Alert October 27, 2009

The FRB Proposes Guidance on Incentive Compensation Practices

On October 22, 2009, the FRB issued proposed guidance and announced two initiatives relating to the incentive compensation policies and practices of banking organizations under the FRB’s supervision.  The FRB’s release (1) sets forth a set of principles designed to ensure that banking organizations’ incentive compensation practices do not undermine the safety and soundness of such organizations or encourage excessive risk taking, and (2) announces the following two new FRB supervisory initiatives:

  • a special “horizontal review” of the incentive compensation practices at 28 large complex banking organizations (“LCBOs”); and
  • a review of incentive compensation practices at smaller regional, community and other banking organizations not classified as LCBOs, as part of a regular risk-focused examination process.

The FRB did not name the 28 LCBOs subject to the “horizontal review.”  The proposed guidance explains the FRB’s expectation that each LCBO will cooperate with the compensation review and work closely with the FRB to evaluate its incentive compensation practices.  Such cooperation includes providing the FRB with information and documents clearly describing the LCBO’s existing incentive compensation arrangements, processes and plans and all related risk-management controls and practices.  The FRB will supervise each LCBO to make certain that results of the review are implemented in a timely manner, and the FRB may take enforcement actions against non-compliant organizations.  For non‑LCBO’s, the FRB’s review will be tailored to reflect the complexity and scope of the organization’s activities and compensation arrangements.

Within the release, the FRB also sets out and explains three guiding principles for incentive compensation arrangements at banking organizations.  Such arrangements should:

  • provide employees with incentives that do not encourage risk-taking behavior in excess of the banking organization’s ability to identify and manage risk effectively and that effectively balance risk-taking incentives;
  • be compatible with an organization’s effective controls and risk management; and
  • be supported by strong corporate governance practices, including active and effective oversight by the board of directors (or compensation committee, as appropriate).

The FRB will conduct the reviews discussed above and make recommendations in accordance with these guiding principles.  The proposed guidance and review initiatives will apply to incentive compensation arrangements for the following employees:

  • senior executives and other employees with responsibility for oversight of the organization’s firm-wide activities or material business lines;
  • individual employees whose activities may expose the organization to material risks; and
  • groups of employees with the same or similar incentive compensation arrangements that, in the aggregate, could expose the organization to material risk.
The proposed guidance will become effective 30 days after its publication in the Federal Register.  In a related Q & A, the FRB also explained that it does not favor a pay cap or other “one size fits all” approaches for its the organizations over which it has supervisory authority.