Federal Banking Regulators Issue Final Guidance on Incentive Compensation

Legal Alerts

6.21.10

The Federal Reserve Board ("FRB"), the Office of the Comptroller of the Currency ("OCC"), the Office of Thrift Supervision ("OTS") and the Federal Deposit Insurance Corporation ("FDIC"), collectively, the "Agencies," today issued final guidance (the "Guidance") to ensure that in structuring incentive compensation arrangements, financial institutions take risk into account and ensure safe and sound banking practices. The proposed guidance was issued by the FRB last year, however, the OCC, OTS and FDIC have joined in issuing this final Guidance. Accordingly, the Guidance applies to all of the banking institutions supervised by these agencies, including national banks, state member banks, state non-member banks, savings associations, U.S. bank holding companies, savings and loan holding companies, the U.S. operations of foreign banks with a branch, agency, or commercial lending company in the U.S. and Edge and agreement corporations (collectively, "financial institutions").

Believing that unsound compensation packages in the financial industry were a contributing factor to the current financial crisis, the Agencies designed the Guidance to ensure that incentive compensation arrangements appropriately link rewards to longer-term performance and do not threaten the safety and soundness of the financial institution or create undue risks to the financial system. The Guidance is based on the following key principles and underlying considerations:

(1) Incentive compensation arrangements at financial institutions should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their institution to imprudent risk:

  • Financial Institutions 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.
  • The manner in which a financial institution 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 financial institutions.
  • Financial institutions 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 institutions.
  • Financial institutions should effectively communicate to employees the ways in which incentive compensation awards and payments will be reduced as risks increase.

(2) These arrangements should be compatible with effective controls and risk management:

  • Financial institutions 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 institution's processes for designing incentive compensation arrangements and assessing their effectiveness in restraining imprudent 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.
  • Financial institutions should monitor the performance of their incentive compensation arrangements and should revise the arrangements as needed if payments do not appropriately reflect risk.

(3) These arrangements should be supported by strong corporate governance, including active and effective oversight by the institution's board of directors:

  • The board of directors should monitor the performance, and regularly review the design and function, of incentive compensation arrangements.
  • The institution, composition, and resources of the board of directors should permit effective oversight of incentive compensation.
  • A financial institution's disclosure practices should support safe and sound incentive compensation arrangements.
  • Large financial institutions should follow a systematic approach to developing a compensation system that has balanced incentive compensation arrangements.

The Guidance will become effective as soon as it is published in the Federal Register, which should occur by next week and the Agencies will soon be examining institutions in regard to their incentive compensation arrangements.

The Agencies expect financial institutions to regularly review their incentive compensation arrangements for all executives and non-executive employees who, either individually or as part of a group, have the ability to expose the institution to material amounts of risk, as well as to regularly review the risk-management, control, and corporate governance processes related to these arrangements.

While some financial institutions have already begun to review their incentive compensation arrangements, all institutions should now be doing so in conformance with the Guidance. They should begin by identifying those employees who can expose the institution to material risk and who are compensated on an incentive basis. The incentive compensation arrangements should be reviewed to ensure that they are risk-sensitive, fully capture the risks involved, and disincentivize unacceptable risk-taking. The incentive arrangements should also be tailored to the type of employee, the type and duration of the risk and size and complexity of the institution.



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