Bankin’ Bits

The Board of Governors of the Federal Reserve System (the “Board”) recently issued proposed guidance regarding the incentive compensation policies of banking organizations (available here ). In recognition that one size does not fit all, the Board opted to center its guidance on three key principles, rather than implementing pay caps or prohibiting particular practices.

Of note, the Board chose to apply these principles to “employees,” which includes senior executives as well as other employees who, either individually or as part of a group, may expose the banking organization to material amounts of risk. The guidance made clear that the Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements for these employees and the risk management, control, and corporate governance processes related to these arrangements. Any deficiencies in these arrangements or processes that are inconsistent with safety and soundness should be addressed immediately.

These three principles and a brief summary of the Board’s explanation of how a banking organization implements each principle is provided below:

Principle 1:  Balanced Risk Taking.  Incentives should not encourage risk-taking beyond the institution’s ability to identify and manage overall risk.

• Banking organizations 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, in assessing whether incentive compensation arrangements are balanced.

• An unbalanced arrangement can be moved toward balance by adding or modifying features that cause the amounts ultimately received by employees to appropriately reflect risk and risk outcomes.  Suggested methods include risk adjustment of awards, deferral of payment, longer performance periods and reduced sensitivity to short-term performance.

• The manner in which a banking organization seeks to achieve balanced incentive compensation arrangements should be tailored to account for the differences between employees–including the substantial differences between senior executives and other employees–as well as between banking organizations.

• 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.

• Banking organizations should effectively communicate to employees the ways in which incentive compensation awards and payments will be reduced as risks increase.

Principle 2: Compatibility with Effective Controls and Risk Management.

• Banking organizations should have appropriate controls to ensure that their processes for achieving balanced compensation arrangements are followed and to maintain the integrity of their risk management and other functions.

• Appropriate personnel, including risk-management personnel, should have input into the organization’s processes for designing incentive compensation arrangements and assessing their effectiveness in restraining excessive risk-taking.

• Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified personnel and should avoid conflicts of interest.

• Banking organizations should monitor the performance of their incentive compensation arrangements and should revise the arrangements as needed if payments do not appropriately reflect risk.

Principle 3:  Effective and Active Corporate Governance.

• The board of directors of a banking organization should actively oversee incentive compensation arrangements.

• The board of directors should monitor the performance, and regularly review the design and function, of incentive compensation arrangements.

• The organization, composition, and resources of the board of directors should permit effective oversight of incentive compensation.

• A banking organization’s disclosure practices should support safe and sound incentive compensation arrangements.

• Identify employees who are eligible to receive incentive compensation and whose activities may expose the organization to material risks.