Federal Reserve Board Compensation Guidance
By: Theodore R. Ginsburg, JD, CPA

As we are all aware, one of the side effects of the nation’s recovery from the financial crisis has been a dramatic increase in financial institution regulation from Congress, the executive branch   and from the Federal Reserve Board (“FRB”).  One of the primary areas of the FRB’s focus has been the compensation practices of member banks.  On June 21, 2010, the FRB (in conjunction with the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation) issued its “Final Guidance on Sound Incentive Compensation Policies” (the “Guidance”). 

In general, the FRB believes that incentive compensation programs caused bank employees to take actions that put their employers at risk.  While this is important information for banks, the overall guidance that the FRB provides is worth noting by all employers.

This brief article will summarize some of the key points of the 47 pages of guidance that the FRB issued.

The FRB’s review of banking practices to date

The FRB reviewed the incentive compensation arrangements of many of the large banking organizations (LBOs) and found that they were deficient in the following areas related to incentive compensation programs and risk to the institution:

• Identification of employees who could expose the institution to risk
• Designing risk sensitive inventive compensation plans that fully captured the risks involved and applying the design to a sufficient number of employees
• Tailoring deferral programs according to duration of risk or type, instead of applying the same design to all programs
• Determining whether established programs successfully balance risk

The Guidance’s principles

The Guidance’s purpose is to make sure that incentive compensation arrangements at banking organizations (the Guidance applies to all banking organizations under the supervision of any of the agencies referred to above—approximately 8,700) do not encourage excessive risk-taking or undermine the safety and soundness of the organization.   There are three key principles:

• Balanced risk taking incentives—incentive compensation programs should balance risk and financial results so that employees do not expose the institution to imprudent risks.  The institution should consider the full range of risks associated with an employee’s activities, as well as the time horizon over which the risk could be realized. The FRB believes that short term programs are inherently more risky than long term programs. If an arrangement is viewed to be too risky, it should be modified in a number of ways: payment deferral (until we are certain that the risk will not come to pass); claw backs; risk adjustment of rewards; reduced sensitivity to short-term performance; or, changing the incentive payment structure.    Particular care should be taken with ‘golden parachute’ provisions, which could cause acceleration of payments in the event of a change in control—these programs could lead to risk taking to increase the organization’s apparent value and effectuate a sale to accelerate the time of payment.
• Risk management programs / internal controls should support this process—risk management personnel should have input into the creation of incentive compensation programs, and should have some responsibility for monitoring the results.  If risk management personnel participate in an incentive program, their program should not be tied to the financial performance of the lines of business that they review.
• Improve corporate governance:   Boards of directors should directly approve compensation arrangements involving senior executives and become more involved in monitoring the performance of incentive programs; to do this, boards should have access to the resources necessary to perform this task.  Shareholders should receive information relating to incentive compensation arrangements and related risk-management, control, and governance processes. 

The final guidance can be found at the following link:  http://www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm

Next steps

What should banks and employers in general consider doing at the present time?  We would suggest the following approach:

• Identify those executives and employees who have the ability (alone or as part of a group) to expose the organization to material risk.
• Review all of the incentive compensation programs in which these individuals participate to determine whether the programs create a possibility for material risk to the entity; among the items to be reviewed are the nature of the program, its term, and whether changes in circumstances could lead to potential risk.
• If modifications are needed, involve the directors, risk management personnel along with senior management and human resources personnel.
• Review your internal control and risk management processes to ensure that the above-mentioned incentive compensation programs are monitored and results delivered to the board of directors.

We would be pleased to assist you in this process.  Please call Herzl Ginsburg at 440-449-6800 to discuss this in more detail.