Examiners are Carefully Scrutinizing Financial Institutions’ Compensation Arrangements

December 13, 2017

It has come to our attention that some examiners have recently been carefully scrutinizing financial institutions’ employee compensation arrangements. Although it now appears unlikely that the proposed Dodd-Frank rules on financial-institution incentive compensation (which only apply to institutions with at least $1 billion in total assets) will ever take effect, examiners still do take compensation, particularly executive compensation, into account as a part of the regular risk-management, internal controls, and corporate governance examination process. Given the recent scrutiny, it may be prudent to review your institution’s compensation arrangements in light of regulatory guidance on the subject.

In 2010, the FDIC and several other regulatory agencies published a final “Guidance on Sound Incentive Compensation Policies”, which is still the most instructive authority. To identify and prevent compensation policies that encourage employees to take inordinate amounts of risk in order to boost their compensation without adequate safeguards or oversight, it requires that all FDIC-supervised institutions apply certain principles in their employee compensation programs. The Guidance provides that, in assessing the general health of each organization, regulators will consider the extent to which “incentive compensation arrangements” are consistent with safety and soundness. “Incentive compensation” is defined as “that portion of an employee’s current or potential compensation that is tied to achievement of one or more specific metrics.” Examples of incentive compensation would include:

  • a bonus paid out upon the organization reaching certain revenue-growth benchmarks;
  • an annual bonus calculated based on fiscal year profits; or
  • stock options that vest upon the organization’s stock reaching a certain price.

The Guidance states that, in order to be consistent with safety and soundness, banks need to consider their incentive compensation programs carefully for “covered employees,” which include senior executives and any other employees who, individually or as part of a group, have the ability to expose the banking organization to material amounts of risk.  The Guidance suggests that incentive compensation arrangements that apply to these covered employees should:

  • provide employees incentives that appropriately balance risk and reward;
  • be compatible with effective controls and risk-management; and
  • be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The above considerations attempt to ensure that incentive compensation programs align with risk-based concerns. These principles are fairly abstract, but the FDIC does give some ideas of concrete actions institutions can take to ensure that their compensation policies will not be deemed inconsistent with safety and soundness.

Simple incentive compensation policies that do not take risk into account, such as awarding an executive an annual bonus upon reaching certain revenue growth benchmarks, do not comply with the standards set forth in the Guidance. However, adding some combination of the following strategies could bring such a policy into compliance:

  • Risk Adjustment Awards. The bonus is adjusted based on measures that take into account the risk the employee’s activities may pose to the organization rather than solely considering profit, revenue, growth, etc. Risk-based measures may be quantitative, or the size of a risk adjustment may be subject to the board of directors’ discretion based on their more general assessment.
  • Deferral of Payment. The actual payout of the bonus is deferred significantly beyond the end of the performance, and the amounts paid are adjusted for actual losses or other aspects of performance that are realized or become better known only during the deferral period.
  • Longer Performance Periods. The time period covered by the bonus policy performance measures is extended (for example, from one year to two or more years). Longer performance periods and deferral of payment are related in that both methods allow awards or payments to be made after some or all risk outcomes are realized or better known.
  • Reduced Sensitivity to Short-Term Performance. The bonus policy could reduce the rate at which the payout increases as short-term profits or other short-term performance measures increase, instead giving long-term measures more weight. This method reduces the influence of short-term incentives and allows for the sort of long-term, safety and soundness outlook the examiners seek.
  • Board Discretion and Oversight. The board of directors could be given the authority and the discretion to modify at least part of each bonus based on their assessment of the employee’s performance. The board could also be required to review the design and function of the bonus plan on a regular basis. 

The Guidance makes it clear that the “monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization, as well as its use of incentive compensation.” Therefore, while smaller institutions do not need incentive compensation programs as robust as larger organizations, even smaller institutions should probably incorporate some of the strategies outlined above.

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