Alert February 02, 2010

Basel Committee Issues Guidance Concerning Banks’ Compensation Practices

The Basel Committee on Banking Supervision of the Bank for International Settlements (the “Basel Committee”) issued guidance on “Compensation Principles and Standards Assessment Methodology” (the “Guidance”).  The Guidance is designed to assist national financial supervisory agencies in assessing a bank’s compensation practices.  The Basel Committee said that the Guidance “will contribute to ongoing implementation of” nine “Principles for Sound Compensation Practices” (the “Principles”) adopted by the Financial Stability Board (the predecessor of the Financial Statutory Forum (the “FSF”)) that the Basel Committee believes are appropriate standards to use in implementing banks’ compensation practices. 

The Guidance covers all nine Principles, which are organized into three sections and address: (1) governance of compensation; (2) alignment of compensation with prudent risk taking; and (3) supervisory oversight of compensation practices and engagement by stakeholders.  The Principles were proposed by the FSF as standards to reduce individuals’ incentives to take excessive risks present in banks’ compensation arrangements. 

The Guidance recognizes that the Principles are designed to be internationally agreed upon objectives and high level principles with only a few specific benchmarks.  The Basel Committee also acknowledges that the translation of the Principles and Guidance into national (rather than international) rules is key and that “in many countries, domestic rules represent the key reference point for supervisors, both in practice and in a legal sense.”  In addition, the Basel Committee stated that the Guidance is targeted at “significant financial institutions, particularly large, systematically important firms.” 

The assessment methodology provided in the Guidance has two major parts.  The first part provides examples of criteria that could be used to assess whether a bank’s compensation practices achieve the objectives of the applicable Principle.  The second component – a supervisory review section – provides a toolkit that the Basel Committee said should be adapted to existing supervisory approaches and to the bank being examined.  The Basel Committee further stated that the Guidance is “designed to help support a level playing field.”

The nine Principles are set forth below and certain aspects of the related Guidance proposed by the Basel Committee are discussed following each set of Principles:

I.          Principles concerning effective governance of compensation

Principle 1:  The firm’s board of directors must actively oversee the compensation system’s design and operation.  The compensation system should not be primarily controlled by the chief executive officer and management team.  Relevant board members and employees must have independence and expertise in risk management and compensation.

Principle 2:  The firm’s board of directors must monitor and review the compensation system to ensure the system operates as intended.  The compensation system should include controls.  The practical operation of the system should be regularly reviewed for compliance with design policies and procedures.  Compensation outcomes, risk measurements, and risk outcomes should be regularly reviewed for consistency with intentions.

Principle 3:  Staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm.  Effective independence and appropriate authority of such staff are necessary to preserve the integrity of financial and risk management’s influence on incentive compensation.

Principles 1, 2 and 3 focus on governance of compensation practices and the effectiveness of an independent financial and risk control function.  The Guidance discusses the need for a compensation committee of the Board of Directors that exercises competent and independent judgment on compensation policies and practices, that works closely with a bank’s risk management committee and/or risk management function and that ensures that compensation arrangements do not provide incentives for excessive risk taking.  Among suggestions made are that personnel involved in controlling compensation risk management be themselves compensated at a level “sufficient to allow them to carry out their function effectively” and that the Board and/or the compensation committee be actively involved in performance reviews of these individuals.

II.         Principles concerning alignment of compensation with prudent risk taking

Principle 4:  Compensation must be adjusted for all types of risk.  Two employees who generate the same short-run profit but take different amounts of risk on behalf of their firm should not be treated the same by the compensation system.  In general, both quantitative measures and human judgment should play a role in determining risk adjustments.  Risk adjustments should account for all types of risk, including difficult-to-measure risks such as liquidity risk, reputation risk and cost of capital.

Principle 5:  Compensation outcomes must be symmetric with risk outcomes.  Compensation systems should link the size of the bonus pool to the overall performance of the firm.  Employees’ incentive payments should be linked to the contribution of the individual and business to such performance.  Bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.

Principle 6:  Compensation payout schedules must be sensitive to the time horizon of risks.  Profits and losses of different activities of a financial firm are realized over different periods of time.  Variable compensation payments should be deferred accordingly.  Payments should not be finalized over short periods where risks are realized over long periods.  Management should question payouts for income that cannot be realized or whose likelihood of realization remains uncertain at the time of payout.

Principle 7:  The mix of cash, equity and other forms of compensation must be consistent with risk alignment.  The mix will vary depending on the employee’s position and role.  The firm should be able to explain the rationale for its mix.

Principles 4 through 7 focus on compensation practices that reduce employees’ incentives to take excessive risk.  The Guidance suggests that in determining a business unit’s variable compensation pool, the amount should be adjusted for all types of risk and notes specifically as elements to be considered: (a) the cost and quantity of capital required to support the risk of the business; (b) the liquidity risk assumed in the conduct of the business; and (c) consistency with the timing and likelihood of potential future revenues incorporated into current earnings.  The Guidance provides that compensation payments should be deferred to permit clawback in the event of realization of risks during the deferral period.  The Guidance suggests that firms have measures or strategies to treat “difficult-to-measure” risks, such as reputational risk, in their compensation practices.  The Guidance further states that a low level of profits or losses at the firm-wide level should reduce or eliminate bonus pool payments and variable compensation to senior executives.  Furthermore, the Basel Committee says that firms should have in place procedures or guidelines that explain the rationale for the percentage of cash, equity and other forms of compensation granted to an individual.

III.       Principles concerning supervisory oversight and engagement by stakeholders

Principle 8:  Supervisory review of compensation practices must be rigorous and sustained, and deficiencies must be addressed promptly with supervisory action.  Supervisors should include compensation practices in their risk assessment of firms, and firms should work constructively with supervisors to ensure their practices conform with the Principles.  Regulations and supervisory practices will naturally differ across jurisdictions and potentially among authorities within a country.  Nevertheless, all supervisors should strive for effective review and intervention.  National authorities, working through the FSF, will ensure even application across domestic financial institutions and jurisdictions

Principle 9:  Firms must disclose clear, comprehensive and timely information about their compensation practices to facilitate constructive engagement by all stakeholders.  Stakeholders need to be able to evaluate the quality of support for the firm’s strategy and risk posture.  Appropriate disclosure related to risk management and other control systems will enable a firm’s counterparties to make informed decisions about their business relations with the firm.  Supervisors should have access to all information they need to evaluate the conformance of practice to the Principles.

Principles 8 and 9 address supervisory review of compensation practices and transparency of disclosure of compensation practices.  The Guidance urges that national supervisors should limit variable compensation as a percentage of total net revenue when it is inconsistent with the maintenance of sound capital levels.  In addition, the Guidance provides that national supervisors should coordinate their efforts so that compensation standards are implemented consistently across jurisdictions.  Furthermore, the Guidance suggests that disclosure of compensation practices should include, among other things, criteria used for performance measurement and risk adjustment, the linkage between pay and performance, deferral policy and vesting criteria, and the parameters used for allocating cash versus other forms of compensation.

The Principles of the Basel Committee’s Guidance represent an international attempt to articulate best practices for compensation practices at large banks.  These initiatives will continue both on a U.S. and international level and the Alert will continue to follow developments in this area.