I. Introduction Incentive compensation practices in the financial
industry were one of many factors contributing to the financial crisis
that began in mid-2007. Banking organizations too often rewarded employees
for increasing the organization’s revenue or short-term profit without
adequate recognition of the risks the employees’ activities posed
to the organization.
1 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 incentive compensation practices to banking organizations
supervised by the Federal Reserve, the Office of the Comptroller of
the Currency, the Federal Deposit Insurance Corporation, and the Office
of Thrift Supervision (collectively, the “agencies”).
2 This guidance is intended to
assist banking organizations in designing and implementing incentive
compensation arrangements and related policies
and procedures
that effectively consider potential risks and risk outcomes.
3Alignment of incentives provided
to employees with the interests of shareholders of the organization
often also benefits safety and soundness. However, aligning employee
incentives with the interests of shareholders is not always sufficient
to address safety-and-soundness concerns. Because of the presence
of the federal safety net, (including the ability of insured depository
institutions to raise insured deposits and access the Federal Reserve’s
discount window and payment services), 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 agencies expect 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. To be con
sistent with safety and soundness, incentive
compensation arrangements
4 at a banking organization should:
- Provide employees incentives that appropriately balance
risk and reward;
- 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 them, are discussed later in this guidance.
The agencies expect banking organizations
to regularly review their incentive compensation arrangements for
all executive and non-executive employees who, either individually
or as part of a group, have the ability to expose the organization
to material amounts of risk, as well as to regularly review the risk-management,
control, and corporate governance processes related to these arrangements.
Banking organizations should immediately address any identified 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 that they do not encourage
employees to expose the organization to imprudent risks that may pose
a threat to the safety and soundness of the organization.
The agencies recognize that incentive
compensation arrangements often seek to serve several important and
worthy objectives. For example, incentive compensation arrangements
may be used to help attract skilled staff, induce better organization-wide
and employee performance, promote employee retention, provide retirement
security to employees, or allow compensation expenses to vary with
revenue on an organization-wide basis. Moreover, the analysis and
methods for ensuring that incentive compensation arrangements take
appropriate account of risk should be tailored to the size, complexity,
business strategy, and risk tolerance of each organization. The resources
required will depend upon the complexity of the firm and its use of
incentive compensation arrangements. For some, the task of designing
and implementing compensation arrangements that properly offer incentives
for executive and nonexecutive employees to pursue the organization’s
long-term well-being and that do not encourage imprudent risk-taking
is a complex task that will require the commitment of adequate resources.
While issues related to designing and implementing incentive compensation
arrangements are complex, the agencies are committed to ensuring that
banking organizations move forward in incorporating the principles
described in this guidance into their incentive compensation practices.
5As discussed further below, because of the size and complexity
of their operations, LBOs
6 should have and adhere to systematic and formalized
policies, procedures, and processes.
These are considered important in ensuring
that incentive compensation arrangements for all covered employees
are identified and reviewed by appropriate levels of management (including
the board of directors where appropriate and control units), and that
they appropriately balance risks and rewards. In several places, this
guidance specifically highlights the types of policies, procedures,
and systems that LBOs should have and maintain, but that generally
are not expected of smaller, less complex organizations. LBOs warrant
the most intensive supervisory attention because they are significant
users of incentive compensation arrangements and because flawed approaches
at these organizations are more likely to have adverse effects on
the broader financial system. The agencies will work with LBOs as necessary
through the supervisory process to ensure that they promptly correct
any deficiencies that may be inconsistent with the safety and soundness
of the organization.
The policies, procedures, and systems of smaller banking
organizations that use incentive compensation arrangements
7 are expected to be less extensive, formalized,
and detailed than those of LBOs. Supervisory reviews of incentive
compensation arrangements at smaller, less-complex banking organizations
will be conducted by the agencies as part of the evaluation of those
organizations’ risk-management, internal controls, and corporate governance
during the regular, risk-focused examination process. These reviews
will be tailored to reflect the scope and complexity of an organization’s
activities, as well as the prevalence and scope of its incentive compensation
arrangements. Little, if any, additional examination work is expected
for smaller banking organizations that do not use, to a significant
extent, incentive compensation arrangements.
8For all banking organizations, supervisory
findings related to incentive compensation will be communicated to
the organization and included in the relevant report of examination
or inspection. 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.
An organization’s appropriate federal supervisor 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, particularly when the organization is not taking prompt
and effective measures to correct the deficiencies. For example, the
appropriate federal supervisor may take an enforcement action if material
deficiencies are found to exist in the organization’s incentive compensation
arrangements or related risk management, control, or governance processes,
or the organization fails to promptly develop, submit, or adhere to
an effective plan designed to ensure that its incentive compensation
arrangements do not encourage imprudent 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 take affirmative
action, such as developing a corrective action plan that is acceptable
to the appropriate federal supervisor to rectify safety-and-soundness
deficiencies in its incentive compensation arrangements or related
processes. Where warranted, the appropriate federal supervisor may
require the organization to take additional affirmative action to
correct or remedy deficiencies related to organization’s incentive
compensation practices.
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 agencies will review and update this guidance as appropriate to
incorporate best practices that emerge from these efforts.
II. Scope of Application The incentive compensation arrangements and related policies and
procedures of banking organizations should be consistent with principles
of safety and soundness.
9 Incentive
compensation arrangements for
executive officers as well as for nonexecutive 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. Accordingly, this 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;10
- Individual employees, including non-executive employees,
whose activities may expose the organization to material amounts of
risk (e.g., traders with large position limits relative to
the organization’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 organization to material amounts of risk, even if no
individual employee is likely to expose the organization 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 hereafter as “covered employees”
or “employees.” Depending on the facts and circumstances of the individual
organization, the types of employees or categories of employees that
are outside the scope of this guidance because they do not have the
ability to expose the organization to material risks would likely
include, for example, tellers, bookkeepers, couriers, or data processing
personnel.
In determining whether an employee, or group of employees,
may expose a banking organization to material risk, the organization
should consider the full range of inherent risks arising from, or
generated by, the employee’s activities, even if the organization
uses risk-management processes or controls to limit the risks such
activities ultimately may pose to the organization. Moreover, risks
should be considered to be material for purposes of this guidance
if they are material to the organization, or are material to a business
line or operating unit that is itself material to the organization.
11 For purposes of illustration, assume that a banking organization
has a structured finance unit that is material to the organization.
A group of employees within that unit who originate structured-finance
transactions that may expose the unit to material risks should be
considered “covered employees” for purposes of this guidance even
if those transactions must be approved by an independent risk function
prior to consummation, or the organization uses other processes or
methods to limit the risk that such transactions may present to the
organization.
Strong and effective risk-management and internal control
functions are critical to the safety and soundness of banking organizations.
However, irrespective of the quality of these functions, poorly designed
or managed incentive compensation arrangements can themselves be a
source of risk to a banking organization. For example, incentive compensation
arrangements that provide employees strong incentives to increase
the organization’s short-term revenues or profits, without regard
to the short- or long-term risk associated with such business, can
place substantial strain on the risk management and internal control
functions of even well-managed organizations.
Moreover, poorly balanced incentive compensation
arrangements can encourage employees to take affirmative actions to
weaken or circumvent the organization’s risk-management or internal
control functions, such as by providing inaccurate or incomplete information
to these functions, to boost the employee’s personal compensation.
Accordingly, sound compensation practices are an integral part
of strong risk-management and internal control functions. A key goal
of this guidance is to encourage banking organizations to incorporate
the risks related to incentive compensation into their broader risk
management framework. Risk management procedures and risk controls
that ordinarily limit risk-taking do not obviate the need for incentive
compensation arrangements to properly balance risk-taking incentives.
III. Principles of a Sound Incentive
Compensation System Principle
1: Balanced Risk-Taking Incentives Incentive
compensation arrangements should balance risk and financial results
in a manner that does not encourage employees to expose their organizations
to imprudent risks. Incentive compensation arrangements typically
attempt to encourage actions that result in greater revenue or profit
for the organization. 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 expose
the organization to more risk.
An incentive compensation arrangement is balanced when
the amounts paid to an employee appropriately take into account the
risks (including compliance 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.
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 imprudent
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 business generated, the potential for the arrangement to
encourage imprudent risk-taking may be quite strong. Similarly, traders
who work with positions that close at year-end could have an incentive
to take large risks toward the end of a year if there is no mechanism
for factoring how such positions perform over a longer period of time.
The same result could ensue if the performance measures themselves
lack integrity or can be manipulated inappropriately by the employees
receiving incentive compensation.
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, organization-wide profit), the potential for the arrangement
to encourage the employee to take imprudent risks on behalf of the
organization may be weak. For this reason, plans that provide for
awards based solely on overall organization-wide performance are unlikely
to provide employees, other than senior executives and individuals
who have the ability to materially affect the organization’s overall
risk profile, with unbalanced risk-taking incentives.
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 activities with
substantial risk.
- Banking organizations should consider the full range
of risks associated with an employee’s activities, as well as the
time horizon over which those risks may be realized, in assessing
whether incentive compensation arrangements are balanced.
The activities of employees may create a wide range of
risks for a banking organization, such as credit, market, liquidity,
operational, legal, compliance, and reputational risks, as well as
other risks to the viability or operation of the organization. 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).
12 In addition,
some risks (or combinations of risky strategies and positions) 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 the infrequency of their realization and
the existence of the federal safety net, these risks warrant special
attention for safety-and-soundness reasons given the threat they pose
to the organization’s solvency and the federal safety net.
Banking organizations should consider
the full range of current and potential risks associated with the
activities of covered 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, supported by available data, to estimate risks and risk
outcomes in the absence of reliable quantitative risk measures.
Large banking organizations. In designing and modifying
incentive compensation arrangements, LBOs should assess in advance
of implementation whether such arrangements are likely to provide
balanced risk-taking incentives. Simulation analysis of incentive
compensation arrangements is one way of doing so. Such analysis uses
forward-looking projections of incentive compensation awards and payments
based on a range of performance levels, risk outcomes, and levels
of risks taken. This type of analysis, or other analysis that results
in assessments of likely effectiveness, can help an LBO assess whether
incentive compensation awards and 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 expose their banking organization to imprudent risks,
the organization should modify the arrangement as needed to ensure
that it is consistent with safety and soundness. Four methods are
often used to make compensation more sensitive to risk. These methods
are:
- 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
may pose to the organization. Such measures may be quantitative, or the
size of a risk adjustment may be set judgmentally, subject to appropriate
oversight.
- 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 are realized or become better
known only during the deferral period.13 Deferred payouts may be altered
according to risk outcomes either formulaically or judgmentally, subject
to appropriate oversight. To be most effective, the deferral period
should be 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.
- 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 or more 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.
- 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. This method also can include improving
the quality and reliability of performance measures in taking into
account both short-term and long-term risks, for example improving
the reliability and accuracy of estimates of revenues and long-term
profits upon which performance measures depend.14
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 imprudent 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 more 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,
or certain risks such as reputational or operational risk that may
be difficult to measure with respect to particular activities), especially
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 associated
with the employee’s activities, the stronger the effect should be
of the methods applied to achieve balance. Thus, for example, risk
adjustments used to counteract a materially unbalanced compensation
arrangement should have a similarly material impact on the incentive
compensation paid under the arrangement. Further, improvements in
the quality and reliability of performance measures themselves, for
example improving the reliability and accuracy of estimates of revenues
and profits upon which performance measures depend, can significantly
improve the degree of balance in risk-taking incentives.
Where judgment plays a significant
role in the design or operation of an incentive compensation arrangement,
strong policies and procedures, 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 are balanced and do not encourage imprudent risk-taking.
For example, if a banking organization relies to a significant degree
on the judgment of one or more managers to ensure that the incentive
compensation awards to employees are appropriately risk adjusted,
the organization should have policies and procedures that describe
how managers are expected to exercise that judgment to achieve balance
and that provide for the manager(s) to receive appropriate available
information about the employee’s risk-taking activities to make informed
judgments.
Large banking organizations. Methods and practices
for making compensation sensitive to risk are likely to evolve rapidly
during the next few years, driven in part by the efforts of supervisors
and other stakeholders. LBOs should actively monitor developments
in the field and should incorporate into their incentive compensation
systems new or emerging methods or practices that are likely to improve
the organization’s long-term financial well-being and safety and soundness.
- 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, activities, risks, and incentive compensation
practices may differ materially among banking organizations based
on, among other things, the scope or complexity of activities conducted
and the business strategies pursued by the organizations. These differences
mean that methods for achieving balanced compensation arrangements
at one organization may not be effective in restraining incentives
to engage in imprudent risk-taking at another organization. Each organization
is responsible for ensuring that its incentive compensation arrangements
are consistent with the safety and soundness of the organization.
Moreover, the risks associated with the activities of
one group of nonexecutive employees (e.g., loan originators)
within a banking organization may differ significantly from those
of another group of nonexecutive employees (e.g., spot foreign
exchange traders) within the organization. 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 factor can make it difficult for banking organizations to achieve
balanced compensation arrangements for senior executives who have
responsibility for managing risks on an organization-wide basis solely
through use of the risk-adjustment-of-award method.
Furthermore, 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 helpful in restraining the risk-taking incentives of
senior executives and other covered employees whose activities may
have a material effect on the overall financial performance of the
organization. However, equity-related deferred compensation may not
be as effective in restraining the incentives of lower-level covered
employees (particularly at large organizations) to take risks because
such 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 result in arrange
ments that are unbalanced at least with respect
to some employees.
15Large banking organizations. Incentive compensation arrangements for senior executives at LBOs
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 LBOs 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 organization during the deferral period.
The portion of the incentive compensation of
other covered 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 organization and its stock price.
Deferral of a substantial portion of an employee’s incentive compensation
may not be workable for employees at lower pay scales because of their
more limited financial resources. This may require increased reliance
on other measures in the incentive compensation arrangements for these
employees to achieve balance.
- 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
expose the organization to undue risk. For example, an arrangement
that provides an employee with a guaranteed payout upon departure
from an organization, regardless of performance, may neutralize the
effect of any balancing features included in the arrangement to help
prevent imprudent 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. In appropriate circumstances an organization
should consider including balancing features—such as risk adjustment
or deferral requirements that extend past the employee’s departure—in
the arrangements to mitigate the potential for the arrangements to
encourage imprudent risk-taking. In all cases, a banking organization
should ensure that the structure and terms of any golden parachute
arrangement entered into by the organization do not encourage imprudent
risk-taking in light of the other features of the employee’s incentive
compensation arrangements.
Large banking organizations. Provisions that require
a departing employee to forfeit deferred incentive compensation payments
may weaken the effectiveness of the deferral arrangement if the departing
employee is able to negotiate a “golden handshake” arrangement with
the new employer.
16 This weakening effect can be particularly
significant for senior executives or other skilled employees at LBOs
whose services are in high demand within the market.
Golden handshake arrangements present special
issues for LBOs and supervisors. For example, while a banking organization
could
adjust its deferral arrangements so that departing employees will
continue to receive any accrued deferred compensation after departure
(subject to any clawback or malus
17), these changes could reduce the employee’s incentive to remain
at the organization and, thus, weaken an organization’s ability to
retain qualified talent, which is an important goal of compensation,
and create conflicts of interest. Moreover, actions of the hiring
organization (which may or may not be a supervised banking organization)
ultimately may defeat these or other risk-balancing aspects of a banking
organization’s deferral arrangements. LBOs should monitor whether
golden handshake arrangements are materially weakening the organization’s
efforts to constrain the risk-taking incentives of employees. The
agencies will continue to work with banking organizations and others
to develop appropriate methods for addressing any effect that such
arrangements may have on the safety and soundness of banking organizations.
- 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 need to 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 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. 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, in ways designed to
increase the employee’s pay, the risk measures or other information
or judgments that are used to make the employee’s pay sensitive to
risk.
Such actions may significantly weaken the effectiveness
of an organization’s incentive compensation arrangements in restricting
imprudent 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.
For this reason, traditional risk-management controls alone do not
eliminate the need to identify employees who may expose the organization
to material risk, nor do they obviate the need for the incentive compensation
arrangements for these employees to be balanced. Rather, 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.
To help prevent damage from occurring, a banking organization
should have strong controls governing its process for designing, implementing,
and monitoring incentive compensation arrangements. Banking organizations
should create and maintain sufficient documentation to permit an audit
of the effectiveness of the organization’s processes for establishing,
modifying, and monitoring incentive compensation arrangements. Smaller
banking organizations should incorporate reviews of these processes
into their overall framework for compliance monitoring (including
internal audit).
Large banking organizations. LBOs should have and
maintain policies and procedures that (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.
An LBO also 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 LBO’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.
- 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 imprudent risk-taking.
Developing incentive compensation arrangements that provide
balanced risk-taking incentives 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 imprudent risk-taking.
18 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 covered employees; (ii) approving the risk measures used in risk
adjustments and performance measures, as well as measures of risk
outcomes used in deferred-payout arrangements; and (iii) analyzing
risk-taking and risk outcomes relative to incentive compensation payments.
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, oversight, and operation of incentive compensation arrangements
should have appropriate skills and experience needed to effectively
fulfill their roles. These skills and experiences should be sufficient
to equip the personnel to remain effective in the face of challenges
by covered 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 experience and expertise in these fields
that is appropriate in light of the size, activities, and complexity
of the organization.
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 substantially 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., 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 monitor 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 or high levels of risk taken. Results
should be reported to appropriate levels of management, including
the board of directors where warranted and consistent with Principle
3 below. The monitoring methods and processes used by a banking organization
should be commensurate with the size and complexity of the organization,
as well as its use of incentive compensation. Thus, for example, a
small, noncomplex organization that uses incentive compensation only
to a limited extent may find that it can appropriately monitor its
arrangements through normal management processes.
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 imprudent
risks.
Principle 3: Strong Corporate
Governance Banking organizations should
have strong and effective corporate governance to help ensure sound
compensation practices, including active and effective oversight by
the board of directors.
Given the key role of senior executives in managing the
overall risk-taking activities of an organization, the board of directors
of a banking organization should directly approve the incentive compensation
arrangements for senior executives.
19 The board also 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 of an organization also
is ultimately responsible for ensuring that the organization’s incentive
compensation arrangements for all covered employees are appropriately
balanced and do not jeopardize the safety and soundness of the organization.
The involvement of the board of directors in oversight of the organization’s
overall incentive compensation program should be scaled appropriately
to the scope and prevalence of the organization’s incentive compensation
arrangements.
Large banking organizations and organizations that
are significant users of incentive compensation. The board of
directors of an LBO or other banking organization that uses incentive
compensation to a significant extent should actively oversee the development
and operation of the organization’s incentive compensation policies,
systems, and related control processes. The board of directors of
such an organization should review and approve the overall goals and
purposes of the organization’s incentive compensation system. In addition,
the board should provide clear direction to management to ensure that
the goals and policies it establishes are carried out in a manner
that achieves balance and is consistent with safety and soundness.
The board of directors of such an organization also should
ensure that steps are taken so that the incentive compensation system—including
performance measures and targets—is designed and operated in a manner
that will achieve balance.
- The board of directors should monitor the performance,
and regularly review the design and function, of incentive compensation
arrangements. 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. 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.
The board of directors of a banking organization should
closely monitor incentive compensation payments to senior executives
and the sensitivity of those payments to risk outcomes. In addition,
if the 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 and executed as planned.
The board of directors of a banking organization should
seek to stay abreast of significant emerging changes in compensation
plan mechanisms and incentives in the marketplace as well as developments
in academic research and regulatory advice regarding incentive compensation
policies. However, the board should recognize that organizations,
activities, and practices within the industry are not identical. Incentive
compensation arrangements at one organization may not be suitable
for use at another organization because of differences in the risks,
controls, structure, and management among organizations. 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 organization’s
ability to manage effectively, regardless of the practices employed
by other organizations.
Large banking organizations and organizations that
are significant users of incentive compensation. The board of
an LBO or other organization that uses incentive compensation to a
significant extent 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 increase the potential
for imprudent risk-taking.
The board of such an organization also 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
imprudent risk-taking. Boards of directors of these organizations
also should consider periodically obtaining and reviewing simulation
analysis of compensation on a forward-looking basis based on a range
of performance levels, risk outcomes, and the amount of risks taken.
- The organization, composition, and resources of the
board of directors should permit effective oversight of incentive
compensation.
The board of directors of a banking organization should
have, or have access to, 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. This level of expertise may be present collectively among
the members of the board, may come from formal training or from experience
in addressing these issues, including as a director, or may be obtained
through advice received from outside counsel, consultants, or other
experts with expertise in incentive compensation and risk-management.
The board of directors of an organization with less complex and extensive
incentive compensation arrangements may not find it necessary or appropriate
to require special board expertise or to retain and use outside experts
in this area.
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 organization 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.
Large banking organizations and
organizations that are significant users of incentive compensation. If a separate compensation committee is not already in place or
required by other authorities,
20 the board of directors of an LBO or other
banking organization that uses incentive compensation to a significant
extent 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. The compensation committee should work closely with any board-level
risk and audit committees where the substance of their actions overlap.
- 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.
21 To
help promote safety and soundness, a banking organization should provide
an appropriate amount of information concerning its incentive compensation
arrangements for executive and non-executive employees 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 imprudent risks. Such disclosuresshould include information
relevant to em
ployees other than senior executives. 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.
22
- Large 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 LBO 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
organization 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 organization 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 imprudent risks;
- Include balancing elements, 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 in light of the size, type, and time
horizon of the inherent risks of the employees’ activities;
- 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 outcomes for these employees and modify the
relevant arrangements if payments made are not appropriately sensitive
to risk and risk outcomes.
III. Conclusion Banking organizations are responsible for ensuring that
their incentive compensation arrangements do not encourage imprudent
risk-taking behavior and are consistent with the safety and soundness
of the organization. The agencies expect banking organizations to
take prompt action to address deficiencies in their incentive compensation
arrangements or related risk-management, control, and governance processes.
The agencies intend 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 agencies 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 agencies also will update this guidance as appropriate to incorporate
best practices as they develop over time.
This concludes the text of the Guidance on Sound Incentive
Compensation Policies.
