Register published proposed guidance from the Federal Reserve for structuring incentive compensation arrangements at banking organizations.

There are several notable aspects of the proposed guidance. First, the Federal Reserve expects all banking organizations, not just entities participating in the Troubled Asset Relief Program, to review their incentive compensation arrangements in light of the guidance. Second, the guidance sets forth principles that banking organizations should follow and implement as part of their incentive compensation arrangements, but does not establish pay caps or other specific formulas for calculating incentive compensation. Third, the principles in the guidance apply to incentive compensation arrangements for executives, employees, and groups of employees who may expose the organization to material amounts of risk. They are not limited to compensation arrangements for executive officers or other highly compensated employees.

Principles of a Sound Incentive Compensation System

The Federal Reserve guidance is centered on three (3) main principles that should be followed when designing a sound incentive compensation system.

Principle #1: Balanced Risk-Taking Incentives

  • Incentive compensation arrangements should account for risks associated with employee’s activities when developing incentive compensation arrangements.

An incentive compensation arrangement should balance the risk and the reward associated with activities undertaken by the employee. This balance is achieved when incentive compensation paid to an employee accounts for the risks and the financial benefits associated with the employee’s activities. This may require banking organizations to reduce the amount of incentive compensation payable to an employee to account for the risks.

Example: Two employees generate the same amount of short-term profit, but the activities of one employee result in greater risk to the banking organization. Under a balanced incentive compensation arrangement, the employee whose activities result in a greater risk to the banking organization should receive less than the employee whose activities did not result in a greater risk to the banking organization.

  • Employees should understand how risk and risk outcomes are accounted for in their incentive compensation arrangements.

Banking organizations should communicate clearly to employees how an incentive compensation arrangement will account for risk and risk outcomes. The communication should include examples and should be tailored to the employees.

  • The full range of risks associated with an employee’s activities and the time horizon over which those risks may be realized should be considered when assessing whether an incentive compensation arrangement is balanced.

Banking organizations should consider the long-term impact of activities that result in short-term increases in revenue. They should also consider and account for risks that have a low probability of occurring but would have a highly negative impact on the banking organization if the risks are realized.

The guidance recommends the use of “scenario analysis,” particularly by large, complex banking organizations, when assessing whether an incentive compensation arrangement properly balances risk and reward over the long-term. This is a forward-looking approach to analyzing whether incentive compensation arrangements are likely to be reduced appropriately for risks to the organization. “Scenario analysis” involves projecting payment amounts at various levels of performance, risk outcomes, and the levels of risk taken. The guidance also recommends using reliable quantitative measures of risk and risk outcomes where available. If such quantitative measures are not available, banking organizations should rely on informed judgments to estimate risks and risk outcomes.

  • Balanced incentive compensation arrangements can be achieved by adding or modifying features that cause the amounts ultimately received by employees to appropriately reflect risk and risk outcomes.

The guidance suggests using the following four methods to make incentive compensation arrangements more sensitive to risk:

  1. Adjust the amount of incentive compensation to account for the risk posed to the organization by the employee’s activities.
  2. Defer payment beyond the end of the performance period to allow for the realization of risks and adjust incentive compensation for losses and other aspects of performance that come to light after the performance period ends.
  3. Extend the performance period for determining an award to account for long-term performance.
  4. Reduce incentives for taking greater short-term risks by reducing the rate at which an award increases in value as higher performance levels are achieved.

These four options are not exclusive, and additional methods or variations may be developed to restrain excessive risk-taking.

  • A banking organization should not rely on a formulaic approach to designing balanced incentive compensation arrangements and should instead customize the arrangements for the employees and the organization itself.

The methods employed by a banking organization to balance incentive compensation arrangements should be customized for the banking organization’s particular circumstances and tailored to account for the differences between employees’ positions and the different risks associated with those positions. For example, the risks associated with loan originators will differ from the risks associated with exchange traders. Another aspect banking organizations should consider when developing balanced incentive compensation arrangements is the effect of the payment form, such as cash or equity, on restraining risk-taking incentives. For example, grants of equity or equity-based incentives may effectively balance risk and reward for an individual whose actions may affect the overall financial health of the organization and the organization’s stock price; however, they may not be as effective in restraining risk-taking by lower-level employees whose actions do not have the same effect on the organization’s overall financial health and stock price.

  • Banking organizations should also consider the impact of severance payments, accelerated vesting, and “golden handshakes” on the effectiveness of deferred compensation to affect an employee’s risk-taking behavior.

One concern raised by the guidance is that severance payments may encourage an employee to take excessive risks by providing the employee with a financial cushion upon termination. However, the guidance also raises the concern that forfeiture of deferred compensation upon an employee’s termination may reduce the effectiveness of the deferral arrangement to mitigate risk by removing the employee’s exposure to financial losses resulting from the employee’s risk-taking. This effect can be magnified if an employee is able to negotiate a “golden handshake” with a new employer that compensates the employee for forfeited amounts. By cautioning against forfeiture provisions, accelerated vesting, and severance payments, the guidance creates uncertainty about the acceptability of many common compensatory arrangements.

Principle #2: Compatibility with Effective Controls and Risk Management

  • Banking organizations should have appropriate controls in place to support and preserve the balanced incentive compensation arrangements and to maintain the integrity of the organization’s risk management.

Documented controls and policies should (i) identify and describe the roles of those involved in designing, implementing, and monitoring incentive compensation arrangements; (ii) identify the sources of significant risk-related inputs into the decision, implementation, and monitoring of incentive compensation arrangements; and (iii) identify individuals within the banking organization who approve new arrangements and modifications to existing arrangements. On a regular basis, banking organizations should conduct internal reviews of the processes established to achieve and maintain balanced incentive compensation arrangements. A tracking system of some type should also be instituted by banking organizations to ensure that risk outcomes are being factored appropriately into incentive compensation arrangements.

  • Risk management personnel with the appropriate skills and experience should be involved in developing incentive compensation arrangements.

When designing incentive compensation arrangements, risk management personnel should be included to assess whether the arrangements effectively restrain excessive risk-taking. Personnel in human resources and finance should also be included when designing incentive compensation arrangements. Due to the importance of assessing the effectiveness of an arrangement in restraining risk-taking actions, risk management personnel should have appropriate skills and experience to effectively fulfill their roles. Thus, compensation for risk management personnel should be sufficient to attract and retain qualified individuals. However, the guidance suggests tying performance objectives for risk management personnel to risk management and not the financial results of business units reviewed by the risk management personnel.

Principle #3: Strong Corporate Governance

  • Strong corporate governance practices should be developed to monitor, assess, and revise incentive compensation arrangements as needed to promote and protect sound compensation practices.

The board of directors of a banking organization should be actively involved in overseeing the development of incentive compensation arrangements and the related control processes for restraining excessive risks. This includes approving and reviewing the overall goals and purposes of the banking organization’s incentive compensation system. To assure appropriate and effective oversight by the board of directors, the guidance recommends establishing a compensation committee if the organization is not already required to do so.

The board of directors should regularly review the design and monitor the performance of the organization’s incentive compensation system. This involves reviewing data and analysis from management or others on the banking organization’s incentive compensation systems to assess whether the overall design and performance of the system are consistent with the organization’s safety and soundness. The review should include a backward-looking review to determine whether the organization’s incentive compensation arrangements may be promoting excessive risk-taking, and a forward-looking scenario analysis of future payments on a range of performance levels, risk outcomes, and the amount of risks taken. The board of directors should also remain current on changes to and the evolution of incentive compensation arrangements in the marketplace and consider how they may be adapted to the unique circumstances of the organization.

The guidance also suggests that large complex banking organizations should develop a systematic approach to ensure that incentive compensation arrangements are appropriately balanced and consistent with safety and soundness. In addition, regional and community banking organizations should develop and implement appropriate policies and procedures that are tailored to the organization’s size and complexity of its activities.

  • The board of directors of a banking organization should directly approve incentive compensation arrangements for senior executives.

Any material exceptions or adjustments to incentive compensation arrangements for senior executives should be approved and documented by the board of directors. Approved exceptions and adjustments should then be monitored for their effect on the balance of the arrangement, the risk-taking incentives of the senior executives, and the overall safety and soundness of the organization.

  • Appropriate disclosures contribute to effective corporate governance.

Disclosures of the banking organization’s incentive compensation arrangements should assure that shareholders have sufficient information to monitor the incentive compensation arrangements and the systems in place for reducing excessive risk to the organization by the actions of employees.

Supervisory Initiatives

In addition to the principles to be considered in developing incentive compensation arrangements, the guidance sets forth two supervisory initiatives that the Federal Reserve will undertake to monitor compensation practices within the industry. The first initiative will be a special review of incentive compensation practices at large, complex banking organizations. Each large complex banking organization will be expected to provide the Federal Reserve with its plans for improving the risk-sensitivity of its incentive compensation arrangements. A special multidisciplinary team at the Federal Reserve will then work with the large complex banking organizations to review, analyze, and provide input on each large complex banking organization’s incentive compensation arrangements. The second initiative will be a review of all other community and regional banking organizations. This review will be conducted as part of the entity’s regular examination process and will be tailored to the scope and complexity of the entity’s incentive compensation practices.