December 14, 2009
Authored by: Bryan Cave
On October 22, 2009, the Federal Register published proposed guidance from the Federal Reserve for structuring incentive compensation arrangements at banking organizations.
There are several notable aspects of the proposed guidance. First, the Federal Reserve expects all banking organizations, not just entities participating in the Troubled Asset Relief Program, to review their incentive compensation arrangements in light of the guidance. Second, the guidance sets forth principles that banking organizations should follow and implement as part of their incentive compensation arrangements, but does not establish pay caps or other specific formulas for calculating incentive compensation. Third, the principles in the guidance apply to incentive compensation arrangements for executives, employees, and groups of employees who may expose the organization to material amounts of risk. They are not limited to compensation arrangements for executive officers or other highly compensated employees.
Principles of a Sound Incentive Compensation System
The Federal Reserve guidance is centered on three (3) main principles that should be followed when designing a sound incentive compensation system.
Principle #1: Balanced Risk-Taking Incentives
- Incentive compensation arrangements should account for risks associated with employee’s activities when developing incentive compensation arrangements.
An incentive compensation arrangement should balance the risk and the reward associated with activities undertaken by the employee. This balance is achieved when incentive compensation paid to an employee accounts for the risks and the financial benefits associated with the employee’s activities. This may require banking organizations to reduce the amount of incentive compensation payable to an employee to account for the risks.
Example: Two employees generate the same amount of short-term profit, but the activities of one employee result in greater risk to the banking organization. Under a balanced incentive compensation arrangement, the employee whose activities result in a greater risk to the banking organization should receive less than the employee whose activities did not result in a greater risk to the banking organization.
- Employees should understand how risk and risk outcomes are accounted for in their incentive compensation arrangements.
Banking organizations should communicate clearly to employees how an incentive compensation arrangement will account for risk and risk outcomes. The communication should include examples and should be tailored to the employees.