Proposed Guidance on Sound Incentive Compensation Policies, 55227-55238 [E9-25766]

Agencies

• FEDERAL RESERVE SYSTEM

[Federal Register Volume 74, Number 206 (Tuesday, October 27, 2009)]
[Notices]
[Pages 55227-55238]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-25766]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1374]


Proposed Guidance on Sound Incentive Compensation Policies

AGENCY: Board of Governors of the Federal Reserve System (Board).

ACTION: Proposed guidance with request for public comment.

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SUMMARY: The Board is requesting comment on proposed guidance (the 
``guidance'') designed to help ensure that incentive compensation 
policies at banking organizations do not encourage excessive risk-
taking and are consistent with the safety and soundness of the 
organization. The Federal Reserve also is commencing two supervisory 
initiatives to spur progress by the banking industry in the development 
and implementation of sound incentive compensation arrangements, 
identify emerging best practices, and advance the state of practice 
more generally in the banking industry. The Federal Reserve expects all 
banking organizations to evaluate their incentive compensation 
arrangements and related risk management, control, and corporate 
governance processes and immediately address deficiencies in these 
arrangements or processes that are inconsistent with safety and 
soundness.

DATES: Comments must be submitted on or before November 27, 2009.

ADDRESSES: The Board will review all of the comments submitted. Please 
consider submitting your comments by e-mail or fax since paper mail in 
the Washington DC area and at the Board is subject to delay. You may 
submit comments, identified by Docket No. OP-1374, by any of the 
following methods:
     Agency Web Site: https://www.federalreserve.gov. Follow the 
instructions for submitting comments at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: regs.comments@federalreserve.gov. Include the 
docket number in the subject line of the message.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.

All public comments are available from the Board's Web site at https://
www.federalreserve.gov/generalinfo/

[[Page 55228]]

foia/ProposedRegs.cfm as submitted, unless modified for technical 
reasons. Accordingly, your comments will not be edited to remove any 
identifying or contact information. Public comments may also be viewed 
in electronic or paper form in Room MP-500 of the Board's Martin 
Building (20th and C Streets, NW.,) between 9 a.m. and 5 p.m. on 
weekdays.

FOR FURTHER INFORMATION CONTACT: Barbara J. Bouchard, Associate 
Director, (202) 452-3072, William F. Treacy, Adviser, (202) 452-3859, 
Robert Motyka, Senior Project Manager, (202) 452-5231, Division of 
Banking Supervision and Regulation; Mark S. Carey, Adviser, (202) 452-
2784, Division of International Finance; or Kieran J. Fallon, Assistant 
General Counsel, (202) 452-5270, or Michael W. Waldron, Counsel, (202) 
452-2798, Legal Division. For users of Telecommunications Device for 
the Deaf (``TDD'') only, contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

I. Background

    Incentive compensation practices in the financial services industry 
were one of many factors contributing to the financial crisis that 
began in 2007. Banking organizations too often rewarded employees for 
increasing the firm's short-term revenue or profit without adequate 
recognition of the risks the employees' activities posed for the firm. 
Importantly, problematic compensation practices were not limited to the 
most senior executives at financial firms. Compensation practices can 
incent employees at various levels of a banking organization, either 
individually or as a group, to undertake imprudent risks that can 
significantly and adversely affect the risk profile of the firm.
    Supervisory attention and action is necessary to address the 
potential for incentive compensation arrangements to encourage 
employees to take excessive risks on behalf of their organization. 
Shareholders of a banking organization cannot directly control the day-
to-day operations of the firm--especially a large and complex firm--and 
must rely on the firm's management to do so, subject to direction and 
oversight by shareholder-elected boards of directors. Incentive 
compensation arrangements are one way that firms can encourage managers 
and other employees to take actions that are consistent with the 
interests of shareholders by appropriately rewarding behavior that 
increases the organization's revenue, profits, or other measures of 
performance. However, flawed compensation programs can incentivize 
employees to take additional risk beyond the firm's tolerance for, or 
ability to manage, risk in order to increase the employees' personal 
compensation. Shareholders have an interest in ensuring that incentive 
compensation arrangements do not encourage employees to take risks 
beyond the risk tolerance of shareholders.
    Aligning the interests of shareholders and employees, however, is 
not always sufficient to protect the safety and soundness of a banking 
organization. Because of the protections offered by the federal safety 
net, shareholders of a banking organization in some cases may be 
willing to tolerate a degree of risk that is inconsistent with the 
organization's safety and soundness. Thus, a review of incentive 
compensation arrangements and related corporate governance practices to 
ensure that they are effective from the standpoint of shareholders is 
not sufficient to ensure they adequately protect the safety and 
soundness of the organization.
    In addition, supervisors can provide a common prudential foundation 
for incentive compensation arrangements across banking organizations 
and promote the overall movement of the industry toward better 
practices. Even if the owners or managers of an individual firm do not 
like the way compensation is structured at their firm, they may be 
unwilling to make unilateral changes because doing so might mean losing 
valuable employees and business to other firms. Supervisory action can 
play a critical role in addressing this ``first mover'' problem that 
may make it difficult for individual firms to act alone in addressing 
misaligned incentives. Through their actions, supervisors can help to 
better align the interests of managers and other employees with the 
long-term health of the organization, and also reduce firms' concerns 
that making prudent modifications to their incentive compensation 
arrangements might have adverse competitive consequences.

II. Federal Reserve Guidance

    The Federal Reserve has developed the attached guidance to help 
protect the safety and soundness of banking organizations and promote 
the prompt improvement of incentive compensation practices throughout 
the banking industry.\1\ The guidance is based on three key principles 
that are designed to ensure that incentive compensation arrangements at 
a banking organization do not encourage employees to take excessive 
risks. These principles provide that incentive compensation 
arrangements at a banking organization should--
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    \1\ As used in the guidance, the term ``banking organization'' 
includes U.S. bank holding companies, state member banks, Edge and 
agreement corporations, and the U.S. operations of foreign banks 
with a branch, agency, or commercial lending company subsidiary in 
the United States.
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     Provide employees incentives that do not encourage 
excessive risk-taking beyond the organization's ability to effectively 
identify and manage risk;
     Be compatible with effective controls and risk management; 
and
     Be supported by strong corporate governance, including 
active and effective oversight by the organization's board of 
directors.
    These principles, and the types of policies, procedures, and 
systems that banking organizations should have to help ensure 
compliance with these principles, are discussed in more detail in the 
attached proposed guidance. These principles and the guidance are 
consistent with the Principles for Sound Compensation Practices adopted 
by the Financial Stability Board (FSB) in April 2009, as well as the 
Implementation Standards for those principles issued by the FSB in 
September 2009.
    Because incentive compensation arrangements for executive and non-
executive employees may pose safety and soundness risks if not properly 
structured, the proposed guidance applies to senior executives as well 
as other employees who, either individually or as part of a group, may 
expose the relevant banking organization to material amounts of risk. 
In addition, implementation of the guidance by a banking organization 
should be appropriate in light of the scope and complexity of the 
organization's activities, as well as the prevalence and scope of its 
incentive compensation arrangements. Thus, for example, the reviews, 
policies, procedures, and systems implemented by a small banking 
organization that uses incentive compensation arrangements on a limited 
basis will be substantially less extensive, formalized, and detailed 
than those at large, complex banking organization that uses incentive 
compensation arrangements extensively.
    The Board invites comment on all aspects of the guidance. In 
particular, are the three core principles described in the guidance 
appropriate and sufficient to help ensure that incentive compensation 
arrangements do not threaten the safety and soundness of banking 
organizations? Should

[[Page 55229]]

additional or different principles be included to achieve this goal? To 
what extent are the current incentive compensation arrangements of 
banking organizations consistent with the principles set forth in the 
guidance and are there material legal, regulatory, or other impediments 
to the prompt implementation of incentive compensation arrangements and 
related processes that would be consistent with these principles?
    In addition, some have suggested that one or more formulaic limits 
be adopted for some or all banking organizations, and, in particular, 
have suggested consideration of an approach in which at least 60 
percent of all incentive compensation received by senior executives of 
all large, complex banking organizations be deferred and at least 50 
percent of incentive compensation be paid in the form of stock, 
options, or other equity-linked instruments. Would such formulaic 
limits on determining and paying incentive compensation likely promote 
the long-term safety and soundness of banking organizations generally 
if applied to certain types or classes of executive or non-executive 
employees across all or certain types of banking organizations? If so, 
what are those classes of executives, employees and institutions, and 
what formulaic limits would be most effective? Moreover, would market 
forces or practices in the broader financial services industry, such as 
the use of ``golden parachute'' or ``golden handshake'' arrangements to 
retain or attract employees, present challenges for banking 
organizations in developing and maintaining balanced incentive 
compensation arrangements? If so, what types of statutory, regulatory, 
or private-sector actions might help mitigate these challenges?
    Further, the Board seeks comment on whether the proposed guidance 
would impose undue burdens on, or have unintended consequences for, 
banking organizations and, particularly, regional and small 
organizations, and whether there are ways such potential burdens or 
consequences could be addressed in a manner consistent with safety and 
soundness. Also, are there types of incentive compensation plans, such 
as firm-wide profit sharing plans that provide for distributions in a 
manner that is not materially linked to the performance of specific 
employees or groups of employees, that could and should be exempted 
from, or treated differently under, the guidance because they are 
unlikely to affect the risk-taking incentives of all, or a significant 
number of, employees? If so, what are the features of these plans and 
the types of employees for which they are unlikely to affect risk-
taking behavior?

III. Federal Reserve Supervisory Initiatives

    The Federal Reserve expects all banking organizations to evaluate 
their incentive compensation arrangements and related risk management, 
control, and corporate governance processes and immediately address 
deficiencies in these arrangements or processes that are inconsistent 
with safety and soundness. Banking organizations are responsible for 
ensuring that their incentive compensation arrangements are consistent 
with the principles described in the guidance, do not encourage 
excessive risk-taking, and do not pose a threat to the safety and 
soundness of the organization.
    The Federal Reserve is committed to moving the banking industry 
forward to incorporate the principles described in the guidance into 
incentive compensation practices. Accordingly, in addition to proposing 
guidance, the Federal Reserve is commencing the following two 
supervisory initiatives to spur and monitor the industry's progress 
towards the implementation of safe and sound incentive compensation 
arrangements, identify emerging best practices, and advance the state 
of practice more generally in the industry:
     A special horizontal review of incentive compensation 
practices at large complex banking organizations (LCBOs); and
     A review of incentive compensation practices at other 
banking organizations as part of the risk-focused examination process 
for these organizations.
    LCBOs warrant special supervisory attention because they are 
significant users of incentive compensation arrangements and because 
the adverse effects of flawed approaches at these institutions are more 
likely to have adverse effects on the broader financial system.\2\ As 
part of the horizontal review of these firms, each LCBO will be 
expected to provide the Federal Reserve information and documentation 
that clearly describes the organization's current incentive 
compensation practices and its plans (including timetables) for 
improving these practices.
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    \2\ An important aspect of the Federal Reserve's consolidated 
supervision programs for bank holding companies and the combined 
U.S. operations of foreign banking organizations is the assessment 
and evaluation of practices across groups of organizations with 
similar characteristics and risk profiles. LCBOs are characterized 
by the scope and complexity of their domestic and international 
operations; their participation in large volume payment and 
settlement systems; the extent of their custody operations and 
fiduciary activities; and the complexity of their regulatory 
structures, both domestically and in foreign jurisdictions. To be 
designated as an LCBO, a banking organization must meet specified 
criteria to be considered a significant participant in at least one 
key financial market. See SR letter 08-9, Consolidated Supervision 
of Bank Holding Companies and the Combined U.S. Operations of 
Foreign Banking Organization (Oct. 16, 2008).
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    The horizontal review of LCBOs will be led by Board staff, working 
with relevant Reserve Bank supervisors, and will draw on a 
multidisciplinary group comprised of staff with expertise in banking 
supervision, risk management, economics, finance, law, accounting, and 
other areas as appropriate. This multidisciplinary team also will have 
access to information and analysis developed as part of the reviews of 
other banking organizations, and will serve as a resource for 
supervisory staff across the System on incentive compensation matters.
    The Federal Reserve will work closely with each LCBO to ensure that 
its plans are likely to result in the establishment and maintenance of 
incentive compensation arrangements that do not encourage excessive 
risk-taking. The Federal Reserve also will supervise these 
organizations to ensure that these plans are fully implemented in a 
timely manner.
    In the second initiative, the Federal Reserve will review incentive 
compensation arrangements at non-LCBO banking organizations as part of 
risk management reviews during the regular, risk-focused examination 
process. As with other aspects of the examination process, these 
reviews will be tailored to reflect the scope and complexity of the 
organization's activities, as well as the prevalence and scope of the 
organization's incentive compensation arrangements.\3\
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    \3\ Similarly, for foreign banking organizations, the management 
of U.S. operations will be assessed with regard to the consistency 
of incentive compensation arrangements and related processes with 
the principles set forth in this guidance, taking into account the 
size and complexity of U.S. operations. See SR letter 08-9, 
Consolidated Supervision of Bank Holding Companies and the Combined 
U.S. Operations of Foreign Banking Organizations (Oct. 16, 2008).
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    For LCBOs and other organizations, supervisory findings will be 
included in the relevant report of examination or inspection, 
communicated to the organization, and incorporated, as appropriate, 
into the organization's supervisory ratings. The Federal Reserve in 
appropriate circumstances may take enforcement action against a banking 
organization if its incentive compensation arrangements or related risk 
management, control, or governance processes pose a risk to the safety 
and soundness of the organization and the organization is not taking 
prompt and

[[Page 55230]]

effective measures to correct the deficiencies. Where appropriate, such 
an action may require an organization to develop a corrective action 
plan that is acceptable to the Federal Reserve to rectify deficiencies 
in its incentive compensation arrangements or related processes.
    Additional information concerning these supervisory initiatives is 
provided in the guidance. Effective and balanced incentive compensation 
practices are likely to evolve significantly in the coming years, 
spurred by the efforts of banking organizations, supervisors, and other 
stakeholders. The Federal Reserve will review and update the guidance 
as appropriate to incorporate best practices that emerge from these 
efforts. In addition, in order to monitor and encourage improvements, 
Federal Reserve staff will prepare a report on trends and developments 
in compensation practices at banking organizations after the conclusion 
of 2010.

IV. Other Matters

    In accordance with the Paperwork Reduction Act (PRA) of 1995 (44 
U.S.C. 3506; 5 CFR Part 1320 Appendix A.1), the Board reviewed the 
proposed guidance under the authority delegated to the Board by the 
Office of Management and Budget (OMB). The Board has determined that 
certain aspects of the proposed guidance may constitute a collection of 
information. In particular, these aspects are the provisions that state 
a banking organization should (i) have policies and procedures that 
identify and describe the role(s) of the personnel and units authorized 
to be involved in incentive compensation arrangements, identify the 
source of significant risk-related inputs, establish appropriate 
controls governing these inputs to help ensure their integrity, and 
identify the individual(s) and unit(s) whose approval is necessary for 
the establishment or modification of incentive compensation 
arrangements; (ii) create and maintain sufficient documentation to 
permit an audit of the organization's processes for incentive 
compensation arrangements; (iii) have any material exceptions or 
adjustments to the incentive compensation arrangements established for 
senior executives approved and documented by its board of directors; 
and (iv) have its board of directors receive and review, on an annual 
or more frequent basis, an assessment by management of the 
effectiveness of the design and operation of the organization's 
incentive compensation system in providing risk-taking incentives that 
are consistent with the organization's safety and soundness. The 
Federal Reserve estimates that the above-described information 
collections included in the proposed guidance would take respondents, 
on average, 40 hours each year. Any changes to the Federal Reserve's 
regulatory reporting forms that may be made in the future to collect 
information related to incentive compensation arrangements would be 
addressed in a separate Federal Register notice. The Board may not 
conduct or sponsor, and an organization is not required to respond to, 
an information collection unless the information collection displays a 
currently valid OMB control number.
    For purposes of the PRA, this information collection will be titled 
Recordkeeping Provisions Associated with the Incentive Compensation 
Guidance. The agency form number for the collection is FR 4027. The 
agency control number for this new collection will be assigned by OMB.
    This information collection is authorized pursuant to sections 
11(a), 11(i), 25, and 25A of the Federal Reserve Act (12 U.S.C. 248(a), 
248(i), 602, and 611), section 5 of the Bank Holding Company Act (12 
U.S.C. 1844), and section 7(c) of the International Banking Act (12 
U.S.C. 3105(c)). The Board expects to review the policies and 
procedures for incentive compensation arrangements as part of the 
Board's supervisory process. To the extent the Board collects 
information during an examination of a banking organization, 
confidential treatment may be afforded to the records under exemption 8 
of the Freedom of Information Act (FOIA), 5 U.S.C. 552(b)(8).
    The frequency of information collection is estimated to be annual. 
Respondents are banking organizations as defined in the guidance, which 
total 6,889. The estimated annual reporting hours are 275,560.
    Comments on the collection of information should be sent to 
Michelle Shore, Federal Reserve Board Clearance Officer, Division of 
Research and Statistics, Mail Stop 95-A, Board of Governors of the 
Federal Reserve System, Washington, DC 20551, with copies of such 
comments sent to the Office of Management and Budget, Paperwork 
Reduction Project (Docket No. OP-1374), Washington, DC 20503.
    Comments are invited on:
    (1) Whether the proposed collection of information is necessary for 
the proper performance of the Federal Reserve's functions; including 
whether the information has practical utility;
    (2) The accuracy of the Federal Reserve's estimate of the burden of 
the proposed information collection, including the cost of compliance;
    (3) Ways to enhance the quality, utility, and clarity of the 
information to be collected; and
    (4) Ways to minimize the burden of information collection on 
respondents, including through the use of automated collection 
techniques or other forms of information technology.
    While the guidance is not being adopted as a rule, the Board also 
has considered the potential impact of the proposed guidance on small 
banking organizations in accordance with the Regulatory Flexibility Act 
(5 U.S.C. 603(b)). For the reasons discussed in the ``Supplementary 
Information'' above, the Board believes that issuance of the proposed 
guidance is needed to help ensure that incentive compensation 
arrangements do not pose a threat to the safety and soundness of 
banking organizations, including small banking organizations.
    It is estimated that the proposed guidance, if adopted in final 
form, would apply to 3002 small banking organizations (defined as 
banking organizations with $175 million or less in total assets). See 
13 CFR 121.201. The Board has focused the guidance on those employees 
who have the ability, either individually or as part of a group, to 
expose a banking organization to material amounts of risk. In addition, 
the Board has sought to tailor the guidance and its supervisory 
initiatives to account for the differences between large and small 
banking organizations and has provided that, in conducting reviews of 
small banking organizations as part of the regular examination process, 
the Federal Reserve will take into account the scope and complexity of 
the organization's activities, as well as the prevalence and scope of 
its incentive compensation arrangements. In light of the foregoing, the 
Board does not believe that the proposed guidance, if adopted in final 
form, would have a significant economic impact on a substantial number 
of small entities. As noted above, the Board specifically seeks comment 
on whether the proposed guidance would impose undue burdens on, or have 
unintended consequences for, small organizations and whether there are 
ways such potential burdens or consequences could be addressed in a 
manner consistent with safety and soundness.

V. Proposed Guidance

    The text of the proposed guidance is as follows:

[[Page 55231]]

I. Introduction

    Incentive compensation practices in the financial industry were one 
of many factors contributing to the financial crisis. Banking 
organizations too often rewarded employees for increasing the firm's 
revenue or short-term profit without adequate recognition of the risks 
the employees' activities posed to the firm. These practices 
exacerbated the risks and losses at a number of banking organizations 
and resulted in the misalignment of the interests of employees with the 
long-term well being and safety and soundness of their organizations.
    This document provides guidance on sound compensation practices to 
banking organizations supervised by the Federal Reserve.\1\ Alignment 
of the incentives provided to employees with the interests of 
shareholders of the organization often also furthers safety and 
soundness. However, aligning those interests is not always sufficient 
to address safety and soundness concerns. Because of the presence of 
the federal safety net, shareholders of a banking organization in some 
cases may be willing to tolerate a degree of risk that is inconsistent 
with the organization's safety and soundness. Accordingly, the Federal 
Reserve expects banking organizations to maintain incentive 
compensation practices that are consistent with safety and soundness, 
even when these practices go beyond those needed to align shareholder 
and employee interests.
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    \1\ As used in this guidance, the term ``banking organizations'' 
includes U.S. bank holding companies, state member banks, Edge and 
agreement corporations, and the U.S. operations of foreign banks 
with a branch, agency, or commercial lending company in the United 
States.
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    To be consistent with safety and soundness, incentive compensation 
arrangements at a banking organization should:
     Provide employees incentives that do not encourage 
excessive risk-taking beyond the organization's ability to effectively 
identify and manage risk;
     Be compatible with effective controls and risk management; 
and
     Be supported by strong corporate governance, including 
active and effective oversight by the organization's board of 
directors.
    These principles, and the types of policies, procedures, and 
systems that banking organizations should have to help ensure 
compliance with these principles, are discussed in Part II of this 
guidance.
    The Federal Reserve expects all banking organizations to evaluate 
their incentive compensation arrangements for executive and non-
executive employees who, either individually or as part of a group, 
have the ability to expose the firm to material amounts of risk and the 
risk management, control, and corporate governance processes related to 
these arrangements. Banking organizations should immediately address 
deficiencies in these arrangements or processes that are inconsistent 
with safety and soundness. Banking organizations are responsible for 
ensuring that their incentive compensation arrangements are consistent 
with the principles described in this guidance and do not encourage 
excessive risk-taking or pose a threat to the safety and soundness of 
the organization.\2\
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    \2\ In this guidance, the term ``incentive compensation'' refers 
to that portion of an employee's current or potential compensation 
that is tied to achievement of one or more specific metrics (e.g., a 
level of sales, revenue, or income). Incentive compensation does not 
include compensation that is awarded solely for, and the payment of 
which is tied to, continued employment (e.g., salary).
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    Designing and implementing compensation arrangements that properly 
incent employees to pursue the organization's long-term well being and 
that do not encourage excessive risk-taking is a complex task and one 
that requires the commitment of adequate resources. The Federal Reserve 
recognizes that incentive compensation arrangements often seek to serve 
several important and worthy objectives.\3\ It is important that 
incentive compensation arrangements be properly structured for all 
employees at a banking organization, including non-executive employees, 
who have the ability, either individually or as a group, to take 
material risks. The analysis and methods for making incentive 
compensation arrangements take appropriate account of risk also should 
be tailored to the business model, risk tolerance, size, and complexity 
of each firm. Thus, achieving and sustaining adherence to sound 
practices will present challenges.
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    \3\ For example, incentive compensation arrangements may be used 
to help attract skilled staff, promote better firm and employee 
performance, promote employee retention, provide retirement security 
to employees, or provide a closer tie between compensation expenses 
and revenue on a firm-wide basis.
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    While the issues are complex, the Federal Reserve is committed to 
moving banking organizations forward to incorporate the principles 
described in this guidance into incentive compensation practices. To 
help accomplish this, the Federal Reserve is commencing two supervisory 
initiatives:
     A special horizontal review of incentive compensation 
practices at large, complex banking organizations; and
     A review of incentive compensation practices at other 
banking organizations as part of the regular risk-focused examination 
process for these organizations.

These initiatives, which are described in greater detail in Part III of 
this guidance, are designed to spur and monitor progress toward safe 
and sound incentive compensation arrangements, identify emerging best 
practices, and advance the state of practice more generally in the 
industry.
    The Federal Reserve expects to commence promptly the horizontal 
review of large, complex banking organizations (LCBOs). As part of this 
review, each LCBO will be expected to provide the Federal Reserve with, 
among other things, the organization's plans, including relevant 
timetables, for improving the risk-sensitivity of its incentive 
compensation arrangements and related risk management, controls, and 
corporate governance practices. The Federal Reserve will work with 
these organizations as necessary through the supervisory process to 
ensure that they produce plans that will promptly result in incentive 
compensation arrangements that are consistent with safety and 
soundness, and will supervise the organizations to ensure that these 
plans are fully implemented in an expeditious manner.
    To promote consistency and to leverage the resources available at 
the Federal Reserve, the horizontal review of LCBOs will be led by 
Board staff, working with Reserve Bank supervisors responsible for 
LCBOs. This coordinating group will be comprised of staff with 
expertise in banking supervision, risk management, economics, finance, 
law, accounting, and other areas as appropriate. This multidisciplinary 
team also will have access to information and analysis developed as 
part of the reviews of other banking organizations and will serve as a 
resource for supervisory staff across the System on incentive 
compensation matters.
    As part of the supervisory process for all banking organizations, 
the Federal Reserve will assess the potential for incentive 
compensation arrangements to encourage excessive risk-taking, the 
actions an organization has taken or proposes to take to correct 
deficiencies, and the adequacy of the organization's compensation-
related risk management, control, and corporate governance processes. 
Reviews at regional and community banking organizations will be 
conducted as part of the evaluation

[[Page 55232]]

the firm's risk management, internal controls, and corporate governance 
during the regular examination process.\4\ These reviews will be 
tailored to reflect the scope and complexity of the organization's 
activities, as well as the prevalence and scope of its incentive 
compensation arrangements. In this regard, the compensation-related 
policies, procedures, and systems at a small banking organization that 
uses incentive compensation arrangements on a limited basis will be 
substantially less extensive, formalized, and detailed than those of an 
LCBO that uses incentive compensation arrangements extensively.
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    \4\ Thus, for example, reviews at bank holding companies with 
total consolidated assets of $5 billion or less will be conducted in 
accordance with the risk-focused supervision program for these 
organizations. See SR letter 02-1, Revisions to Bank Holding Company 
Supervision Procedures for Organizations with Total Consolidated 
Assets of $5 Billion or Less (Jan. 9, 2002).
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    Supervisory findings for all types of organizations will be 
included in the relevant report of examination or inspection and 
communicated to the organization.\5\ In addition, these findings will 
be incorporated, as appropriate, into the organization's rating 
component(s) and subcomponent(s) relating to risk management, internal 
controls, and corporate governance under the relevant supervisory 
rating system, as well as the organization's overall supervisory 
rating.\6\
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    \5\ See SR letter 08-1, Communication of Examination/Inspection 
Findings (Jan. 24, 2008).
    \6\ For example, supervisory findings for bank holding companies 
in the areas discussed in this guidance should be incorporated into 
the assessment of the appropriate subcomponent(s) for the BHC's 
``Risk Management'' rating component in the RFI (Risk Management, 
Financial Condition, and Impact) rating. See SR letter 04-18, Bank 
Holding Company Rating System (Dec. 6, 2004).
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    In appropriate circumstances, the Federal Reserve may take 
enforcement action against a banking organization if its incentive 
compensation arrangements or related risk management, control, or 
governance processes pose a risk to the safety and soundness of the 
organization and the organization is not taking prompt and effective 
measures to correct the deficiencies. For example, the Federal Reserve 
may take an enforcement action it considers appropriate against an LCBO 
if the organization fails to develop, submit, or adhere to an effective 
plan designed to ensure that the organization's incentive compensation 
arrangements do not encourage excessive risk-taking and are consistent 
with principles of safety and soundness. As provided under section 8 of 
the Federal Deposit Insurance Act (12 U.S.C. 1818), an enforcement 
action may, among other things, require an organization to develop a 
corrective action plan that is acceptable to the Federal Reserve to 
rectify deficiencies in its incentive compensation arrangements or 
related processes. Where warranted, the Federal Reserve may require the 
organization to take affirmative action to correct or remedy 
deficiencies related to the organization's incentive compensation 
practices until its corrective action plan is implemented.
    Effective and balanced incentive compensation practices are likely 
to evolve significantly in the coming years, spurred by the efforts of 
banking organizations, supervisors, and other stakeholders. The Federal 
Reserve will review and update this guidance as appropriate to 
incorporate best practices that emerge from these efforts.

II. Principles of a Sound Incentive Compensation System

    The incentive compensation arrangements and related policies and 
procedures of banking organizations should be consistent with 
principles of safety and soundness.\7\ This guidance is intended to 
assist banking organizations in designing and implementing incentive 
compensation arrangements and related policies and procedures that 
effectively take account of potential risks and risk outcomes.\8\ 
Because incentive compensation arrangements for executive and non-
executive personnel who have the ability to expose a banking 
organization to material amounts of risk may, if not properly 
structured, pose a threat to the organization's safety and soundness, 
this guidance applies to incentive compensation arrangements for:
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    \7\ In the case of the U.S. operations of foreign banks, the 
organization's policies, including management, review, and approval 
requirements, should be coordinated with the foreign bank's group-
wide policies developed in accordance with the rules of the foreign 
bank's home country supervisor and should be consistent with the 
foreign bank's overall corporate and management structure as well as 
its framework for risk management and internal controls.
    \8\ This guidance and the principles reflected herein are 
consistent with the Principles for Sound Compensation Practices 
issued by the Financial Stability Board (FSB) in April 2009, and 
with the FSB's Implementation Standards for those principles, issued 
in September 2009.
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     Senior executives and others who are responsible for 
oversight of the organization's firm-wide activities or material 
business lines;
     Individual employees, including non-executive employees, 
whose activities may expose the firm to material amounts of risk (e.g., 
traders with large position limits relative to the firm's overall risk 
tolerance); and
     Groups of employees who are subject to the same or similar 
incentive compensation arrangements and who, in the aggregate, may 
expose the firm to material amounts of risk, even if no individual 
employee is likely to expose the firm to material risk (e.g., loan 
officers who, as a group, originate loans that account for a material 
amount of the organization's credit risk).
    For ease of reference, these executive and non-executive employees 
are collectively referred to as ``employees.'' Depending on the facts 
and circumstances of the individual organization, jobs and job families 
that are outside the scope of this guidance because they do not have 
the ability to expose the organization to material risks may include, 
for example, tellers, bookkeepers, couriers, or data processing 
personnel.
Principle 1: Balanced Risk-Taking Incentives
    Incentive compensation arrangements should balance risk and 
financial results in a manner that does not provide employees 
incentives to take excessive risks on behalf of the banking 
organization.
    Incentive compensation arrangements typically attempt to encourage 
actions that result in greater revenue or profit for the firm. However, 
short-run revenue or profit can often diverge sharply from actual long-
run profit because risk outcomes may become clear only over time. 
Activities that carry higher risk typically yield higher short-term 
revenue, and an employee who is given incentives to increase short-term 
revenue or profit, without regard to risk, will naturally be attracted 
to opportunities to take more risk.
    An incentive compensation arrangement is balanced when the amounts 
paid to an employee appropriately take into account the risks, as well 
as the financial benefits, from the employee's activities and the 
impact of those activities on the organization's safety and soundness. 
As an example, under a balanced incentive compensation arrangement, two 
employees who generate the same amount of short-term revenue or profit 
for an organization should not receive the same amount of incentive 
compensation if the risks taken by the employees in generating that 
revenue or profit differ materially. The employee whose activities 
create materially larger risks for the organization should receive less 
than the other employee, all else being equal.

[[Page 55233]]

    The performance measures used in an incentive compensation 
arrangement have an important effect on the incentives provided 
employees and, thus, the potential for the arrangement to encourage 
excessive risk-taking. For example, if an employee's incentive 
compensation payments are closely tied to short-term revenue or profit 
of business generated by the employee, without any adjustments for the 
risks associated with the associated business, the potential for the 
arrangement to encourage excessive risk-taking may be quite strong. On 
the other hand, if an employee's incentive compensation payments are 
determined based on performance measures that are only distantly linked 
to the employee's activities (e.g., for most employees, firm-wide 
profit), the potential for the arrangement to encourage the employee to 
take excessive risks on behalf of the organization may be weak.\9\
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    \9\ Similarly, the size of an employee's incentive compensation 
payments in relation to the employee's total compensation package 
may affect the likelihood that the incentive compensation 
arrangement may induce the employee to take excessive risks. For 
example, where incentive compensation is a small portion of 
employees' total compensation--as is the case for many employees at 
regional and community banking organizations--such compensation is 
less likely to affect the employees' risk-taking behavior than when 
incentive compensation represents a large percentage, or even a 
majority, of the employees' total compensation.
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    Incentive compensation arrangements should not only be balanced in 
design, they also should be implemented so that actual payments vary 
based on risks or risk outcomes. If, for example, employees are paid 
substantially all of their potential incentive compensation even when 
risk or risk outcomes are materially worse than expected, employees 
have less incentive to avoid excessively risky activities.
     Banking organizations should consider the full range of 
risks associated with an employee's activities, as well as the time 
horizon over which those risks may be realized, in assessing whether 
incentive compensation arrangements are balanced.
    The activities of employees may create a wide range of risks for a 
banking organization, including credit, market, liquidity, operational, 
legal, compliance, and reputational risks. Some of these risks may be 
realized in the short term, while others may become apparent only over 
the long term. For example, future revenues that are booked as current 
income may not materialize, and short-term profit-and-loss measures may 
not appropriately reflect differences in the risks associated with the 
revenue derived from different activities (e.g., the higher credit or 
compliance risk associated with subprime loans versus prime loans).\10\ 
In addition, some risks may have a low probability of being realized, 
but would have highly adverse effects on the organization if they were 
to be realized (``bad-tail risks''). While shareholders may have less 
incentive to guard against bad-tail risks because of their infrequency 
and the existence of the federal safety net, these risks warrant 
special attention from a safety-and-soundness perspective given the 
threat they pose to the organization's solvency and the federal safety 
net.
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    \10\ Importantly, the time horizon over which a risk outcome may 
be realized is not necessarily the same as the stated maturity of an 
exposure. For example, the ongoing reinvestment of funds by a cash 
management unit in commercial paper with a one-day maturity not only 
exposes the organization to one-day credit risk, but also exposes 
the organization to liquidity risk that may be realized only 
infrequently.
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    Banking organizations should consider the full range of current and 
potential risks associated with the activities of employees, including 
the cost and amount of capital and liquidity needed to support those 
risks, in developing balanced incentive compensation arrangements. 
Reliable quantitative measures of risk and risk outcomes 
(``quantitative measures''), where available, may be particularly 
useful in developing balanced compensation arrangements and in 
assessing the extent to which arrangements are properly balanced. 
However, reliable quantitative measures may not be available for all 
types of risk or for all activities, and their utility for use in 
compensation arrangements varies across business lines and employees. 
The absence of reliable quantitative measures for certain types of 
risks or outcomes does not mean that banking organizations should 
ignore such risks or outcomes for purposes of assessing whether an 
incentive compensation arrangement achieves balance. For example, while 
reliable quantitative measures may not exist for many bad-tail risks, 
it is important that such risks be considered given their potential 
effect on safety and soundness. As in other risk-management areas, 
banking organizations should rely on informed judgments to estimate 
risks and risk outcomes in the absence of reliable quantitative risk 
measures.\11\
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    \11\ Where judgment plays a significant role in the design or 
operation of an incentive compensation arrangement, strong internal 
controls and ex post monitoring of incentive compensation payments 
relative to actual risk outcomes are particularly important to help 
ensure that the arrangements as implemented do not encourage 
excessive risk-taking.
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    Banking organizations, and particularly large, complex 
organizations, should consider using scenario analysis to help assess 
whether the features included in incentive compensation arrangements 
are likely to achieve balance over time. Scenario analysis of incentive 
compensation arrangements involves the evaluation of payments on a 
forward-looking basis based on a range of performance levels, risk 
outcomes, and the levels of risks taken. This type of analysis can help 
an organization assess whether incentive compensation payments to an 
employee are likely to be reduced appropriately as the risks to the 
organization from the employee's activities increase.
     An unbalanced arrangement can be moved toward balance by 
adding or modifying features that cause the amounts ultimately received 
by employees to appropriately reflect risk and risk outcomes.
    If an incentive compensation arrangement may encourage employees to 
take excessive risks, the banking organization should modify the 
arrangement as needed to ensure that it is consistent with safety and 
soundness. Four methods currently are often used to make compensation 
more sensitive to risk. These methods are:
    [cir] Risk Adjustment of Awards: The amount of an incentive 
compensation award for an employee is adjusted based on measures that 
take into account the risk the employee's activities pose to the 
organization. Such measures may be quantitative, or the size of a risk 
adjustment may be set judgmentally, subject to appropriate oversight.
    [cir] Deferral of Payment: The actual payout of an award to an 
employee is delayed significantly beyond the end of the performance 
period, and the amounts paid are adjusted for actual losses or other 
aspects of performance that become clear only during the deferral 
period.\12\ Deferred payouts may be altered according to risk outcomes 
either formulaically or judgmentally, though extensive use of judgment 
might make it more difficult to execute deferral arrangements in a 
sufficiently predictable fashion to influence employee behavior. To be 
most effective, the deferral period should be

[[Page 55234]]

sufficiently long to allow for the realization of a substantial portion 
of the risks from employee activities, and the measures of loss should 
be clearly explained to employees and closely tied to their activities 
during the relevant performance period.
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    \12\ The deferral of payment method is sometimes referred to in 
the industry as a ``clawback.'' The term ``clawback'' also may refer 
specifically to an arrangement under which an employee must return 
incentive compensation payments previously received by the employee 
(and not just deferred) if certain risk outcomes occur. Section 304 
of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7243), which applies to 
chief executive officers and chief financial officers of public 
banking organizations, is an example of this more specific type of 
``clawback'' requirement.
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    [cir] Longer Performance Periods: The time period covered by the 
performance measures used in determining an employee's award is 
extended (for example, from one year to two years). Longer performance 
periods and deferral of payment are related in that both methods allow 
awards or payments to be made after some or all risk outcomes are 
realized or better known.
    [cir] Reduced Sensitivity to Short-Term Performance: The banking 
organization reduces the rate at which awards increase as an employee 
achieves higher levels of the relevant performance measure(s). Rather 
than offsetting risk-taking incentives associated with the use of 
short-term performance measures, this method reduces the magnitude of 
such incentives.\13\
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    \13\ Performance targets may have a material effect on risk-
taking incentives. Such targets may offer employees greater rewards 
for increments of performance that are above the target or may 
provide that awards will be granted only if a target is met or 
exceeded. Employees may be particularly motivated to take excessive 
risk in order to reach performance targets that are aggressive, but 
potentially achievable.
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    These methods for achieving balance are not exclusive, and 
additional methods or variations may exist or be developed. Moreover, 
each method has its own advantages and disadvantages. For example, 
where reliable risk measures exist, risk adjustment of awards may be 
more effective than deferral of payment in reducing incentives for 
excessive risk-taking. This is because risk adjustment potentially can 
take account of the full range and time horizon of risks, rather than 
just those risk outcomes that occur or become evident during the 
deferral period. On the other hand, deferral of payment may be more 
effective than risk adjustment in mitigating incentives to take hard-
to-measure risks (such as the risks of new activities or products), 
particularly if such risks are likely to be realized during the 
deferral period. Accordingly, in some cases two or more methods may be 
needed in combination for an incentive compensation arrangement to be 
balanced. The greater the potential incentives an arrangement creates 
for an employee to increase the risks borne by the organization, the 
stronger the effect should be of the methods applied to achieve 
balance.
    Methods and practices for making compensation sensitive to risk-
taking are likely to evolve rapidly during the next few years, driven 
in part by the efforts of supervisors and other stakeholders. A banking 
organization should monitor developments in the field and should 
incorporate new or emerging methods or practices that are likely to 
improve the organization's safety and soundness into its incentive 
compensation systems.
     The manner in which a banking organization seeks to 
achieve balanced incentive compensation arrangements should be tailored 
to account for the differences between employees--including the 
substantial differences between senior executives and other employees--
as well as between banking organizations.
    Activities and risks may vary significantly both across banking 
organizations and across employees within a particular banking 
organization. For example, the risks associated with the activities of 
one group of non-executive employees (e.g., loan originators) may 
differ significantly from those of another group of non-executive 
employees (e.g., spot foreign exchange traders). In addition, reliable 
quantitative measures of risk and risk outcomes are unlikely to be 
available for a banking organization as a whole, particularly a large 
complex organization. This can make it difficult for banking 
organizations to achieve balanced compensation arrangements for senior 
executives who have responsibility for managing risks on a firm-wide 
basis through use of the risk adjustment of award method.
    Moreover, the payment of deferred incentive compensation in equity 
(such as restricted stock of the organization) or equity-based 
instruments (such as options to acquire the organization's stock) may 
be effective in restraining the risk-taking incentives of senior 
executives and other employees whose activities may have a material 
effect on the overall financial performance of the firm. However, 
equity-related deferred compensation may not be as effective in 
restraining the incentives of lower-level employees (particularly at 
large organizations) to take risks because such employees are unlikely 
to believe that their actions will materially affect the organization's 
stock price.
    Banking organizations should take account of these differences when 
constructing balanced compensation arrangements. For most banking 
organizations, the use of a single, formulaic approach to making 
employee incentive compensation arrangements appropriately risk-
sensitive is likely to provide at least some employees with incentives 
to take excessive risks.\14\
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    \14\ For example, spreading payouts of incentive compensation 
awards over a three-year period may not be sufficient by itself to 
balance the compensation arrangements of employees who may expose 
the organization to substantial longer-term risks.
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    Incentive compensation arrangements for senior executives at LCBOs 
are likely to be better balanced if they involve deferral of a 
substantial portion of the executives' incentive compensation over a 
multi-year period in a way that reduces the amount received in the 
event of poor performance, substantial use of multi-year performance 
periods, or both. Similarly, the compensation arrangements for senior 
executives at LCBOs are likely to be better balanced if a significant 
portion of the incentive compensation of these executives is paid in 
the form of equity-based instruments that vest over multiple years, 
with the number of instruments ultimately received dependent on the 
performance of the firm during the deferral period. The portion of the 
incentive compensation of other employees that is deferred or paid in 
the form of equity-based instruments should appropriately take into 
account the level, nature, and duration of the risks that the 
employees' activities create for the organization and the extent to 
which those activities may materially affect the overall performance of 
the firm and its stock price.
     Banking organizations should carefully consider the 
potential for ``golden parachutes'' and the vesting arrangements for 
deferred compensation to affect the risk-taking behavior of employees 
while at the organizations.
    Arrangements that provide for an employee (typically a senior 
executive), upon departure from the organization or a change in control 
of the organization, to receive large additional payments or the 
accelerated payment of deferred amounts without regard to risk or risk 
outcomes, can provide the employee significant incentives to engage in 
undue risk-taking. Banking organizations should carefully review any 
such existing or proposed arrangements (sometimes called ``golden 
parachutes'') and the potential impact of such arrangements on the 
organization's safety and soundness. A banking organization should 
ensure that golden parachute arrangements do not encourage excessive 
risk-taking in light of the other features of the employee's incentive 
compensation arrangements.
    Similarly, provisions that require an employee to forfeit deferred 
incentive compensation payments upon departure from the organization 
may weaken the

[[Page 55235]]

effectiveness of the deferral arrangement in achieving balance by 
removing the employee's financial exposure to the risk outcomes of the 
employee's activities at the firm. This weakening effect can be 
particularly significant for senior executives or other skilled 
individuals whose services are in high demand within the market. In 
such circumstances, the departing employee often may be able to 
negotiate a ``golden handshake'' arrangement with the employee's new 
firm, which compensates the employee for some or all of the estimated, 
non-risk-adjusted value of the deferred incentive compensation 
forfeited by the employee upon departure from the organization. While a 
banking organization may not be able to control the hiring practices of 
other firms, it should consider whether golden handshake arrangements 
are materially weakening the organization's efforts to constrain the 
risk-taking incentives of employees and, if so, whether changes to the 
organization's deferred compensation vesting policies or other aspects 
of its incentive compensation arrangements should be made to ensure 
that they do not encourage employees to take excessive risks while 
employed by the organization.
     Banking organizations should effectively communicate to 
employees the ways in which incentive compensation awards and payments 
will be reduced as risks increase.
    In order for the risk-sensitive provisions of incentive 
compensation arrangements to affect employee risk-taking behavior, the 
organization's employees must understand that the amount of incentive 
compensation that they may receive will vary based on the risk 
associated with their activities. Accordingly, banking organizations 
should ensure that the employees covered by an incentive compensation 
arrangement are informed about the key ways in which risks are taken 
into account in determining the amount of incentive compensation paid. 
Where feasible, an organization's communications with employees should 
include examples of how incentive compensation payments may be adjusted 
to reflect projected or actual risk-outcomes. An organization's 
communications should be tailored appropriately to reflect the 
sophistication of the relevant audience(s).
Principle 2: Compatibility With Effective Controls and Risk Management
    A banking organization's risk-management processes and internal 
controls should reinforce and support the development and maintenance 
of balanced incentive compensation arrangements.
     Banking organizations should have appropriate controls to 
ensure that their processes for achieving balanced compensation 
arrangements are followed and to maintain the integrity of their risk 
management and other functions.
    In order to increase their own compensation, employees may seek to 
evade the processes established by a banking organization to achieve 
balanced compensation arrangements. Similarly, an employee covered by 
an incentive compensation arrangement may seek to influence the risk 
measures or other information or judgments that are used to make the 
employee's pay sensitive to risk in ways designed to increase the 
employee's pay.
    If successful, these actions may significantly weaken the 
effectiveness of an organization's incentive compensation arrangements 
in restricting excessive risk-taking. These actions can have a 
particularly damaging effect on the safety and soundness of the 
organization if they result in the weakening of risk measures, 
information, or judgments that the organization uses for other risk 
management, internal control, or financial purposes. In such cases, the 
employee's actions may weaken not only the balance of the 
organization's incentive compensation arrangements, but also the risk 
management, internal controls, and other functions that are supposed to 
act as a separate check on risk-taking.
    To help prevent this damage from occurring, a banking organization 
should have strong controls governing its process for designing, 
implementing, and monitoring incentive compensation arrangements. For 
example, an organization's policies and procedures should (i) identify 
and describe the role(s) of the personnel, business units, and control 
units authorized to be involved in the design, implementation, and 
monitoring of incentive compensation arrangements; (ii) identify the 
source of significant risk-related inputs into these processes and 
establish appropriate controls governing the development and approval 
of these inputs to help ensure their integrity; and (iii) identify the 
individual(s) and control unit(s) whose approval is necessary for the 
establishment of new incentive compensation arrangements or 
modification of existing arrangements. Banking organizations also 
should create and maintain sufficient documentation to permit an audit 
of the organization's processes for establishing, modifying, and 
monitoring incentive compensation arrangements.
    A banking organization should conduct regular internal reviews to 
ensure that its processes for achieving and maintaining balanced 
incentive compensation arrangements are consistently followed. Such 
reviews should be conducted by audit, compliance, or other personnel in 
a manner consistent with the organization's overall framework for 
compliance monitoring. An organization's internal audit department also 
should separately conduct regular audits of the organization's 
compliance with its established policies and controls relating to 
incentive compensation arrangements. The results should be reported to 
appropriate levels of management and, where appropriate, the 
organizat