The Federal Reserve Board has issued proposed guidance that would provide the Fed with enhanced supervisory powers over incentive compensation programs at the institutions it regulates. The proposal focuses on the management of risk by targeting programs that create incentives that threaten the institution’s safety and soundness. Only institutions subject to Fed regulation will be affected by the proposal, including (i) U.S. bank holding companies, state member banks, and foreign banks with a U.S. branch, agency or lending subsidiary. It can be expected, however, that other federal and state regulators will follow suit in the coming months with similar guidance.

The proposal does not create specific compensation guidelines or impose specific limits on executive pay. Rather, the Fed has advanced a series of principles for supervisory review of incentive pay programs. Under the proposal, incentive compensation arrangements must (i) provide incentives that do not encourage excessive risk-taking beyond the organization’s ability to effectively identify and manage the risk, (ii) be compatible with effective controls and risk management and (iii) be support by strong corporate governance, including active and effective board oversight.

Nor does the proposal limit its coverage to an institution’s most senior executives as was the case for institutions that received TARP assistance. Under the Fed proposal, covered groups include (i) senior executives and others responsible for firm-wide or material business lines, (ii) individual employees, including non-executives, whose activities may expose the institution to risk and (iii) groups of employees, such as loan officers, who, in the aggregate, may expose the institution to material risk.

The proposal includes detailed guidance on the scope of each principle. Without mandating specific action, the Fed offers commentary on the ways in which each principle can be satisfied. For example, four approaches are suggested as the basis for programs that create balanced risk-taking incentives: (i) risk adjustment of rewards such that employees who achieve results based on higher risk activities may receive reduced awards, (ii) deferral of payouts to ensure that the risks from employee activities are fully realized prior to payment, (iii) expansion of performance periods to allow risk potential to be fully realized and (iv) reducing the sensitivity of awards to short-term performance.

The Fed proposal also tightens the nexus between an institution’s compensation policy makers (the board, senior managers, human resources department) and the institution’s risk management team. The proposal encourages risk management personnel to participate in the design phase of the compensation planning process and should have a role in “assessing their effectiveness in restraining excessive risk taking.”

Finally, the proposal highlights the role of the board and appropriate board committees in all phases of the compensation process. Again, the emphasis is on risk management. Under the proposal, the board is charged with periodic review of all compensation programs from a risk perspective since the board, in the Fed’s view, is “ultimately responsible for ensuring that the organizations incentive compensation arrangements.…do not jeopardize the safety and soundness of the organization.”

The proposed rules indicate that the Fed is launching two new supervisory initiatives as a follow-on effort to the new guidance. The first initiative targets, in the Fed’s term, large complex banking organizations or “LCBOs” that warrant the highest degree of regulatory scrutiny. The Fed will conduct a formal review of incentive compensation arrangements at LCBOs to increase supervisory understanding of LCBO programs, evaluate internal risk controls, analyze corporate governance practices and identify best practices.

The second initiative will focus on regional and community banks where the focus will be on the review of incentive compensation programs in the course of the regular supervisory examination process. The release notes, however, that small institutions that use incentive arrangements on a limited basis would not be “expected to have as formalized, extensive, and detailed policies, procedures, and systems governing its incentive compensation arrangements” as an LCBO.

The Fed proposal is noteworthy from several perspectives. First, the release highlights the position of the Fed as the “first among equals” federal regulator, taking the lead on broad-based guidance on compensation matters. It is likely that other agencies will follow suit, particularly in the examination context. Second, the proposal represents a significant increase in supervisory interest in, if not authority over, compensation matters at financial institutions. In the past, it has been typical that most incentive compensation arrangements fell well within the bounds of safety and soundness. Under the Fed principles identified in this release, it is possible that many “garden variety” arrangements, including annual bonus programs and golden parachute arrangements, will be called into question from a risk perspective.

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