The Federal Reserve Board (the “FRB”) has issued proposed guidance for banking organizations regarding their executive incentive compensation policies. The goal is to ensure that the incentive compensation packages of banking organizations do not encourage excessive risk-taking. The proposed guidance provides the following three general principles, which should be true of all incentive compensation arrangements:
- Arrangements should provide employees with incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage risk;
- Arrangements should be compatible with effective controls and risk management; and
- Arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.
The term “incentive compensation” refers to that portion of an employee’s current or potential compensation that is tied to achievement of one or more specific metrics (e.g., a level of sales, revenue, or income). Incentive compensation does not include compensation that is awarded solely for, and the payment of which is tied to, continued employment (e.g., salary).
The guidance applies to incentive compensation arrangements for:
- Senior executives and others who are responsible for oversight of the organization’s firm-wide activities or material business lines;
- Individual employees, including non-executive employees, whose activities may expose the firm to material amounts of risk (for example, traders with large position limits relative to the firm’s overall risk tolerance); and
- Groups of employees who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, may expose the firm to material amounts of risk (for example, loan officers who, as a group, originate loans that account for a material amount of the organization’s credit risk).
Interestingly, the preamble to the proposed guidance noted that some have suggested that one or more formulaic limits be adopted for some or all banking organizations, and, in particular, have suggested consideration of an approach in which at least 60 percent of all incentive compensation received by senior executives of all large, complex banking organizations be deferred and at least 50 percent of incentive compensation be paid in the form of stock, options, or other equity-linked instruments. The FRB did not adopt these suggestions in the proposed guidance, but asked for comments on the proposed guidance in general, and specifically with respect to these suggestions. The suggestion to defer receipt of performance bonuses is consistent with recent statements by Special Master for TARP Executive Compensation, Kenneth R. Feinberg, who suggests that executives should provide for their retirements with wealth based on performance while they are employed, rather than being guaranteed substantial retirement benefits beyond those provided to everyday workers. This appears to be a departure from previously negative views and proposed limits on nonqualified deferred compensation, at least when it is performance based.
The FRB also announced that it is commencing two supervisory initiatives. The first initiative, applicable to 28 large, complex banking organizations, will implement review of each firm’s policies and practices to determine their consistency with the principles for risk-appropriate incentive compensation set forth in the proposal. Under the second initiative, supervisors will review compensation practices at regional, community, and other banking organizations not classified as large and complex as part of the regular, risk-focused examination process.
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