On October 22, 2009, the Federal Reserve Board (the "Board") issued supervisory guidance ("Proposed Guidance") designed to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of those organizations. The Proposed Guidance attempts to strengthen supervision of banking organizations. As Board Chairman Ben Bernanke stated, "[c]ompensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability." Although the Proposed Guidance is subject to comment until November 27, the Board expects banking organizations to immediately review their incentive compensation arrangements to ensure they do not encourage excessive risk-taking, and to immediately implement corrective programs if necessary to address deficiencies in arrangements that are inconsistent with safety and soundness.

The Board's proposal is in the form of a Proposed Guidance to better deal with differences among banking organizations and their varied approaches. Formal rules may be viewed as too constraining or too open-ended. The Proposed Guidance will apply to all banking organizations supervised by the Board, which includes U.S. bank holding companies, state member banks, Edge and Agreement corporations, and the U.S. operations of foreign banks with a branch, agency, or commercial lending company subsidiary in the United States. For such organizations, the Proposed Guidance will apply to incentive compensation arrangements for (i) senior executives and others responsible for oversight of the organization's firmwide activities or material business lines; (ii) individual employees, including non-executives, whose activities may expose the firm to material amounts of risk (such as traders with large positions); and (iii) groups of employees who, in the aggregate, may expose the firm to material amounts of risk, such as loan officers.

The Proposed Guidance is based on three principles. Those principles and their sub-components are the following:

  • Balanced Risk-Taking Incentives
    • 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.
    • The manner in which a banking organization seeks to achieve balanced incentive compensation arrangements should be tailored to account for the 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.
  • 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 organizations' 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.
  • Strong 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.
    • Large, complex banking organizations should follow a systemic approach to developing a compensation system that has balanced incentive compensation arrangements.

The Proposed Guidance includes two supervisory initiatives:

Large, Complex Banking Organizations. The first supervisory initiative is applicable to 28 large, complex banking organizations ("LCBOs"), which will review each firm's policies and practices to determine their consistency with the principles for risk-appropriate incentive compensation set forth in the Proposed Guidance. These firm-specific policies will be assessed in a special "horizontal review," by a multidisciplinary group comprised of staff with expertise in banking supervision, risk management, economics, finance, law, accounting and other areas as appropriate. This review will be an examination of practices at the 28 firms. Each LCBO will be expected to provide the Board with information and documentation clearly describing (i) the structure of the organization's current incentive compensation arrangements, (ii) the existing processes used by the organization to oversee these arrangements and help ensure that they do not encourage employees to take excessive risks, and (iii) the organization's plans for improving the risk-sensitivity of incentive compensation arrangements and related risk management, controls, and corporate governance practices.

Regional, Community, and other Banking Organizations. Board supervisors will also review compensation practices at regional, community, and other banking organizations not classified as LCBOs, as part of the regular, risk-focused examination process. These reviews will be tailored to reflect the scope and complexity of the organization's activities, and the prevalence and scope of its incentive compensation arrangements.

Supervisory findings will be included in the relevant reports of examination or inspection, and communicated to the organizations. These findings will also be incorporated into the banking organization's rating components and subcomponents relating to risk management, internal controls, and corporate governance under the relevant supervisory rating system, as well as the organization's overall supervisory rating.

In some cases, the Board may decide to take enforcement action against a banking organization if its incentive compensation arrangements or related risk management, control, or governance processes are deemed to represent a safety and soundness risk, and if the organization is viewed as not taking prompt and effective measures to correct any deficiencies.

The federal banking regulators have for a number of years had the power to regulate executive compensation under the safety and soundness standards in section 39 of the Federal Deposit Insurance Act (12 USC 1831p-1) and 12 CFR Part 30. The true test for this Proposed Guidance is what impact it will have on those institutions, particularly investment banks, that are now for the first time subject to the Board's jurisdiction. Also, whether the Proposed Guidance will be adopted by other regulatory authorities and to what extent it establishes a baseline for those operating outside the Board's jurisdiction.

Click here for the Board's Proposed Guidance.

If you have any questions or comments regarding this proposal, or if you need assistance in reviewing your incentive compensation plans, please contact one of the members of Reed Smith's executive compensation team.

This article is presented for informational purposes only and is not intended to constitute legal advice.