SRC Insights: Fourth Quarter 2011

Incentive Compensation: Proposed Guidance to Help Equalize the Risks and Rewards

by Ivy M. Washington, Supervising Examiner

Many factors contributed to the financial crisis that began in 2007, including unsound incentive compensation programs and practices. As a result, financial institutions are beginning to re-evaluate their incentive compensation structures to ensure that the financial interests of executives and employees align properly with the overall soundness of the institution. Historically, incentive compensation programs have been tools for the effective management of a financial institution. They provide easy avenues for attracting skillful staff, promoting performance, offering a security cushion for employees at retirement, and giving institutions the ability to better manage personnel costs. While compensation arrangements have clearly been an economic benefit for employees in more recent years, these same arrangements have led financial institution executives and employees to make inappropriate, and often imprudent, risk decisions, causing a misalignment between employee rewards and the institution's risk appetite.

As a result, guidance on incentive-based compensation arrangements was issued to assist banks in dealing with this topic.¹ This article outlines the different elements of both the proposed and final guidance on incentive compensation arrangements, including changes made based on the written responses and the standards aimed at improving the related practices.

The Proposed Guidance

Because incentive compensation programs can pose a significant safety and soundness risk to an institution if not properly structured, the Federal Reserve issued initial guidance on the topic in October 2009. The details of the guidance apply to senior executives and other bank employees, who, either individually or in unison, may expose their banking institution to material risk. The guidance builds on three basic principles:

To provide employees with the appropriate incentives that balance risk and reward
To be well-matched with an effective internal control and risk management process
To be aligned with a strong corporate governance structure, including active and effective board and corporate oversight

Incentive compensation arrangements at many banking institutions were often established to encourage short-term results, even at the cost of an institution's short- and long-term risks. As such, the first principle of this guidance sought to encourage banking institutions to tailor their incentive compensation programs so that employees receiving the benefit from a certain business activity were held accountable for some of the related risk of that activity. For this proposed principle to be fully effective, banking institutions would have to apply this thought process across all business lines and assess the impact of these risk-taking activities on the overall soundness of the institution. The proposed guidance aligns with the Financial Stability Board's principles for sound compensation practices and is consistent with its focus on the containment of excessive risk-taking.

Additionally, the proposed guidance provided banking institutions with strategies for implementing the second principle of integrating incentive compensation awards with an institution's internal control and risk management framework. Principally, the guidance encouraged banking institutions to involve the individuals who manage risk with the overall design of the incentive compensation program, with the expectation that it would result in better monitoring and better assessments of whether the arrangements promote imprudent risk-taking. As a part of this principle, the guidance requested banking institutions to track incentive compensation awards, the risk related to an award, and the actual risk outcome in order to understand whether the awards paid were adjusted to reflect any adverse results.

Finally, the third principle of the proposed guidance discussed the necessity of having an informed and active board of directors. These directors should ensure that the compensation program strikes a uniform balance between risk and reward at inception and on an ongoing basis. In conjunction with the responsibility, the guidance requests that members of the board review and approve key elements of the institution's incentive compensation program, review periodic evaluations on the effectiveness of the institution's risk-mitigation objectives, and directly approve compensation arrangements for the institution's senior executives.²

While the proposed guidance was issued to protect the safety and soundness of all banking institutions supervised by the Federal Reserve, it was also extended to other federal agencies. Provisions of the guidance reflect the diversity of these banking institutions relative to the complexity of their banking activities and frequency of compensation arrangements. For instance, incentive compensation programs at smaller banking institutions may differ substantially from those programs at larger banking institutions. Smaller banking institutions may utilize an informal approach to rewarding employees, while larger banking institutions tend to implement a more formal compensation plan. As a result, the measurement and monitoring systems for incentive compensation programs should reflect the risk appetite of an individual banking institution.

Changes to the Proposed Guidance

The Federal Reserve received 34 written responses to the proposed guidance from a spectrum of entities, from banking institutions to laborers. The majority of the comments supported the goal of the proposed guidance of ensuring that incentive compensation programs balance reward and risk and do not encourage inappropriate or imprudent risks. In addition, the guidance received support for its principles-based approach. There were also comments asking the Federal Reserve to revise and/or clarify the proposed guidance to include such elements of imposing specific restrictions on banking institutions' incentive compensation practices or mandating certain practices for corporate governance or risk management.

As a result, a number of changes were factored into the final guidance, giving some flexibility to a banking institution in how it constructs its incentive compensation program. Even so, the same key principles delineated in the proposed guidance were retained in the final document. The final document better addressed the safety and soundness risks associated with compensation arrangements, as it focuses on the fundamental problems that compensation programs pose when not structured adequately.

The Final Guidance

Included in the final guidance are three key principles similar to those in the proposed guidance. These principles give banking institutions some flexibility in constructing their incentive compensation programs to achieve their recognition objectives, while still promoting a safe and sound institution. The three principles are now known as:

Balanced incentive compensation arrangements
Compatibility with effective controls and risk management
Strong corporate governance

1. Balanced Incentive Compensation Arrangements

This principle of the final guidance requires that compensation arrangements paid to employees appropriately balance risk with financial results. The amount of pay given to a covered employee should be evaluated and adjusted to account for the risk, losses, and gains associated with the employee's activities to ensure that imprudent actions are not taken. The covered employees under this guidance include senior management and others responsible for oversight on a firmwide basis and individual employees or groups of employees whose activities may expose the institution to material risk. This principle was amended to clarify the need to develop compensation arrangements that properly balance risk-taking initiatives. As such, banking institutions are required to implement adjustments to their incentive compensation arrangements that address the full range of risks impacting the institution, which have been primarily credit, market, liquidity, operational, legal, compliance, and reputational risks.

The final guidance recognizes the importance of a strong internal control and risk management environment. Poorly designed incentive compensation programs alone can bring risk upon an institution, undermining the controls enacted and straining risk management oversight. As such, the final guidance outlines four methods to make compensation programs more risk sensitive. These methods are:

Adjustment of compensation awards
Deferral of compensation payments
Longer performance periods
Reduced sensitivity to short-term performance

Four Methods to Increase Risk Sensitivity of Compensation Programs

Because the aforementioned methods have advantages and disadvantages, they are not considered all-inclusive. Other methods or variations of these may exist or can be developed by banking institutions to achieve the same balanced objective. Each institution is responsible for ensuring that its incentive compensation arrangements are consistent with the safety and soundness of the institution,³ and, therefore, should enact governance tailored to their risk profile and complexity.

2. Compatibility with Effective Controls and Risk Management

This second principle of the final guidance affirms that a banking institution's risk management processes and internal control environment should reinforce and support the development of balanced incentive compensation programs by integrating compensation arrangements into both frameworks. Particularly, appropriate personnel, including individuals managing risk, should have input in the design and assessment of compensation arrangements to ensure that they are sufficient to attract and retain qualified personnel based on their achievement of the institution's goals and objectives, rather than based substantially on the financial performance of a given business line.

Monitoring processes, which include creating and maintaining sufficient documentation to permit independent assessment of effectiveness, should be implemented to ensure that compensation arrangements adequately reflect the risks of the institution. As such, compensation rewards should be offered when performance objectives have been met or exceeded and reduced when they have not.

3. Strong Corporate Governance

This last principle of the final guidance requires the support of a strong corporate governance structure, including the active participation of a banking institution's board of directors. Ultimately, the board of directors is responsible for establishing an effective incentive compensation program and ensuring that it utilizes a balanced approach for all covered employees. In turn, members should receive and analyze compensation data that are comprehensive enough to detail whether the overall design and performance of the incentive compensation program is consistent with the institution's risk soundness. Such reviews should be customized appropriately to the size, risk complexity, and risk activities of the institution.

In addition, compensation payments made to senior executives should be approved and monitored by an institution's board of directors, given its critical role in managing the institution's risk activities.

Continuing Supervisory Initiatives

When the proposed guidance on incentive compensation programs was issued in October 2009, two supervisory initiatives were also endorsed by the Federal Reserve. These initiatives include a special horizontal review of incentive compensation arrangements at large banking institutions (LBOs) and a review of incentive compensation practices at other banking institutions as a part of the normal, risk-focused examination process.

Supervisory teams from the Federal Reserve and other federal banking agencies have collected extensive data from LBOs to ascertain the effectiveness of their existing incentive compensation practices and identify any shortcomings relative to the proposed compensation guidance. These horizontal reviews concluded recently, with the key findings shared amongst the federal agencies and LBOs. Some notable findings include the following:

Institutions need to enhance the compensation process used to identify which employees, either individually or as a group, can expose the institution to material risk.
Institutions have not fully captured the varying risks with their incentive compensation programs and have not consistently applied risk-sensitive methods to enough employees.
Institutions have initiated deferral arrangements to adjust risk; however, they have taken a “one size fits all” approach instead of amending these adjustments to the type or duration of institutional risk.
Institutions have not appropriately documented the use of discretion with incentive compensation arrangements.
Institutions have not implemented an adequate mechanism to gauge their success in balancing risk in compensation practices.

Some banking institutions have already revised their incentive compensation programs so that they are more risk-sensitive and meet the principles outlined in the final guidance. Other institutions have considerable work to conduct, especially in developing processes that effectively compare risk and reward. These changes are expected to occur throughout the remainder of this year and well into 2012.

Conclusion

Overall, most banking institutions recognize that a strong risk management environment is not enough to protect their institution from undue risk with incentive compensation practices. Accordingly, the federal agencies will continue to regularly review incentive compensation arrangements and related risk management, internal control, and corporate governance practices to promptly identify any deficiencies that may not comply with the final guidance.

A second phase of the horizontal review is under way, aimed at assessing compensation practices at the business line and/or unit levels. Completion of this firm-specific work will provide assurance that all supervisory issues have been reasonably identified and will aid in creating comprehensive supervisory guidance in evaluating incentive compensation programs.

If you have any questions about this article, please contact Supervising Examiner Ivy Washington at (215) 574-6642.

¹ Rule on Incentive-Based Compensation Arrangements, Federal Register, Vol. 75, No. 122, Friday, June 25, 2010, available online.
² www.mofo.com/files/Uploads/Images/Banking-Agency-Guidance-on-Sound-Incentive-Compensation-Policies.pdf.
³ www.fdic.gov/regulations/laws/rules/5000-5350.html.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.