[Federal Register Volume 74, Number 206 (Tuesday, October 27, 2009)]
[Notices]
[Pages 55227-55238]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-25766]
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FEDERAL RESERVE SYSTEM
[Docket No. OP-1374]
Proposed Guidance on Sound Incentive Compensation Policies
AGENCY: Board of Governors of the Federal Reserve System (Board).
ACTION: Proposed guidance with request for public comment.
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SUMMARY: The Board is requesting comment on proposed guidance (the
``guidance'') designed to help ensure that incentive compensation
policies at banking organizations do not encourage excessive risk-
taking and are consistent with the safety and soundness of the
organization. The Federal Reserve also is commencing two supervisory
initiatives to spur progress by the banking industry in the development
and implementation of sound incentive compensation arrangements,
identify emerging best practices, and advance the state of practice
more generally in the banking industry. The Federal Reserve expects all
banking organizations to evaluate their incentive compensation
arrangements and related risk management, control, and corporate
governance processes and immediately address deficiencies in these
arrangements or processes that are inconsistent with safety and
soundness.
DATES: Comments must be submitted on or before November 27, 2009.
ADDRESSES: The Board will review all of the comments submitted. Please
consider submitting your comments by e-mail or fax since paper mail in
the Washington DC area and at the Board is subject to delay. You may
submit comments, identified by Docket No. OP-1374, by any of the
following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected]. Include the
docket number in the subject line of the message.
FAX: 202/452-3819 or 202/452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at http://
www.federalreserve.gov/generalinfo/
[[Page 55228]]
foia/ProposedRegs.cfm as submitted, unless modified for technical
reasons. Accordingly, your comments will not be edited to remove any
identifying or contact information. Public comments may also be viewed
in electronic or paper form in Room MP-500 of the Board's Martin
Building (20th and C Streets, NW.,) between 9 a.m. and 5 p.m. on
weekdays.
FOR FURTHER INFORMATION CONTACT: Barbara J. Bouchard, Associate
Director, (202) 452-3072, William F. Treacy, Adviser, (202) 452-3859,
Robert Motyka, Senior Project Manager, (202) 452-5231, Division of
Banking Supervision and Regulation; Mark S. Carey, Adviser, (202) 452-
2784, Division of International Finance; or Kieran J. Fallon, Assistant
General Counsel, (202) 452-5270, or Michael W. Waldron, Counsel, (202)
452-2798, Legal Division. For users of Telecommunications Device for
the Deaf (``TDD'') only, contact (202) 263-4869.
SUPPLEMENTARY INFORMATION:
I. Background
Incentive compensation practices in the financial services industry
were one of many factors contributing to the financial crisis that
began in 2007. Banking organizations too often rewarded employees for
increasing the firm's short-term revenue or profit without adequate
recognition of the risks the employees' activities posed for the firm.
Importantly, problematic compensation practices were not limited to the
most senior executives at financial firms. Compensation practices can
incent employees at various levels of a banking organization, either
individually or as a group, to undertake imprudent risks that can
significantly and adversely affect the risk profile of the firm.
Supervisory attention and action is necessary to address the
potential for incentive compensation arrangements to encourage
employees to take excessive risks on behalf of their organization.
Shareholders of a banking organization cannot directly control the day-
to-day operations of the firm--especially a large and complex firm--and
must rely on the firm's management to do so, subject to direction and
oversight by shareholder-elected boards of directors. Incentive
compensation arrangements are one way that firms can encourage managers
and other employees to take actions that are consistent with the
interests of shareholders by appropriately rewarding behavior that
increases the organization's revenue, profits, or other measures of
performance. However, flawed compensation programs can incentivize
employees to take additional risk beyond the firm's tolerance for, or
ability to manage, risk in order to increase the employees' personal
compensation. Shareholders have an interest in ensuring that incentive
compensation arrangements do not encourage employees to take risks
beyond the risk tolerance of shareholders.
Aligning the interests of shareholders and employees, however, is
not always sufficient to protect the safety and soundness of a banking
organization. Because of the protections offered by the federal safety
net, shareholders of a banking organization in some cases may be
willing to tolerate a degree of risk that is inconsistent with the
organization's safety and soundness. Thus, a review of incentive
compensation arrangements and related corporate governance practices to
ensure that they are effective from the standpoint of shareholders is
not sufficient to ensure they adequately protect the safety and
soundness of the organization.
In addition, supervisors can provide a common prudential foundation
for incentive compensation arrangements across banking organizations
and promote the overall movement of the industry toward better
practices. Even if the owners or managers of an individual firm do not
like the way compensation is structured at their firm, they may be
unwilling to make unilateral changes because doing so might mean losing
valuable employees and business to other firms. Supervisory action can
play a critical role in addressing this ``first mover'' problem that
may make it difficult for individual firms to act alone in addressing
misaligned incentives. Through their actions, supervisors can help to
better align the interests of managers and other employees with the
long-term health of the organization, and also reduce firms' concerns
that making prudent modifications to their incentive compensation
arrangements might have adverse competitive consequences.
II. Federal Reserve Guidance
The Federal Reserve has developed the attached guidance to help
protect the safety and soundness of banking organizations and promote
the prompt improvement of incentive compensation practices throughout
the banking industry.\1\ The guidance is based on three key principles
that are designed to ensure that incentive compensation arrangements at
a banking organization do not encourage employees to take excessive
risks. These principles provide that incentive compensation
arrangements at a banking organization should--
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\1\ As used in the guidance, the term ``banking organization''
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.
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Provide employees incentives that do not encourage
excessive risk-taking beyond the organization's ability to effectively
identify and manage risk;
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.
These principles, and the types of policies, procedures, and
systems that banking organizations should have to help ensure
compliance with these principles, are discussed in more detail in the
attached proposed guidance. These principles and the guidance are
consistent with the Principles for Sound Compensation Practices adopted
by the Financial Stability Board (FSB) in April 2009, as well as the
Implementation Standards for those principles issued by the FSB in
September 2009.
Because incentive compensation arrangements for executive and non-
executive employees may pose safety and soundness risks if not properly
structured, the proposed guidance applies to senior executives as well
as other employees who, either individually or as part of a group, may
expose the relevant banking organization to material amounts of risk.
In addition, implementation of the guidance by a banking organization
should be appropriate in light of the scope and complexity of the
organization's activities, as well as the prevalence and scope of its
incentive compensation arrangements. Thus, for example, the reviews,
policies, procedures, and systems implemented by a small banking
organization that uses incentive compensation arrangements on a limited
basis will be substantially less extensive, formalized, and detailed
than those at large, complex banking organization that uses incentive
compensation arrangements extensively.
The Board invites comment on all aspects of the guidance. In
particular, are the three core principles described in the guidance
appropriate and sufficient to help ensure that incentive compensation
arrangements do not threaten the safety and soundness of banking
organizations? Should
[[Page 55229]]
additional or different principles be included to achieve this goal? To
what extent are the current incentive compensation arrangements of
banking organizations consistent with the principles set forth in the
guidance and are there material legal, regulatory, or other impediments
to the prompt implementation of incentive compensation arrangements and
related processes that would be consistent with these principles?
In addition, 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. Would such formulaic
limits on determining and paying incentive compensation likely promote
the long-term safety and soundness of banking organizations generally
if applied to certain types or classes of executive or non-executive
employees across all or certain types of banking organizations? If so,
what are those classes of executives, employees and institutions, and
what formulaic limits would be most effective? Moreover, would market
forces or practices in the broader financial services industry, such as
the use of ``golden parachute'' or ``golden handshake'' arrangements to
retain or attract employees, present challenges for banking
organizations in developing and maintaining balanced incentive
compensation arrangements? If so, what types of statutory, regulatory,
or private-sector actions might help mitigate these challenges?
Further, the Board seeks comment on whether the proposed guidance
would impose undue burdens on, or have unintended consequences for,
banking organizations and, particularly, regional and small
organizations, and whether there are ways such potential burdens or
consequences could be addressed in a manner consistent with safety and
soundness. Also, are there types of incentive compensation plans, such
as firm-wide profit sharing plans that provide for distributions in a
manner that is not materially linked to the performance of specific
employees or groups of employees, that could and should be exempted
from, or treated differently under, the guidance because they are
unlikely to affect the risk-taking incentives of all, or a significant
number of, employees? If so, what are the features of these plans and
the types of employees for which they are unlikely to affect risk-
taking behavior?
III. Federal Reserve Supervisory Initiatives
The Federal Reserve expects all banking organizations to evaluate
their incentive compensation arrangements and related risk management,
control, and corporate governance processes and immediately address
deficiencies in these arrangements or processes that are inconsistent
with safety and soundness. Banking organizations are responsible for
ensuring that their incentive compensation arrangements are consistent
with the principles described in the guidance, do not encourage
excessive risk-taking, and do not pose a threat to the safety and
soundness of the organization.
The Federal Reserve is committed to moving the banking industry
forward to incorporate the principles described in the guidance into
incentive compensation practices. Accordingly, in addition to proposing
guidance, the Federal Reserve is commencing the following two
supervisory initiatives to spur and monitor the industry's progress
towards the implementation of safe and sound incentive compensation
arrangements, identify emerging best practices, and advance the state
of practice more generally in the industry:
A special horizontal review of incentive compensation
practices at large complex banking organizations (LCBOs); and
A review of incentive compensation practices at other
banking organizations as part of the risk-focused examination process
for these organizations.
LCBOs warrant special supervisory attention because they are
significant users of incentive compensation arrangements and because
the adverse effects of flawed approaches at these institutions are more
likely to have adverse effects on the broader financial system.\2\ As
part of the horizontal review of these firms, each LCBO will be
expected to provide the Federal Reserve information and documentation
that clearly describes the organization's current incentive
compensation practices and its plans (including timetables) for
improving these practices.
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\2\ An important aspect of the Federal Reserve's consolidated
supervision programs for bank holding companies and the combined
U.S. operations of foreign banking organizations is the assessment
and evaluation of practices across groups of organizations with
similar characteristics and risk profiles. LCBOs are characterized
by the scope and complexity of their domestic and international
operations; their participation in large volume payment and
settlement systems; the extent of their custody operations and
fiduciary activities; and the complexity of their regulatory
structures, both domestically and in foreign jurisdictions. To be
designated as an LCBO, a banking organization must meet specified
criteria to be considered a significant participant in at least one
key financial market. See SR letter 08-9, Consolidated Supervision
of Bank Holding Companies and the Combined U.S. Operations of
Foreign Banking Organization (Oct. 16, 2008).
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The horizontal review of LCBOs will be led by Board staff, working
with relevant Reserve Bank supervisors, and will draw on a
multidisciplinary group comprised of staff with expertise in banking
supervision, risk management, economics, finance, law, accounting, and
other areas as appropriate. This multidisciplinary team also will have
access to information and analysis developed as part of the reviews of
other banking organizations, and will serve as a resource for
supervisory staff across the System on incentive compensation matters.
The Federal Reserve will work closely with each LCBO to ensure that
its plans are likely to result in the establishment and maintenance of
incentive compensation arrangements that do not encourage excessive
risk-taking. The Federal Reserve also will supervise these
organizations to ensure that these plans are fully implemented in a
timely manner.
In the second initiative, the Federal Reserve will review incentive
compensation arrangements at non-LCBO banking organizations as part of
risk management reviews during the regular, risk-focused examination
process. As with other aspects of the examination process, these
reviews will be tailored to reflect the scope and complexity of the
organization's activities, as well as the prevalence and scope of the
organization's incentive compensation arrangements.\3\
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\3\ Similarly, for foreign banking organizations, the management
of U.S. operations will be assessed with regard to the consistency
of incentive compensation arrangements and related processes with
the principles set forth in this guidance, taking into account the
size and complexity of U.S. operations. See SR letter 08-9,
Consolidated Supervision of Bank Holding Companies and the Combined
U.S. Operations of Foreign Banking Organizations (Oct. 16, 2008).
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For LCBOs and other organizations, supervisory findings will be
included in the relevant report of examination or inspection,
communicated to the organization, and incorporated, as appropriate,
into the organization's supervisory ratings. The Federal Reserve in
appropriate circumstances may take enforcement action against a banking
organization if its incentive compensation arrangements or related risk
management, control, or governance processes pose a risk to the safety
and soundness of the organization and the organization is not taking
prompt and
[[Page 55230]]
effective measures to correct the deficiencies. Where appropriate, such
an action may require an organization to develop a corrective action
plan that is acceptable to the Federal Reserve to rectify deficiencies
in its incentive compensation arrangements or related processes.
Additional information concerning these supervisory initiatives is
provided in the guidance. Effective and balanced incentive compensation
practices are likely to evolve significantly in the coming years,
spurred by the efforts of banking organizations, supervisors, and other
stakeholders. The Federal Reserve will review and update the guidance
as appropriate to incorporate best practices that emerge from these
efforts. In addition, in order to monitor and encourage improvements,
Federal Reserve staff will prepare a report on trends and developments
in compensation practices at banking organizations after the conclusion
of 2010.
IV. Other Matters
In accordance with the Paperwork Reduction Act (PRA) of 1995 (44
U.S.C. 3506; 5 CFR Part 1320 Appendix A.1), the Board reviewed the
proposed guidance under the authority delegated to the Board by the
Office of Management and Budget (OMB). The Board has determined that
certain aspects of the proposed guidance may constitute a collection of
information. In particular, these aspects are the provisions that state
a banking organization should (i) have policies and procedures that
identify and describe the role(s) of the personnel and units authorized
to be involved in incentive compensation arrangements, identify the
source of significant risk-related inputs, establish appropriate
controls governing these inputs to help ensure their integrity, and
identify the individual(s) and unit(s) whose approval is necessary for
the establishment or modification of incentive compensation
arrangements; (ii) create and maintain sufficient documentation to
permit an audit of the organization's processes for incentive
compensation arrangements; (iii) have any material exceptions or
adjustments to the incentive compensation arrangements established for
senior executives approved and documented by its board of directors;
and (iv) have its board of directors receive and review, on an annual
or more frequent basis, an assessment by management of the
effectiveness of the design and operation of the organization's
incentive compensation system in providing risk-taking incentives that
are consistent with the organization's safety and soundness. The
Federal Reserve estimates that the above-described information
collections included in the proposed guidance would take respondents,
on average, 40 hours each year. Any changes to the Federal Reserve's
regulatory reporting forms that may be made in the future to collect
information related to incentive compensation arrangements would be
addressed in a separate Federal Register notice. The Board may not
conduct or sponsor, and an organization is not required to respond to,
an information collection unless the information collection displays a
currently valid OMB control number.
For purposes of the PRA, this information collection will be titled
Recordkeeping Provisions Associated with the Incentive Compensation
Guidance. The agency form number for the collection is FR 4027. The
agency control number for this new collection will be assigned by OMB.
This information collection is authorized pursuant to sections
11(a), 11(i), 25, and 25A of the Federal Reserve Act (12 U.S.C. 248(a),
248(i), 602, and 611), section 5 of the Bank Holding Company Act (12
U.S.C. 1844), and section 7(c) of the International Banking Act (12
U.S.C. 3105(c)). The Board expects to review the policies and
procedures for incentive compensation arrangements as part of the
Board's supervisory process. To the extent the Board collects
information during an examination of a banking organization,
confidential treatment may be afforded to the records under exemption 8
of the Freedom of Information Act (FOIA), 5 U.S.C. 552(b)(8).
The frequency of information collection is estimated to be annual.
Respondents are banking organizations as defined in the guidance, which
total 6,889. The estimated annual reporting hours are 275,560.
Comments on the collection of information should be sent to
Michelle Shore, Federal Reserve Board Clearance Officer, Division of
Research and Statistics, Mail Stop 95-A, Board of Governors of the
Federal Reserve System, Washington, DC 20551, with copies of such
comments sent to the Office of Management and Budget, Paperwork
Reduction Project (Docket No. OP-1374), Washington, DC 20503.
Comments are invited on:
(1) Whether the proposed collection of information is necessary for
the proper performance of the Federal Reserve's functions; including
whether the information has practical utility;
(2) The accuracy of the Federal Reserve's estimate of the burden of
the proposed information collection, including the cost of compliance;
(3) Ways to enhance the quality, utility, and clarity of the
information to be collected; and
(4) Ways to minimize the burden of information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology.
While the guidance is not being adopted as a rule, the Board also
has considered the potential impact of the proposed guidance on small
banking organizations in accordance with the Regulatory Flexibility Act
(5 U.S.C. 603(b)). For the reasons discussed in the ``Supplementary
Information'' above, the Board believes that issuance of the proposed
guidance is needed to help ensure that incentive compensation
arrangements do not pose a threat to the safety and soundness of
banking organizations, including small banking organizations.
It is estimated that the proposed guidance, if adopted in final
form, would apply to 3002 small banking organizations (defined as
banking organizations with $175 million or less in total assets). See
13 CFR 121.201. The Board has focused the guidance on those employees
who have the ability, either individually or as part of a group, to
expose a banking organization to material amounts of risk. In addition,
the Board has sought to tailor the guidance and its supervisory
initiatives to account for the differences between large and small
banking organizations and has provided that, in conducting reviews of
small banking organizations as part of the regular examination process,
the Federal Reserve will take into account the scope and complexity of
the organization's activities, as well as the prevalence and scope of
its incentive compensation arrangements. In light of the foregoing, the
Board does not believe that the proposed guidance, if adopted in final
form, would have a significant economic impact on a substantial number
of small entities. As noted above, the Board specifically seeks comment
on whether the proposed guidance would impose undue burdens on, or have
unintended consequences for, small organizations and whether there are
ways such potential burdens or consequences could be addressed in a
manner consistent with safety and soundness.
V. Proposed Guidance
The text of the proposed guidance is as follows:
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I. Introduction
Incentive compensation practices in the financial industry were one
of many factors contributing to the financial crisis. Banking
organizations too often rewarded employees for increasing the firm's
revenue or short-term profit without adequate recognition of the risks
the employees' activities posed to the firm. These practices
exacerbated the risks and losses at a number of banking organizations
and resulted in the misalignment of the interests of employees with the
long-term well being and safety and soundness of their organizations.
This document provides guidance on sound compensation practices to
banking organizations supervised by the Federal Reserve.\1\ Alignment
of the incentives provided to employees with the interests of
shareholders of the organization often also furthers safety and
soundness. However, aligning those interests is not always sufficient
to address safety and soundness concerns. Because of the presence of
the federal safety net, shareholders of a banking organization in some
cases may be willing to tolerate a degree of risk that is inconsistent
with the organization's safety and soundness. Accordingly, the Federal
Reserve expects banking organizations to maintain incentive
compensation practices that are consistent with safety and soundness,
even when these practices go beyond those needed to align shareholder
and employee interests.
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\1\ As used in this guidance, the term ``banking organizations''
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 in the United
States.
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To be consistent with safety and soundness, incentive compensation
arrangements at a banking organization should:
Provide employees incentives that do not encourage
excessive risk-taking beyond the organization's ability to effectively
identify and manage risk;
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.
These principles, and the types of policies, procedures, and
systems that banking organizations should have to help ensure
compliance with these principles, are discussed in Part II of this
guidance.
The Federal Reserve expects all banking organizations to evaluate
their incentive compensation arrangements for executive and non-
executive employees who, either individually or as part of a group,
have the ability to expose the firm to material amounts of risk and the
risk management, control, and corporate governance processes related to
these arrangements. Banking organizations should immediately address
deficiencies in these arrangements or processes that are inconsistent
with safety and soundness. Banking organizations are responsible for
ensuring that their incentive compensation arrangements are consistent
with the principles described in this guidance and do not encourage
excessive risk-taking or pose a threat to the safety and soundness of
the organization.\2\
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\2\ In this guidance, 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).
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Designing and implementing compensation arrangements that properly
incent employees to pursue the organization's long-term well being and
that do not encourage excessive risk-taking is a complex task and one
that requires the commitment of adequate resources. The Federal Reserve
recognizes that incentive compensation arrangements often seek to serve
several important and worthy objectives.\3\ It is important that
incentive compensation arrangements be properly structured for all
employees at a banking organization, including non-executive employees,
who have the ability, either individually or as a group, to take
material risks. The analysis and methods for making incentive
compensation arrangements take appropriate account of risk also should
be tailored to the business model, risk tolerance, size, and complexity
of each firm. Thus, achieving and sustaining adherence to sound
practices will present challenges.
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\3\ For example, incentive compensation arrangements may be used
to help attract skilled staff, promote better firm and employee
performance, promote employee retention, provide retirement security
to employees, or provide a closer tie between compensation expenses
and revenue on a firm-wide basis.
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While the issues are complex, the Federal Reserve is committed to
moving banking organizations forward to incorporate the principles
described in this guidance into incentive compensation practices. To
help accomplish this, the Federal Reserve is commencing two supervisory
initiatives:
A special horizontal review of incentive compensation
practices at large, complex banking organizations; and
A review of incentive compensation practices at other
banking organizations as part of the regular risk-focused examination
process for these organizations.
These initiatives, which are described in greater detail in Part III of
this guidance, are designed to spur and monitor progress toward safe
and sound incentive compensation arrangements, identify emerging best
practices, and advance the state of practice more generally in the
industry.
The Federal Reserve expects to commence promptly the horizontal
review of large, complex banking organizations (LCBOs). As part of this
review, each LCBO will be expected to provide the Federal Reserve with,
among other things, the organization's plans, including relevant
timetables, for improving the risk-sensitivity of its incentive
compensation arrangements and related risk management, controls, and
corporate governance practices. The Federal Reserve will work with
these organizations as necessary through the supervisory process to
ensure that they produce plans that will promptly result in incentive
compensation arrangements that are consistent with safety and
soundness, and will supervise the organizations to ensure that these
plans are fully implemented in an expeditious manner.
To promote consistency and to leverage the resources available at
the Federal Reserve, the horizontal review of LCBOs will be led by
Board staff, working with Reserve Bank supervisors responsible for
LCBOs. This coordinating group will be comprised of staff with
expertise in banking supervision, risk management, economics, finance,
law, accounting, and other areas as appropriate. This multidisciplinary
team also will have access to information and analysis developed as
part of the reviews of other banking organizations and will serve as a
resource for supervisory staff across the System on incentive
compensation matters.
As part of the supervisory process for all banking organizations,
the Federal Reserve will assess the potential for incentive
compensation arrangements to encourage excessive risk-taking, the
actions an organization has taken or proposes to take to correct
deficiencies, and the adequacy of the organization's compensation-
related risk management, control, and corporate governance processes.
Reviews at regional and community banking organizations will be
conducted as part of the evaluation
[[Page 55232]]
the firm's risk management, internal controls, and corporate governance
during the regular examination process.\4\ These reviews will be
tailored to reflect the scope and complexity of the organization's
activities, as well as the prevalence and scope of its incentive
compensation arrangements. In this regard, the compensation-related
policies, procedures, and systems at a small banking organization that
uses incentive compensation arrangements on a limited basis will be
substantially less extensive, formalized, and detailed than those of an
LCBO that uses incentive compensation arrangements extensively.
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\4\ Thus, for example, reviews at bank holding companies with
total consolidated assets of $5 billion or less will be conducted in
accordance with the risk-focused supervision program for these
organizations. See SR letter 02-1, Revisions to Bank Holding Company
Supervision Procedures for Organizations with Total Consolidated
Assets of $5 Billion or Less (Jan. 9, 2002).
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Supervisory findings for all types of organizations will be
included in the relevant report of examination or inspection and
communicated to the organization.\5\ In addition, these findings will
be incorporated, as appropriate, into the organization's rating
component(s) and subcomponent(s) relating to risk management, internal
controls, and corporate governance under the relevant supervisory
rating system, as well as the organization's overall supervisory
rating.\6\
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\5\ See SR letter 08-1, Communication of Examination/Inspection
Findings (Jan. 24, 2008).
\6\ For example, supervisory findings for bank holding companies
in the areas discussed in this guidance should be incorporated into
the assessment of the appropriate subcomponent(s) for the BHC's
``Risk Management'' rating component in the RFI (Risk Management,
Financial Condition, and Impact) rating. See SR letter 04-18, Bank
Holding Company Rating System (Dec. 6, 2004).
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In appropriate circumstances, the Federal Reserve may take
enforcement action against a banking organization if its incentive
compensation arrangements or related risk management, control, or
governance processes pose a risk to the safety and soundness of the
organization and the organization is not taking prompt and effective
measures to correct the deficiencies. For example, the Federal Reserve
may take an enforcement action it considers appropriate against an LCBO
if the organization fails to develop, submit, or adhere to an effective
plan designed to ensure that the organization's incentive compensation
arrangements do not encourage excessive risk-taking and are consistent
with principles of safety and soundness. As provided under section 8 of
the Federal Deposit Insurance Act (12 U.S.C. 1818), an enforcement
action may, among other things, require an organization to develop a
corrective action plan that is acceptable to the Federal Reserve to
rectify deficiencies in its incentive compensation arrangements or
related processes. Where warranted, the Federal Reserve may require the
organization to take affirmative action to correct or remedy
deficiencies related to the organization's incentive compensation
practices until its corrective action plan is implemented.
Effective and balanced incentive compensation practices are likely
to evolve significantly in the coming years, spurred by the efforts of
banking organizations, supervisors, and other stakeholders. The Federal
Reserve will review and update this guidance as appropriate to
incorporate best practices that emerge from these efforts.
II. Principles of a Sound Incentive Compensation System
The incentive compensation arrangements and related policies and
procedures of banking organizations should be consistent with
principles of safety and soundness.\7\ This guidance is intended to
assist banking organizations in designing and implementing incentive
compensation arrangements and related policies and procedures that
effectively take account of potential risks and risk outcomes.\8\
Because incentive compensation arrangements for executive and non-
executive personnel who have the ability to expose a banking
organization to material amounts of risk may, if not properly
structured, pose a threat to the organization's safety and soundness,
this guidance applies to incentive compensation arrangements for:
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\7\ In the case of the U.S. operations of foreign banks, the
organization's policies, including management, review, and approval
requirements, should be coordinated with the foreign bank's group-
wide policies developed in accordance with the rules of the foreign
bank's home country supervisor and should be consistent with the
foreign bank's overall corporate and management structure as well as
its framework for risk management and internal controls.
\8\ This guidance and the principles reflected herein are
consistent with the Principles for Sound Compensation Practices
issued by the Financial Stability Board (FSB) in April 2009, and
with the FSB's Implementation Standards for those principles, issued
in September 2009.
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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 (e.g.,
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, even if no individual
employee is likely to expose the firm to material risk (e.g., loan
officers who, as a group, originate loans that account for a material
amount of the organization's credit risk).
For ease of reference, these executive and non-executive employees
are collectively referred to as ``employees.'' Depending on the facts
and circumstances of the individual organization, jobs and job families
that are outside the scope of this guidance because they do not have
the ability to expose the organization to material risks may include,
for example, tellers, bookkeepers, couriers, or data processing
personnel.
Principle 1: Balanced Risk-Taking Incentives
Incentive compensation arrangements should balance risk and
financial results in a manner that does not provide employees
incentives to take excessive risks on behalf of the banking
organization.
Incentive compensation arrangements typically attempt to encourage
actions that result in greater revenue or profit for the firm. However,
short-run revenue or profit can often diverge sharply from actual long-
run profit because risk outcomes may become clear only over time.
Activities that carry higher risk typically yield higher short-term
revenue, and an employee who is given incentives to increase short-term
revenue or profit, without regard to risk, will naturally be attracted
to opportunities to take more risk.
An incentive compensation arrangement is balanced when the amounts
paid to an employee appropriately take into account the risks, as well
as the financial benefits, from the employee's activities and the
impact of those activities on the organization's safety and soundness.
As an example, under a balanced incentive compensation arrangement, two
employees who generate the same amount of short-term revenue or profit
for an organization should not receive the same amount of incentive
compensation if the risks taken by the employees in generating that
revenue or profit differ materially. The employee whose activities
create materially larger risks for the organization should receive less
than the other employee, all else being equal.
[[Page 55233]]
The performance measures used in an incentive compensation
arrangement have an important effect on the incentives provided
employees and, thus, the potential for the arrangement to encourage
excessive risk-taking. For example, if an employee's incentive
compensation payments are closely tied to short-term revenue or profit
of business generated by the employee, without any adjustments for the
risks associated with the associated business, the potential for the
arrangement to encourage excessive risk-taking may be quite strong. On
the other hand, if an employee's incentive compensation payments are
determined based on performance measures that are only distantly linked
to the employee's activities (e.g., for most employees, firm-wide
profit), the potential for the arrangement to encourage the employee to
take excessive risks on behalf of the organization may be weak.\9\
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\9\ Similarly, the size of an employee's incentive compensation
payments in relation to the employee's total compensation package
may affect the likelihood that the incentive compensation
arrangement may induce the employee to take excessive risks. For
example, where incentive compensation is a small portion of
employees' total compensation--as is the case for many employees at
regional and community banking organizations--such compensation is
less likely to affect the employees' risk-taking behavior than when
incentive compensation represents a large percentage, or even a
majority, of the employees' total compensation.
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Incentive compensation arrangements should not only be balanced in
design, they also should be implemented so that actual payments vary
based on risks or risk outcomes. If, for example, employees are paid
substantially all of their potential incentive compensation even when
risk or risk outcomes are materially worse than expected, employees
have less incentive to avoid excessively risky activities.
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.
The activities of employees may create a wide range of risks for a
banking organization, including credit, market, liquidity, operational,
legal, compliance, and reputational risks. Some of these risks may be
realized in the short term, while others may become apparent only over
the long term. For example, future revenues that are booked as current
income may not materialize, and short-term profit-and-loss measures may
not appropriately reflect differences in the risks associated with the
revenue derived from different activities (e.g., the higher credit or
compliance risk associated with subprime loans versus prime loans).\10\
In addition, some risks may have a low probability of being realized,
but would have highly adverse effects on the organization if they were
to be realized (``bad-tail risks''). While shareholders may have less
incentive to guard against bad-tail risks because of their infrequency
and the existence of the federal safety net, these risks warrant
special attention from a safety-and-soundness perspective given the
threat they pose to the organization's solvency and the federal safety
net.
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\10\ Importantly, the time horizon over which a risk outcome may
be realized is not necessarily the same as the stated maturity of an
exposure. For example, the ongoing reinvestment of funds by a cash
management unit in commercial paper with a one-day maturity not only
exposes the organization to one-day credit risk, but also exposes
the organization to liquidity risk that may be realized only
infrequently.
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Banking organizations should consider the full range of current and
potential risks associated with the activities of employees, including
the cost and amount of capital and liquidity needed to support those
risks, in developing balanced incentive compensation arrangements.
Reliable quantitative measures of risk and risk outcomes
(``quantitative measures''), where available, may be particularly
useful in developing balanced compensation arrangements and in
assessing the extent to which arrangements are properly balanced.
However, reliable quantitative measures may not be available for all
types of risk or for all activities, and their utility for use in
compensation arrangements varies across business lines and employees.
The absence of reliable quantitative measures for certain types of
risks or outcomes does not mean that banking organizations should
ignore such risks or outcomes for purposes of assessing whether an
incentive compensation arrangement achieves balance. For example, while
reliable quantitative measures may not exist for many bad-tail risks,
it is important that such risks be considered given their potential
effect on safety and soundness. As in other risk-management areas,
banking organizations should rely on informed judgments to estimate
risks and risk outcomes in the absence of reliable quantitative risk
measures.\11\
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\11\ Where judgment plays a significant role in the design or
operation of an incentive compensation arrangement, strong internal
controls and ex post monitoring of incentive compensation payments
relative to actual risk outcomes are particularly important to help
ensure that the arrangements as implemented do not encourage
excessive risk-taking.
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Banking organizations, and particularly large, complex
organizations, should consider using scenario analysis to help assess
whether the features included in incentive compensation arrangements
are likely to achieve balance over time. Scenario analysis of incentive
compensation arrangements involves the evaluation of payments on a
forward-looking basis based on a range of performance levels, risk
outcomes, and the levels of risks taken. This type of analysis can help
an organization assess whether incentive compensation payments to an
employee are likely to be reduced appropriately as the risks to the
organization from the employee's activities increase.
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.
If an incentive compensation arrangement may encourage employees to
take excessive risks, the banking organization should modify the
arrangement as needed to ensure that it is consistent with safety and
soundness. Four methods currently are often used to make compensation
more sensitive to risk. These methods are:
[cir] Risk Adjustment of Awards: The amount of an incentive
compensation award for an employee is adjusted based on measures that
take into account the risk the employee's activities pose to the
organization. Such measures may be quantitative, or the size of a risk
adjustment may be set judgmentally, subject to appropriate oversight.
[cir] Deferral of Payment: The actual payout of an award to an
employee is delayed significantly beyond the end of the performance
period, and the amounts paid are adjusted for actual losses or other
aspects of performance that become clear only during the deferral
period.\12\ Deferred payouts may be altered according to risk outcomes
either formulaically or judgmentally, though extensive use of judgment
might make it more difficult to execute deferral arrangements in a
sufficiently predictable fashion to influence employee behavior. To be
most effective, the deferral period should be
[[Page 55234]]
sufficiently long to allow for the realization of a substantial portion
of the risks from employee activities, and the measures of loss should
be clearly explained to employees and closely tied to their activities
during the relevant performance period.
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\12\ The deferral of payment method is sometimes referred to in
the industry as a ``clawback.'' The term ``clawback'' also may refer
specifically to an arrangement under which an employee must return
incentive compensation payments previously received by the employee
(and not just deferred) if certain risk outcomes occur. Section 304
of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7243), which applies to
chief executive officers and chief financial officers of public
banking organizations, is an example of this more specific type of
``clawback'' requirement.
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[cir] Longer Performance Periods: The time period covered by the
performance measures used in determining an employee's award is
extended (for example, from one year to two 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.
[cir] Reduced Sensitivity to Short-Term Performance: The banking
organization reduces the rate at which awards increase as an employee
achieves higher levels of the relevant performance measure(s). Rather
than offsetting risk-taking incentives associated with the use of
short-term performance measures, this method reduces the magnitude of
such incentives.\13\
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\13\ Performance targets may have a material effect on risk-
taking incentives. Such targets may offer employees greater rewards
for increments of performance that are above the target or may
provide that awards will be granted only if a target is met or
exceeded. Employees may be particularly motivated to take excessive
risk in order to reach performance targets that are aggressive, but
potentially achievable.
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These methods for achieving balance are not exclusive, and
additional methods or variations may exist or be developed. Moreover,
each method has its own advantages and disadvantages. For example,
where reliable risk measures exist, risk adjustment of awards may be
more effective than deferral of payment in reducing incentives for
excessive risk-taking. This is because risk adjustment potentially can
take account of the full range and time horizon of risks, rather than
just those risk outcomes that occur or become evident during the
deferral period. On the other hand, deferral of payment may be more
effective than risk adjustment in mitigating incentives to take hard-
to-measure risks (such as the risks of new activities or products),
particularly if such risks are likely to be realized during the
deferral period. Accordingly, in some cases two or more methods may be
needed in combination for an incentive compensation arrangement to be
balanced. The greater the potential incentives an arrangement creates
for an employee to increase the risks borne by the organization, the
stronger the effect should be of the methods applied to achieve
balance.
Methods and practices for making compensation sensitive to risk-
taking are likely to evolve rapidly during the next few years, driven
in part by the efforts of supervisors and other stakeholders. A banking
organization should monitor developments in the field and should
incorporate new or emerging methods or practices that are likely to
improve the organization's safety and soundness into its incentive
compensation systems.
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.
Activities and risks may vary significantly both across banking
organizations and across employees within a particular banking
organization. For example, the risks associated with the activities of
one group of non-executive employees (e.g., loan originators) may
differ significantly from those of another group of non-executive
employees (e.g., spot foreign exchange traders). In addition, reliable
quantitative measures of risk and risk outcomes are unlikely to be
available for a banking organization as a whole, particularly a large
complex organization. This can make it difficult for banking
organizations to achieve balanced compensation arrangements for senior
executives who have responsibility for managing risks on a firm-wide
basis through use of the risk adjustment of award method.
Moreover, the payment of deferred incentive compensation in equity
(such as restricted stock of the organization) or equity-based
instruments (such as options to acquire the organization's stock) may
be effective in restraining the risk-taking incentives of senior
executives and other employees whose activities may have a material
effect on the overall financial performance of the firm. However,
equity-related deferred compensation may not be as effective in
restraining the incentives of lower-level employees (particularly at
large organizations) to take risks because such employees are unlikely
to believe that their actions will materially affect the organization's
stock price.
Banking organizations should take account of these differences when
constructing balanced compensation arrangements. For most banking
organizations, the use of a single, formulaic approach to making
employee incentive compensation arrangements appropriately risk-
sensitive is likely to provide at least some employees with incentives
to take excessive risks.\14\
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\14\ For example, spreading payouts of incentive compensation
awards over a three-year period may not be sufficient by itself to
balance the compensation arrangements of employees who may expose
the organization to substantial longer-term risks.
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Incentive compensation arrangements for senior executives at LCBOs
are likely to be better balanced if they involve deferral of a
substantial portion of the executives' incentive compensation over a
multi-year period in a way that reduces the amount received in the
event of poor performance, substantial use of multi-year performance
periods, or both. Similarly, the compensation arrangements for senior
executives at LCBOs are likely to be better balanced if a significant
portion of the incentive compensation of these executives is paid in
the form of equity-based instruments that vest over multiple years,
with the number of instruments ultimately received dependent on the
performance of the firm during the deferral period. The portion of the
incentive compensation of other employees that is deferred or paid in
the form of equity-based instruments should appropriately take into
account the level, nature, and duration of the risks that the
employees' activities create for the organization and the extent to
which those activities may materially affect the overall performance of
the firm and its stock price.
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.
Arrangements that provide for an employee (typically a senior
executive), upon departure from the organization or a change in control
of the organization, to receive large additional payments or the
accelerated payment of deferred amounts without regard to risk or risk
outcomes, can provide the employee significant incentives to engage in
undue risk-taking. Banking organizations should carefully review any
such existing or proposed arrangements (sometimes called ``golden
parachutes'') and the potential impact of such arrangements on the
organization's safety and soundness. A banking organization should
ensure that golden parachute arrangements do not encourage excessive
risk-taking in light of the other features of the employee's incentive
compensation arrangements.
Similarly, provisions that require an employee to forfeit deferred
incentive compensation payments upon departure from the organization
may weaken the
[[Page 55235]]
effectiveness of the deferral arrangement in achieving balance by
removing the employee's financial exposure to the risk outcomes of the
employee's activities at the firm. This weakening effect can be
particularly significant for senior executives or other skilled
individuals whose services are in high demand within the market. In
such circumstances, the departing employee often may be able to
negotiate a ``golden handshake'' arrangement with the employee's new
firm, which compensates the employee for some or all of the estimated,
non-risk-adjusted value of the deferred incentive compensation
forfeited by the employee upon departure from the organization. While a
banking organization may not be able to control the hiring practices of
other firms, it should consider whether golden handshake arrangements
are materially weakening the organization's efforts to constrain the
risk-taking incentives of employees and, if so, whether changes to the
organization's deferred compensation vesting policies or other aspects
of its incentive compensation arrangements should be made to ensure
that they do not encourage employees to take excessive risks while
employed by the organization.
Banking organizations should effectively communicate to
employees the ways in which incentive compensation awards and payments
will be reduced as risks increase.
In order for the risk-sensitive provisions of incentive
compensation arrangements to affect employee risk-taking behavior, the
organization's employees must understand that the amount of incentive
compensation that they may receive will vary based on the risk
associated with their activities. Accordingly, banking organizations
should ensure that the employees covered by an incentive compensation
arrangement are informed about the key ways in which risks are taken
into account in determining the amount of incentive compensation paid.
Where feasible, an organization's communications with employees should
include examples of how incentive compensation payments may be adjusted
to reflect projected or actual risk-outcomes. An organization's
communications should be tailored appropriately to reflect the
sophistication of the relevant audience(s).
Principle 2: Compatibility With Effective Controls and Risk Management
A banking organization's risk-management processes and internal
controls should reinforce and support the development and maintenance
of balanced incentive compensation arrangements.
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.
In order to increase their own compensation, employees may seek to
evade the processes established by a banking organization to achieve
balanced compensation arrangements. Similarly, an employee covered by
an incentive compensation arrangement may seek to influence the risk
measures or other information or judgments that are used to make the
employee's pay sensitive to risk in ways designed to increase the
employee's pay.
If successful, these actions may significantly weaken the
effectiveness of an organization's incentive compensation arrangements
in restricting excessive risk-taking. These actions can have a
particularly damaging effect on the safety and soundness of the
organization if they result in the weakening of risk measures,
information, or judgments that the organization uses for other risk
management, internal control, or financial purposes. In such cases, the
employee's actions may weaken not only the balance of the
organization's incentive compensation arrangements, but also the risk
management, internal controls, and other functions that are supposed to
act as a separate check on risk-taking.
To help prevent this damage from occurring, a banking organization
should have strong controls governing its process for designing,
implementing, and monitoring incentive compensation arrangements. For
example, an organization's policies and procedures should (i) identify
and describe the role(s) of the personnel, business units, and control
units authorized to be involved in the design, implementation, and
monitoring of incentive compensation arrangements; (ii) identify the
source of significant risk-related inputs into these processes and
establish appropriate controls governing the development and approval
of these inputs to help ensure their integrity; and (iii) identify the
individual(s) and control unit(s) whose approval is necessary for the
establishment of new incentive compensation arrangements or
modification of existing arrangements. Banking organizations also
should create and maintain sufficient documentation to permit an audit
of the organization's processes for establishing, modifying, and
monitoring incentive compensation arrangements.
A banking organization should conduct regular internal reviews to
ensure that its processes for achieving and maintaining balanced
incentive compensation arrangements are consistently followed. Such
reviews should be conducted by audit, compliance, or other personnel in
a manner consistent with the organization's overall framework for
compliance monitoring. An organization's internal audit department also
should separately conduct regular audits of the organization's
compliance with its established policies and controls relating to
incentive compensation arrangements. The results should be reported to
appropriate levels of management and, where appropriate, the
organization's board of directors. Reviews conducted by regional or
community banking organizations should be tailored to the management,
internal control, compliance, and audit framework for the organization,
as well as the scope and complexity of the organization's activities
and its use of incentive compensation arrangements.
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.
Developing balanced compensation arrangements and monitoring
arrangements to ensure they achieve balance over time requires an
understanding of the risks (including compliance risks) and potential
risk outcomes associated with the activities of the relevant employees.
Accordingly, banking organizations should have policies and procedures
that ensure that risk-management personnel have an appropriate role in
the organization's processes for designing incentive compensation
arrangements and for assessing their effectiveness in restraining
excessive risk-taking.\15\ Ways that risk managers might assist in
achieving balanced compensation arrangements include, but are not
limited to (i) reviewing the types of risks associated with the
activities of employees covered by an incentive compensation
arrangement; (ii) approving the risk measures used in risk adjustments
and performance measures, as well as measures of risk outcomes
[[Page 55236]]
used in deferred-payout arrangements; and (iii) analyzing risk-taking
and risk outcomes relative to incentive compensation payments.
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\15\ Involvement of risk-management personnel in the design and
monitoring of these arrangements also should help ensure that the
organization's risk-management functions can properly understand and
address the full range of risks facing the organization.
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Other functions within an organization, such as its control, human
resources, or finance functions, also play an important role in helping
ensure that incentive compensation arrangements are balanced. For
example, these functions may contribute to the design and review of
performance measures used in compensation arrangements or may supply
data used as part of these measures.
Compensation for employees in risk management and control
functions should be sufficient to attract and retain qualified
personnel and should avoid conflicts of interest.
The risk management and control personnel involved in the design
and oversight of incentive compensation arrangements should have
appropriate skills and experience needed to effectively fulfill their
roles, even when their efforts are challenged by employees seeking to
increase their incentive compensation in ways that are inconsistent
with sound risk management or internal controls. The compensation
arrangements for employees in risk management and control functions
thus should be sufficient to attract and retain qualified personnel
with appropriate experience and expertise in these fields. In addition,
to help preserve the independence of their perspectives, the incentive
compensation received by risk management and control personnel staff
should not be based predominately on the financial performance of the
business units that they review. Rather, the performance measures used
in the incentive compensation arrangements for these personnel should
be based primarily on the achievement of the objectives of their
functions (e.g., risk-adjusted performance or adherence to internal
controls).
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.
Banking organizations should track incentive compensation awards
and payments, risks taken, and actual risk outcomes to determine
whether incentive compensation payments to employees are reduced to
reflect adverse risk outcomes. Results should be reported to
appropriate levels of management, including where warranted, the board
of directors. A banking organization should take the results of such
monitoring into account in establishing or modifying incentive
compensation arrangements and in overseeing associated controls. If,
over time, incentive compensation paid by a banking organization does
not appropriately reflect risk outcomes, the organization should review
and revise its incentive compensation arrangements and related controls
to ensure that the arrangements, as designed and implemented, are
balanced and do not provide employees incentives to take excessive
risks.
Principle 3: Strong Corporate Governance
Banking organizations should have strong and effective corporate
governance to help ensure sound compensation practices.
The board of directors of a banking organization should
actively oversee incentive compensation arrangements.
The board of directors of an organization is ultimately responsible
for ensuring that the organization's incentive compensation
arrangements are appropriately balanced and do not jeopardize the
safety and soundness of the organization. Accordingly, the board of
directors should actively oversee the development and operation of a
banking organization's incentive compensation systems and related
control processes.\16\ For example, the board of directors should
review and approve the overall goals and purposes of the firm's
incentive compensation system. The board should provide clear direction
to management to ensure that its policies and procedures are carried
out in a manner that achieves balance and is consistent with safety and
soundness.
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\16\ As used in this guidance, the term ``board of directors''
is used to refer to the members of the board of directors who have
primary responsibility for overseeing the incentive compensation
system. Depending on the manner in which the board is organized, the
term may refer to the entire board of directors, a compensation
committee of the board, or another committee of the board that has
primary responsibility for overseeing the incentive compensation
system.
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In addition, the board of directors should ensure that the
compensation system--including performance measures and targets--for
business units and individual employees that can expose the firm to
large amounts of risk is designed and operated in a manner that will
achieve balance. Given the key role of senior executives in managing
the overall risk-taking activities of an organization, the board of
directors should directly approve the incentive compensation
arrangements for senior executives. The board should approve and
document any material exceptions or adjustments to the incentive
compensation arrangements established for senior executives and should
carefully consider and monitor the effects of any approved exceptions
or adjustments on the balance of the arrangement, the risk-taking
incentives of the senior executive, and the safety and soundness of the
organization.
The board of directors should monitor the performance, and
regularly review the design and function, of incentive compensation
arrangements.
The board of directors should regularly review the design and
monitor the performance of the organization's incentive compensation
systems. To allow for informed reviews, the board should receive data
and analysis from management or other sources that are sufficient to
allow the board to assess whether the overall design and performance of
the organization's incentive compensation arrangements are consistent
with the organization's safety and soundness. For example, the board
should receive and review, on an annual or more frequent basis, an
assessment by management, with appropriate input from risk-management
personnel, of the effectiveness of the design and operation of the
organization's incentive compensation system in providing risk-taking
incentives that are consistent with the organization's safety and
soundness. These reports should include an evaluation of whether or how
incentive compensation practices may be encouraging excessive risk-
taking. These reviews and reports should be appropriately scoped to
reflect the size and complexity of the banking organization's
activities and the prevalence and scope of its incentive compensation
arrangements.
In addition, at banking organizations that are significant users of
incentive compensation arrangements, the board should receive periodic
reports that review incentive compensation awards and payments relative
to risk outcomes on a backward-looking basis to determine whether the
organization's incentive compensation arrangements may be promoting
excessive risk-taking. Boards of directors of these organizations also
should consider periodically obtaining and reviewing scenario analysis
of compensation on a forward-looking basis based on a range of
performance levels, risk outcomes, and the amount of risks taken.
The board should closely monitor incentive compensation payments to
senior executives and their sensitivity to risk outcomes. This
monitoring should include the review of both backward-looking and
forward-looking scenario analysis for senior executives separate from
other employees. In addition, if the
[[Page 55237]]
compensation arrangement for a senior executive includes a clawback
provision, then the review should include sufficient information to
determine if the provision has been triggered.
The board of directors should seek to stay abreast of significant
emerging changes in compensation plan mechanisms and incentives in the
marketplace. However, the board should recognize that institutions,
activities, and practices within the industry are not identical.
Incentive compensation arrangements at one firm may not be suitable for
use at another firm because of differences in the risks, controls,
structure, and management among firms. The board of directors of each
organization is responsible for ensuring that the incentive
compensation arrangements for its organization do not encourage
employees to take risks that are beyond the firm's ability to manage
effectively, regardless of the practices employed by other firms.
The organization, composition, and resources of the board
of directors should permit effective oversight of incentive
compensation.
If a separate compensation committee is not already in place or
required by other authorities,\17\ the board of directors should
consider establishing such a committee--reporting to the full board--
that has primary responsibility for overseeing the organization's
incentive compensation systems. A compensation committee should be
composed solely or predominantly of non-executive directors. If the
board does not have such a compensation committee, the board should
take other steps to ensure that non-executive directors of the board
are actively involved in the oversight of incentive compensation
systems. At LCBOs and large regional banking organizations, and at
other banking organizations where feasible, one or more of the board of
directors should have a level of expertise and experience in risk
management and compensation practices in the financial services
industry that is appropriate for the nature, scope, and complexity of
the organization's activities. The compensation committee should work
closely with any board-level risk and audit committees where the
substance of their activities overlap.
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\17\ See NYSE Listed Company Manual Section 303A.05(a); Nasdaq
Listing Rule 5605(d); Internal Revenue Code section 162(m) (26
U.S.C. 162(m)).
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The board of directors should have the authority to, where
appropriate, select, compensate, and use outside counsel, consultants,
or other experts with expertise in incentive compensation and risk
management.\18\ In selecting and using outside parties, the board of
directors should give due attention to potential conflicts of interest
arising from other dealings of the parties with the firm or for other
reasons. The board also should exercise caution to avoid allowing
outside parties to obtain undue levels of influence. While the
retention and use of outside parties may be helpful, the board retains
ultimate responsibility for ensuring that the organization's incentive
compensation arrangements are consistent with safety and soundness.
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\18\ It is recognized that the board of directors of an
organization with less complex and extensive incentive compensation
arrangements, such as many smaller regional and community banking
organizations, may not find it necessary or appropriate to retain
and use outside experts in this area.
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A banking organization's disclosure practices should
support safe and sound incentive compensation arrangements.
If a banking organization's incentive compensation arrangements
provide employees incentives to take risks that are beyond the
tolerance of the organization's shareholders, these risks are likely to
also present a risk to the safety and soundness of the
organization.\19\ To help promote safety and soundness, a banking
organization should provide an appropriate amount of information
concerning its incentive compensation arrangements and related risk
management, control, and governance processes to shareholders to allow
them to monitor and, where appropriate, take actions to restrain the
potential for such arrangements and processes to encourage employees to
take excessive risks.
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\19\ On the other hand, as noted previously, compensation
arrangements that are in the interests of the shareholders of a
banking organization are not necessarily consistent with safety and
soundness. This is because the federal safety net bears some of the
downside of risks taken by organizations with access, directly or
through a subsidiary, to the safety net.
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The scope and level of the information disclosed by the
organization should be tailored to the nature and complexity of the
organization and its incentive compensation arrangements. The
Securities and Exchange Commission (SEC), for example, has proposed to
adopt certain disclosure requirements relating to incentive
compensation practices for public companies.\20\ The Federal Reserve
will work with the SEC to improve the disclosures provided by public
banking organizations in ways that promote the safety and soundness of
these organizations. In addition, in connection with the special
horizontal review process, the Federal Reserve will conduct a review of
its regulatory reporting forms to determine what type(s) of summary-
level quantitative information concerning incentive compensation
arrangements, awards, and payments would be appropriate for the Federal
Reserve to collect and make publicly available to help promote balanced
incentive compensation arrangements.
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\20\ See 74 FR 35076, July 17, 2009.
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Large, complex banking organizations should follow a
systematic approach to developing a compensation system that has
balanced incentive compensation arrangements.
At banking organizations with large numbers of risk-taking
employees engaged in diverse activities, an ad hoc approach to
developing balanced arrangements is unlikely to be reliable. Thus, an
LCBO should use a systematic approach--supported by robust and
formalized policies, procedures, and systems--to ensure that those
arrangements are appropriately balanced and consistent with safety and
soundness. Such an approach should provide for the organization
effectively to:
Identify employees who are eligible to receive incentive
compensation and whose activities may expose the organization to
material risks. These employees should include (i) senior executives
and others who are responsible for oversight of the organization's
firm-wide activities or material business lines; (ii) individual
employees, including non-executive employees, whose activities may
expose the firm to material amounts of risk; and (iii) 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;
Identify the types and time horizons of risks to the
organization from the activities of these employees;
Assess the potential for the performance measures included
in the incentive compensation arrangements for these employees to
encourage the employees to take excessive risks;
Include measures, such as risk adjustments or deferral
periods, within the incentive compensation arrangements for these
employees that are reasonably designed to ensure that the arrangement
will be balanced;
Communicate to the employees the ways in which their
incentive compensation awards or payments will be adjusted to reflect
the risks of their activities to the organization; and
Monitor incentive compensation awards, payments, risks
taken, and risk
[[Page 55238]]
outcomes for these employees and modify the relevant arrangements if
payments made are not appropriately sensitive to risk and risk
outcomes.
Regional and community banking organizations should develop and
implement appropriate policies, procedures, and systems in a manner
that is tailored to the size and complexity of the organization's
activities, as well as the prevalence and scope of its incentive
compensation arrangements.
III. Supervisory Initiatives
As noted earlier, the Federal Reserve is commencing two supervisory
initiatives in order to spur and monitor the industry's progress toward
the implementation of safe and sound incentive compensation
arrangements, identify emerging best practices, and advance the state
of practice more generally in the industry. In addition, the Federal
Reserve will, on an on-going basis, assess banking organizations'
incentive compensation arrangements for conformity with the principles
of safety and soundness outlined in this guidance.
Large, complex banking organizations. LCBOs warrant the most
intensive supervisory attention in the short run because they are
significant users of incentive compensation arrangements and because
the adverse effects of flawed approaches at these institutions are more
likely to have adverse effects on the broader financial system.
Accordingly, the Federal Reserve will conduct a formal horizontal
review of incentive compensation arrangements at these organizations.
The review is designed to achieve the following objectives:
1. Enhance supervisory understanding of the details of current
practices, as well as the steps taken or proposed to be taken by
organizations to improve the balance of incentive compensation
arrangements;
2. Assess the strength of controls and whether actual payouts under
incentive compensation arrangements are effectively monitored relative
to actual risk outcomes;
3. Understand the role played by boards of directors, compensation
committees, and risk-management functions in designing, approving, and
monitoring incentive compensation systems; and
4. Identify emerging best practices through comparison of practices
across organizations and business lines.
As part of this review, each LCBO will be expected to provide the
Federal Reserve information and documentation that clearly describes
(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,
including relevant timetables, for improving the risk-sensitivity of
incentive compensation arrangements and related risk management,
controls, and corporate governance practices.
The Federal Reserve will work closely with each LCBO to ensure that
its plans are likely to result in the establishment and maintenance of
incentive compensation arrangements that are consistent with safety and
soundness and do not encourage excessive risk-taking. In addition, the
Federal Reserve will closely monitor actions taken by the organization
under the plan, including the organization's adherence to timetables
set forth in its plan for improvements to be developed and implemented.
As noted earlier, the Federal Reserve may take supervisory action as
appropriate if the organization fails to develop, submit, or adhere to
an effective plan designed to ensure that the organization's incentive
compensation arrangements do not encourage excessive risk-taking and
are consistent with principles of safety and soundness. Such action may
include the establishment of appropriate limitations on the
organization's incentive compensation awards or payments to help ensure
that the organization's incentive compensation arrangements do not pose
a threat to the safety and soundness of the organization.
Community and regional banking organizations with incentive
compensation arrangements. Supervisory staff should review incentive
compensation arrangements at non-LCBO banking organizations as part of
the regular, risk-focused supervisory process.\21\ These reviews should
be conducted in connection with the review of the organization's risk
management, internal controls and corporate governance, and should be
tailored to reflect the scope and complexity of the organization's
activities and prevalence and scope of its incentive compensation
arrangements. Thus, for example, a small banking organization that uses
incentive compensation arrangements on a limited basis is not expected
to have as formalized, extensive, and detailed policies, procedures,
and systems governing its incentive compensation arrangements as a LCBO
that uses incentive compensation arrangements extensively. In addition,
in considering the potential for incentive compensation arrangements,
including commission-based programs, to encourage excessive risk-
taking, examiners should take into account the strength of the
organization's risk management and internal control framework in
managing and controlling risks.
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\21\ Thus, for example, reviews at bank holding companies with
total consolidated assets of $5 billion or less will be conducted in
accordance with the risk-focused supervision program for these
organizations. See SR letter 02-1, Revisions to Bank Holding Company
Supervision Procedures for Organizations with Total Consolidated
Assets of $5 Billion or Less (Jan. 9, 2002).
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If examiners find incentive compensation practices that may be of
concern, examiners should consult with the multidisciplinary group
described previously. The Federal Reserve will incorporate the findings
of these reviews into the organization's supervisory ratings and, where
warranted, may take supervisory action against the organization to
address deficiencies.
IV. Conclusion
Banking organizations are responsible for ensuring that their
incentive compensation arrangements do not encourage excessive risk-
taking and do not pose a threat to the safety and soundness of the
organization. The Federal Reserve expects banking organizations to take
prompt action to address deficiencies in their incentive compensation
arrangements or related risk management, control, and governance
processes.
The Federal Reserve expects to actively monitor the actions taken
by banking organizations in this area and will promote further advances
in designing and implementing balanced incentive compensation
arrangements. Where appropriate, the Federal Reserve will take
supervisory or enforcement action to ensure that material deficiencies
that pose a threat to the safety and soundness of the organization are
promptly addressed. The Federal Reserve also will update this guidance
as appropriate to incorporate best practices as they develop over time.
This concludes the text of the proposed guidance.
By order of the Board of Governors of the Federal Reserve
System, October 22, 2009.
Robert deV. Frierson,
Deputy Secretary of the Board.
[FR Doc. E9-25766 Filed 10-26-09; 8:45 am]
BILLING CODE 6210-01-P