Proposed rules on compensation risk merit consideration by all of us
Five US regulators have jointly published proposed rules regarding compensation risk at the financial institutions they oversee. The agencies are:
- Office of the Comptroller of the Currency, Treasury (OCC);
- Board of Governors of the Federal Reserve System (Board);
- Federal Deposit Insurance Corporation (FDIC);
- Federal Housing Finance Agency (FHFA); National Credit Union Administration (NCUA); and
- S. Securities and Exchange Commission (SEC).
I believe the principles behind these rules are relevant to every organization, whether non-profit, for profit, large, small, manufacturing, retail, or other.
In general, the proposed rules would require a deferral of compensation (which includes salary, bonus, options, and more) that allows time before payment for consideration of whether excessive levels of risk were taken by individuals that led to their achieving or exceeding targets and earning compensation. Clawback provisions are included.
The rules are not limited to executives. They also apply to any individual whose actions could put the organization at significant risk.
The rules specify the obligations of the board and its compensation committee (all of whose members must be independent).
They also require that the risk officers be independent of the units taking the risk. They do NOT require that the risk office report directly to the CEO or board.
Reviews and reports on the effectiveness of the compensation and risk processes by both the risk office and internal audit are required.
Also required are policies and so on that mandate actions consistent with these requirements.
There’s a lot to like here. The agencies have asked for comments in their >500 page document.
The only item that I have a problem with is when they say “The proposed rule … provides that an incentive-based compensation arrangement will be considered to encourage inappropriate risks that could lead to material financial loss to the covered institution”. (They define ‘material financial loss at 0.5% of the organization’s capital.
- No likelihood is defined for ‘could’. Is 0.00001% acceptable? How about 1% or 2% or 5%?
- As with so many of these regulator’s rules, everything is expressed in financial terms – $$$. But, how do you measure compliance risk? Can you put a quantified value on it? At least the discussion includes a reference that incurring excessive compliance risk is a consideration of whether excessive risk overall was taken to earn a reward.
As I reflect on my experience (it is a great many years since I worked in financial services), I can see these principles addressing a couple of real-life problems at non-financial institutions.
- At a number of companies, there was a risk that sales personnel and even management (including both general management and, in some cases, financial management) would collude with third parties such as customers and channel partners to inflate sales for a quarter. Management would agree (a ‘side-letter’) with the third party where the customer or partner would increase an order beyond their needs and receive a credit memo in the next quarter. The fraudsters would receive a larger bonus based on the inflated revenues. Many sales personnel, especially, move from company to company and are willing to take the risk that any discovery of the scheme will be after they have departed. More senior managers, especially if financial managers are part of the scheme, don’t expect to be caught.
If bonuses were deferred, that would delay the reward and reduce the (net) incentive to cheat.
- At several companies, individuals were compensated for actions that were not tied directly to profits. Sales and even production personnel were rewarded for actions such as increasing revenue that have little or no margin (‘empty revenue’) or increasing production when margins were negative. I actually heard, in a management meeting when margins were reported as being negative, “we can make it up on volume”.
What do you think?
How can these principles be applied broadly to good effect?
The remainder of this post is excerpts from the >500 pages.
There is evidence that flawed incentive-based compensation practices in the financial industry were one of many factors contributing to the financial crisis that began in 2007. Some compensation arrangements rewarded employees – including nonexecutive personnel like traders with large position limits, underwriters, and loan officers – for increasing an institution’s revenue or short-term profit without sufficient recognition of the risks the employees’ activities posed to the institutions, and therefore potentially to the broader financial system. Traders with large position limits, underwriters, and loan officers are three examples of non-executive personnel who had the ability to expose an institution to material amounts of risk. Significant losses caused by actions of individual traders or trading groups occurred at some of the largest financial institutions during and after the financial crisis.
Of particular note were incentive-based compensation arrangements for employees in a position to expose the institution to substantial risk that failed to align the employees’ interests with those of the institution. For example, some institutions gave loan officers incentives to write a large amount of loans or gave traders incentives to generate high levels of trading revenues, without sufficient regard for the risks associated with those activities. The revenues that served as the basis for calculating bonuses were generated immediately, while the risk outcomes might not have been realized for months or years after the transactions were completed. When these, or similarly misaligned incentive-based compensation arrangements, are common in an institution, the foundation of sound risk management can be undermined by the actions of employees seeking to maximize their own compensation.
Flawed incentive-based compensation arrangements were evident in not just U.S. financial institutions, but also major financial institutions worldwide. In a 2009 survey of banking organizations engaged in wholesale banking activities, the Institute of International Finance found that 98 percent of respondents recognized the contribution of incentive-based compensation practices to the financial crisis.
Executive officers and employees of a covered institution may be willing to tolerate a degree of risk that is inconsistent with the interests of stakeholders, as well as broader public policy goals.
The Federal Banking Agencies have found that any incentive-based compensation arrangement at a covered institution will encourage inappropriate risks if it does not sufficiently expose the risk-takers to the consequences of their risk decisions over time, and that in order to do this, it is necessary that meaningful portions of incentive-based compensation be deferred and placed at risk of reduction or recovery. The proposed rule reflects the minimums that are required to be effective for that purpose, as well as minimum standards of robust governance, and the disclosures that the statute requires.
…the proposed rule would apply to any covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons.
The proposed rule identifies three categories of covered institutions based on average total consolidated assets:
- Level 1 (greater than or equal to $250 billion);
- Level 2 (greater than or equal to $50 billion and less than $250 billion); and
- Level 3 (greater than or equal to $1 billion and less than $50 billion).
…the proposed rule provides that compensation, fees, and benefits will be considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors.
The proposed rule … provides that an incentive-based compensation arrangement will be considered to encourage inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement:
- Appropriately balances risk and reward;
- Is compatible with effective risk management and controls; and
- Is supported by effective governance.
…the proposed rule specifically provides that an incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it:
- Includes financial and non-financial measures of performance;
- Is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate; and
- Is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.
Under the proposed rule, the board of directors of each covered institution (or a committee thereof) would be required to:
- Conduct oversight of the covered institution’s incentive-based compensation program;
- Approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and
- Approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
The proposed rule would apply deferral requirements to significant risk-takers as well as senior executive officers, and, as described below, would require 40, 50, or 60 percent deferral depending on the size of the covered institution and whether the covered person receiving the incentive-based compensation is a senior executive officer or a significant risk-taker.
A Level 1 or Level 2 covered institution would be required to consider forfeiture or downward adjustment of incentive-based compensation if any of the following adverse outcomes occur:
- Poor financial performance attributable to a significant deviation from the covered institution’s risk parameters set forth in the covered institution’s policies and procedures;
- Inappropriate risk-taking, regardless of the impact on financial performance;
- Material risk management or control failures;
- Non-compliance with statutory, regulatory, or supervisory standards resulting in enforcement or legal action brought by a federal or state regulator or agency, or a requirement that the covered institution report a restatement of a financial statement to correct a material error; and
- Other aspects of conduct or poor performance as defined by the covered institution.
In addition to deferral, downward adjustment, and forfeiture, the proposed rule would require a Level 1 or Level 2 covered institution to include clawback provisions in the incentive-based compensation arrangements for senior executive officers and significant risk-takers.
The proposed rule would require clawback provisions that, at a minimum, allow the covered institution to recover incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in misconduct that resulted in significant financial or reputational harm to the covered institution, fraud, or intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation.
The proposed rule would require all Level 1 and Level 2 covered institutions to have a risk management framework for their incentive-based compensation programs that is independent of any lines of business; includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures; and is commensurate with the size and complexity of the covered institution’s operations. In addition, the proposed rule would require Level 1 and Level 2 covered institutions to:
- Provide individuals in control functions with appropriate authority to influence the risk-taking of the business areas they monitor and ensure covered persons engaged in control functions are compensated independently of the performance of the business areas they monitor; and
- Provide for independent monitoring of:
- incentive-based compensation plans to identify whether the plans appropriately balance risk and reward;
- events related to forfeiture and downward adjustment and decisions of forfeiture and downward adjustment reviews to determine consistency with the proposed rule; and
- compliance of the incentive-based compensation program with the covered institution’s policies and procedures.
To be considered independent under the proposed rule, the group or person at the covered institution responsible for monitoring the areas described above generally should have a reporting line to senior management or the board that is separate from the covered persons whom the group or person is responsible for monitoring. Some covered institutions may use internal audit to perform the independent monitoring that would be required under this section.
…the proposed rule includes a requirement that internal audit or risk management submit a written assessment of the effectiveness of a Level 1 or Level 2 covered institution’s incentive-based compensation program and related control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution.
…the proposed rule would require each Level 1 or Level 2 covered institution to establish a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under the proposed rule. The compensation committee would be required to obtain input from the covered institution’s risk and audit committees, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance incentive-based compensation arrangements. Additionally, management would be required to submit to the compensation committee on an annual or more frequent basis a written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution. The compensation committee would also be required to obtain an independent written assessment from the internal audit or risk management function of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution.
The proposed rule would require all Level 1 and Level 2 covered institutions to have policies and procedures that, among other requirements:
- Are consistent with the requirements and prohibitions of the proposed rule;
- Specify the substantive and procedural criteria for forfeiture and clawback;
- Document final forfeiture, downward adjustment, and clawback decisions;
- Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person;
- Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized;
- Describe how discretion is exercised to achieve balance;
- Require that the covered institution maintain documentation of its processes for the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements;
- Describe how incentive-based compensation arrangements will be monitored;
- Specify the substantive and procedural requirements of the independent compliance program; and
- Ensure appropriate roles for risk management, risk oversight, and other control personnel in the covered institution’s processes for designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting and assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking.
The proposed definition of “significant risk-taker” incorporates two tests for determining whether a covered person is a significant risk-taker. A covered person would be a significant risk-taker if either test was met. [The first test is based on compensation levels.]
The second test is based on whether the covered person has authority to commit or expose 0.5 percent or more of the capital of the covered institution or an affiliate that is itself a covered institution (the “exposure test”).