Guidance on Sound Incentive Compensation Policies, 36395-36414 [2010-15435]

Agencies

• FEDERAL DEPOSIT INSURANCE CORPORATION
• FEDERAL RESERVE SYSTEM
• Office of the Comptroller of the Currency
• DEPARTMENT OF THE TREASURY
• Office of Thrift Supervision
• Comptroller of the Currency

[Federal Register Volume 75, Number 122 (Friday, June 25, 2010)]
[Notices]
[Pages 36395-36414]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-15435]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket ID OCC-2010-0013]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1374]

FEDERAL DEPOSIT INSURANCE CORPORATION

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[Docket ID OTS-2010-0020]


Guidance on Sound Incentive Compensation Policies

AGENCY: Office of the Comptroller of the Currency, Treasury (OCC); 
Board of Governors of the Federal Reserve System, (Board or Federal 
Reserve);

[[Page 36396]]

Federal Deposit Insurance Corporation (FDIC); Office of Thrift 
Supervision, Treasury (OTS).

ACTION: Final guidance.

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SUMMARY: The OCC, Board, FDIC and OTS (collectively, the Agencies) are 
adopting final guidance designed to help ensure that incentive 
compensation policies at banking organizations do not encourage 
imprudent risk-taking and are consistent with the safety and soundness 
of the organization.

DATES: Effective Date: The guidance is effective on June 25, 2010.

FOR FURTHER INFORMATION CONTACT: 
    OCC: Karen M. Kwilosz, Director, Operational Risk Policy, (202) 
874-9457, or Reggy Robinson, Policy Analyst, Operational Risk Policy, 
(202) 874-4438.
    Board: William F. Treacy, Adviser, (202) 452-3859, Division of 
Banking Supervision and Regulation; Mark S. Carey, Adviser, (202) 452-
2784, Division of International Finance; Kieran J. Fallon, Associate 
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.
    FDIC: Mindy West, Chief, Policy and Program Development, Division 
of Supervision and Consumer Protection, (202) 898-7221, or Robert W. 
Walsh, Review Examiner, Policy and Program Development, Division of 
Supervision and Consumer Protection, (202) 898-6649.
    OTS: Rich Gaffin, Financial Analyst, Risk Modeling and Analysis, 
(202) 906-6181, or Richard Bennett, Senior Compliance Counsel, 
Regulations and Legislation Division, (202) 906-7409; Donna Deale, 
Director, Holding Company and International Policy, (202) 906-7488, 
Grovetta Gardineer, Managing Director, Corporate and International 
Activities, (202) 906-6068; Office of Thrift Supervision, 1700 G 
Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION: 

I. Background

    Compensation arrangements are critical tools in the successful 
management of financial institutions. These arrangements serve several 
important and worthy objectives, including attracting skilled staff, 
promoting better organization-wide and employee performance, promoting 
employee retention, providing retirement security to employees, and 
allowing an organization's personnel costs to vary along with revenues.
    It is clear, however, that compensation arrangements can provide 
executives and employees with incentives to take imprudent risks that 
are not consistent with the long-term health of the organization. For 
example, offering large payments to managers or employees to produce 
sizable increases in short-term revenue or profit--without regard for 
the potentially substantial short or long-term risks associated with 
that revenue or profit--can encourage managers or employees to take 
risks that are beyond the capability of the financial institution to 
manage and control.
    Flawed incentive compensation practices in the financial industry 
were one of many factors contributing to the financial crisis that 
began in 2007. Banking organizations too often rewarded employees for 
increasing the organization's revenue or short-term profit without 
adequate recognition of the risks the employees' activities posed to 
the organization.
    Having witnessed the damaging consequences that can result from 
misaligned incentives, many financial institutions are now re-examining 
their compensation structures with the goal of better aligning the 
interests of managers and other employees with the long-term health of 
the institution. Aligning the interests of shareholders and employees, 
however, is not always sufficient to protect the safety and soundness 
of a banking organization. Because banking organizations benefit 
directly or indirectly from the protections offered by the Federal 
safety net (including the ability of insured depository institutions to 
raise insured deposits and access the Federal Reserve's discount window 
and payment services), 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.

A. Proposed Guidance

    In October 2009, the Federal Reserve issued and requested comment 
on Proposed Guidance on Sound Incentive Compensation Policies 
(``proposed guidance'') to help protect the safety and soundness of 
banking organizations supervised by the Federal Reserve and to promote 
the prompt improvement of incentive compensation practices throughout 
the banking industry.\1\ The proposed guidance was based on three key 
principles. These principles provided that incentive compensation 
arrangements at a banking organization should--
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    \1\ 74 FR 55227 (October 27, 2009).
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     Provide employees incentives that appropriately balance 
risk and reward;
     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.
    Because incentive compensation arrangements for executive and non-
executive employees may pose safety and soundness risks if not properly 
structured, the proposed guidance applied to senior executives as well 
as other employees who, either individually or as part of a group, have 
the ability to expose the relevant banking organization to material 
amounts of risk.
    With respect to the first principle, the proposed guidance, among 
other things, provided that a banking organization should ensure that 
its incentive compensation arrangements do not encourage short-term 
profits at the expense of short- and longer-term risks to the 
organization. Rather, the proposed guidance indicated that banking 
organizations should adjust the incentive compensation provided so that 
employees bear some of the risk associated with their activities. To be 
fully effective, these adjustments should take account of the full 
range of risks that the employees' activities may pose for the 
organization. The proposed guidance highlighted several methods that 
banking organizations could use to adjust incentive compensation awards 
or payments to take account of risk.
    With respect to the second principle, the proposed guidance 
provided that banking organizations should integrate their approaches 
to incentive compensation arrangements with their risk-management and 
internal control frameworks to better monitor and control the risks 
these arrangements may create for the organization. Accordingly, the 
proposed guidance provided that banking organizations should ensure 
that risk-management personnel have an appropriate role in designing 
incentive compensation arrangements and assessing whether the 
arrangements may encourage imprudent risk-taking. In addition, the 
proposed guidance provided that banking organizations should track 
incentive compensation awards and payments, risks taken, and actual 
risk outcomes to

[[Page 36397]]

determine whether incentive compensation payments to employees are 
reduced or adjusted to reflect adverse risk outcomes.
    With respect to the third principle, the proposed guidance provided 
that a banking organization's board of directors should play an 
informed and active role in ensuring that the organization's 
compensation arrangements strike the proper balance between risk and 
profit not only at the initiation of a compensation program, but on an 
ongoing basis. Thus, the proposed guidance provided that boards of 
directors should review and approve key elements of their 
organizations' incentive compensation systems across the organization, 
receive and review periodic evaluations of whether their organizations' 
compensation systems for all major segments of the organization are 
achieving their risk-mitigation objectives, and directly approve the 
incentive compensation arrangements for senior executives.
    The Board's proposed guidance applied to all banking organizations 
supervised by the Federal Reserve. However, the proposed guidance also 
included provisions intended to reflect the diversity among banking 
organizations, both with respect to the scope and complexity of their 
activities, as well as the prevalence and scope of incentive 
compensation arrangements. Thus, for example, the proposed guidance 
provided that the reviews, policies, procedures, and systems 
implemented by a smaller banking organization that uses incentive 
compensation arrangements on a limited basis would be substantially 
less extensive, formalized, and detailed than those at a large, complex 
banking organization (LCBO) \2\ that uses incentive compensation 
arrangements extensively. In addition, because sound incentive 
compensation practices are important to protect the safety and 
soundness of all banking organizations, the Federal Reserve announced 
that it would work with the other Federal banking agencies to promote 
application of the guidance to all banking organizations.
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    \2\ In the proposed guidance (issued by the Federal Reserve), 
the term LCBO was used as this is the term utilized by the Federal 
Reserve in describing such organizations. The final guidance uses 
the term Large Banking Organization (LBO), which encompasses 
terminology utilized by the OCC, FDIC and OTS.
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    The Board invited comment on all aspects of the proposed guidance. 
The Board also specifically requested comments on a number of issues, 
including whether:
     The three core principles are appropriate and sufficient 
to help ensure that incentive compensation arrangements do not threaten 
the safety and soundness of banking organizations;
     There are any material legal, regulatory, or other 
impediments to the prompt implementation of incentive compensation 
arrangements and related processes that would be consistent with those 
principles;
     Formulaic limits on incentive compensation would likely 
promote the safety and soundness of banking organizations, whether 
applied generally or to specific types of employees or banking 
organizations;
     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;
     The proposed guidance would impose undue burdens on, or 
have unintended consequences for, banking organizations, particularly 
smaller, less complex organizations, and whether there are ways such 
potential burdens or consequences could be addressed in a manner 
consistent with safety and soundness; and
     There are types of incentive compensation plans, such as 
organization-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.

B. Supervisory Initiatives

    In connection with the issuance of the proposed guidance, the 
Federal Reserve announced two supervisory initiatives:
     A special horizontal review of incentive compensation 
practices at LCBO's; and
     A review of incentive compensation practices at other 
banking organizations as part of the regular, risk-focused examination 
process for these organizations.
    The horizontal review was designed to assess: The potential for 
these arrangements or practices to encourage imprudent risk-taking; the 
actions an organization has taken or proposes to take to correct 
deficiencies in its incentive compensation practices; and the adequacy 
of the organization's compensation-related risk-management, control, 
and corporate governance processes.

II. Overview of Comments

    The Board received 34 written comments on the proposed guidance, 
which were shared and reviewed by all of the Agencies. Commenters 
included banking organizations, financial services trade associations, 
service providers to financial organizations, representatives of 
institutional shareholders, labor organizations, and individuals. Most 
commenters supported the goal of the proposed guidance--to ensure that 
incentive compensation arrangements do not encourage imprudent or undue 
risk-taking at banking organizations. Commenters also generally 
supported the principles-based approach of the proposed guidance. For 
example, many commenters specifically supported the avoidance of 
formulaic or one-size-fits-all approaches to incentive compensation in 
the proposed guidance. These commenters noted financial organizations 
are very diverse and should be permitted to adopt incentive 
compensation measures that fit their needs, while also being consistent 
with safe and sound operations. Several commenters also asserted that a 
formulaic approach would inevitably lead to exaggerated risk-taking 
incentives in some situations while discouraging employees from taking 
reasonable and appropriate risks in others. One commenter also argued 
that unintended consequences would be more likely to result from a 
``rigid rulemaking'' than from a flexible, principles-based approach.
    Many commenters requested that the Board revise or clarify the 
proposed guidance in one or more respects. For example, several 
commenters asserted that the guidance should impose specific 
restrictions on incentive compensation at banking organizations or 
mandate certain corporate governance or risk-management practices. One 
commenter recommended a requirement that most compensation for senior 
executives be provided in the form of variable, performance-vested 
equity awards that are deferred for at least five years, and that stock 
option compensation be prohibited. Another commenter advocated a ban on 
``golden parachute'' payments and on bonuses based on metrics related 
to one year or less of performance. Other commenters suggested that the 
guidance should require banking organizations to have an independent 
chairman of the board of directors, require annual majority voting for 
all directors, or provide for shareholders to have a vote (so called

[[Page 36398]]

``say-on-pay'' voting provisions) on the incentive compensation 
arrangements for certain employees of banking organizations. Other 
commenters requested that certain types of compensation plans, such as 
organization-wide profit sharing plans or 401(k) plans or plans covered 
by the Employee Retirement Income Security Act (29 U.S.C. 1400 et 
seq.), be exempted from the scope of the guidance because they were 
unlikely to provide employees incentives to expose their banking 
organization to undue risk.
    Several commenters, however, did not support the proposed guidance. 
Some of these commenters felt that the proposed guidance was 
unnecessary and that the principles used in the proposed guidance were 
not needed. These commenters argued that the existing system of 
financial regulation and enforcement is sufficient to address the 
concerns raised in the proposed guidance. Several commenters also 
thought that the proposed guidance was too vague to be helpful, and 
that the ambiguity of the proposed guidance would make compliance more 
difficult, leading to increased costs and regulatory uncertainty. Some 
commenters also argued that the guidance was not warranted because 
there is insufficient evidence that incentive compensation practices 
contributed to safety and soundness or financial stability problems, or 
questioned the authority of the Federal Reserve or the other Federal 
banking agencies to act in this area.
    In addition, a number of commenters expressed concern that the 
proposed guidance would impose undue burden on banking organizations, 
particularly smaller, less complex organizations. These commenters 
believed that incentive compensation practices at smaller banking 
organizations were generally not problematic from a safety and 
soundness perspective.\3\ A number of commenters suggested that all or 
most smaller banking organizations should be exempt from the guidance. 
A number of commenters expressed concerns that the proposed guidance 
would impose unreasonable demands on the boards of directors of banking 
organizations and especially smaller organizations.
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    \3\ On the other hand, one commenter requested that the proposed 
guidance not be enforced differently at larger institutions solely 
because of their size.
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    Several commenters also expressed concern that the proposed 
guidance, if implemented, could impede the ability of banking 
organizations to attract or retain qualified staff and compete with 
other financial services providers. In light of these concerns, some 
commenters suggested that the guidance expressly allow banking 
organizations to enter into such compensation arrangements as they deem 
necessary for recruitment or retention purposes. A number of commenters 
also encouraged the Federal Reserve to work with other domestic and 
foreign supervisors and authorities to promote consistent standards for 
incentive compensation practices at financial institutions and a level 
competitive playing field for financial service providers.
    The comments received on the proposed guidance are further 
discussed below.

III. Final Guidance

    After carefully reviewing the comments on the proposed guidance, 
the Agencies have adopted final guidance that retains the same key 
principles embodied in the proposed guidance, with a number of 
adjustments and clarifications that address matters raised by the 
commenters. These principles are: (1) Incentive compensation 
arrangements at a banking organization should provide employees 
incentives that appropriately balance risk and financial results in a 
manner that does not encourage employees to expose their organizations 
to imprudent risk; (2) these arrangements should be compatible with 
effective controls and risk-management; and (3) these arrangements 
should be supported by strong corporate governance, including active 
and effective oversight by the organization's board of directors. The 
Agencies believe that it is important that incentive compensation 
arrangements at banking organizations do not provide incentives for 
employees to take risks that could jeopardize the safety and soundness 
of the organization. The final guidance seeks to address the safety and 
soundness risks of incentive compensation practices by focusing on the 
basic problem they can pose from a risk-management perspective, that 
is, incentive compensation arrangements--if improperly structured--can 
give employees incentives to take imprudent risks.
    The Agencies believe the principles of the final guidance should 
help protect the safety and soundness of banking organizations and the 
stability of the financial system, and that adoption of the guidance is 
fully consistent with the Agencies' statutory mandate to protect the 
safety and soundness of banking organizations.\4\
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    \4\ See, e.g. 12 U.S.C. 1818(b). The Agencies regularly issue 
supervisory guidance based on the authority in section 8 of the 
Federal Deposit Insurance (FDI) Act. Guidance is used to identify 
practices that the Agencies believe would constitute an unsafe or 
unsound practice and/or identify risk-management systems, controls, 
or other practices that the Agencies believe would assist banking 
organizations in ensuring that they operate in a safe and sound 
manner. Savings associations should also refer to OTS's rule on 
employment contracts 12 CFR 563.39.
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    The final guidance applies to all the banking organizations 
supervised by the Agencies, including national banks, State member 
banks, State nonmember banks, savings associations, U.S. bank holding 
companies, savings and loan holding companies, the U.S. operations of 
foreign banks with a branch, agency or commercial lending company in 
the United States, and Edge and agreement corporations (collectively, 
``banking organizations'').
    A number of changes have been made to the proposed guidance in 
response to comments. For example, the final guidance includes several 
provisions designed to reduce burden on smaller banking organizations 
and other banking organizations that are not significant users of 
incentive compensation. The Agencies also have made a number of changes 
to clarify the scope, intent, and terminology of the final guidance.

A. Scope of Guidance

    Compensation practices were not the sole cause of the financial 
crisis, but they certainly were a contributing cause--a fact recognized 
by 98 percent of the respondents to a survey of banking organizations 
engaged in wholesale banking activities conducted in 2009 by the 
Institute of International Finance and publicly by a number of 
individual financial institutions.\5\ Moreover, the problems caused by 
improper compensation practices were not limited to U.S. financial 
institutions, but were evident at major financial institutions 
worldwide, a fact recognized by international bodies such

[[Page 36399]]

as the Financial Stability Board (FSB) and the Senior Supervisors 
Group.\6\
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    \5\ See, Institute of International Finance, Inc. (2009), 
Compensation in Financial Services: Industry Progress and the Agenda 
for Change (Washington: IIF, March) available at https://www.oliverwyman.com/ow/pdf_files/OW_En_FS_Publ_2009_CompensationInFS.pdf. See also UBS, Shareholder Report on UBS's 
Write-Downs, April 18, 2008, pp. 41-42 (identifies incentive effects 
of UBS compensation practices as contributing factors in losses 
suffered by UBS due to exposure to the subprime mortgage market) 
available at https://www.ubs.com/1/ShowMedia/investors/agm?contentId=140333&name=080418ShareholderReport.pdf.
    \6\ See, Financial Stability Forum (2009), FSF Principles for 
Sound Compensation Practices (87 KB PDF) (Basel, Switzerland: FSF, 
April), available at https://www.financialstabilityboard.org/publications/r_0904b.pdf; and Senior Supervisors Group (2009), 
Risk-management Lessons from the Global Banking Crisis of 2008 
(Basel, Switzerland: SSG, October), available at https://www.newyorkfed.org/newsevents/news/banking/2009/ma091021.html. The 
Financial Stability Forum was renamed the Financial Stability Board 
in April 2009.
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    Because compensation arrangements for executive and non-executive 
employees alike may pose safety and soundness risks if not properly 
structured, these principles and the final guidance apply to senior 
executives as well as other employees who, either individually or as 
part of a group, have the ability to expose the banking organization to 
material amounts of risk.\7\ These employees are referred to as 
``covered employees'' in the final guidance. In response to comments, 
the final guidance clarifies that an employee or group of employees has 
the ability to expose a banking organization to material amounts of 
risk if the employees' activities are material to the organization or 
are material to a business line or operating unit that is itself 
material to the organization.
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    \7\ In response to a number of comments requesting clarification 
regarding the scope of the term ``senior executives'' as used in the 
guidance, the final guidance states that ``senior executive'' 
includes, at a minimum, ``executive officers'' within the meaning of 
the Board's Regulation O (12 CFR 215.2(e)(1)) and, for publicly 
traded companies, ``named officers'' within the meaning of the 
Securities and Exchange Commission's rules on disclosure of 
executive compensation (17 CFR 229.402(a)(3)). Savings associations 
should also refer to OTS's rule on loans by savings associations to 
their executive officers, directors, and principal shareholders. 12 
CFR 563.43.
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    Some commenters suggested that certain categories of employees, 
such as tellers, bookkeepers, administrative assistants, or employees 
who process but do not originate transactions, do not expose banking 
organizations to significant levels of risk and therefore should be 
exempted from coverage under the final guidance. The final guidance, 
like the proposed guidance, indicates that the facts and circumstances 
will determine which jobs or categories of employees have the ability 
to expose the organization to material risks and which jobs or 
categories of employees may be outside the scope of the guidance. The 
final guidance recognizes, for example, that tellers, bookkeepers, 
couriers, and data processing personnel would likely not expose 
organizations to significant risks of the types meant to be addressed 
by the guidance. On the other hand, employees or groups of employees 
who do not originate business or approve transactions could still 
expose a banking organization to material risk in some circumstances. 
Therefore, the Agencies do not believe it would be appropriate to 
provide a blanket exemption from the final guidance for any category of 
covered employees that would apply to all banking organizations.
    After reviewing the comments, the Agencies have retained the 
principles-based framework of the proposed guidance. The Agencies 
believe this approach is the most effective way to address incentive 
compensation practices, given the differences in the size and 
complexity of banking organizations covered by the guidance and the 
complexity, diversity, and range of use of incentive compensation 
arrangements by those organizations. For example, activities and risks 
may vary significantly across banking organizations and across 
employees within a particular banking organization. For this reason, 
the methods used to achieve appropriately risk-sensitive compensation 
arrangements likely will differ across and within organizations, and 
use of a single, formulaic approach likely will provide at least some 
employees with incentives to take imprudent risks.
    The Agencies, however, have not modified the guidance, as some 
commenters requested, to provide that a banking organization may enter 
into incentive compensation arrangements that are inconsistent with the 
principles of safety and soundness whenever the organization believes 
that such action is needed to retain or attract employees. The Agencies 
recognize that while incentive compensation serves a number of 
important goals for banking organizations, including attracting and 
retaining skilled staff, these goals do not override the requirement 
for banking organizations to have incentive compensation systems that 
are consistent with safe and sound operations and that do not encourage 
imprudent risk-taking. The final guidance provides banking 
organizations with considerable flexibility in structuring their 
incentive compensation arrangements in ways that both promote safety 
and soundness and that help achieve the arrangements' other objectives.
    The Agencies are mindful, however, that banking organizations 
operate in both domestic and international competitive environments 
that include financial services providers that are not subject to 
prudential oversight by the Agencies and, thus, not subject to the 
final guidance. The Agencies also recognize that international 
coordination in this area is important both to promote competitive 
balance and to ensure that internationally active banking organizations 
are subject to consistent requirements. For this reason, the Agencies 
will continue to work with their domestic and international 
counterparts to foster sound compensation practices across the 
financial services industry. Importantly, the final guidance is 
consistent with both the Principles for Sound Compensation Practices 
and the related Implementation Standards adopted by the FSB in 2009.\8\ 
A number of commenters expressed concern about the levels of 
compensation paid to some employees of banking organizations. As noted 
above, several commenters requested that the Board eliminate or limit 
certain types of incentive compensation for employees of banking 
organizations. Other commenters advocated that certain forms of 
compensation be required. For example, some commenters urged a ban on 
incentive compensation payments made in stock options, while others 
supported their mandatory use. Comments also were received with regard 
to the use of other types of stock-based compensation, such as 
restricted stock and stock appreciation rights. Consistent with its 
principles-based approach, the final guidance does not mandate or 
prohibit the use of any specific forms of payment for incentive 
compensation or establish mandatory compensation levels or caps. 
Rather, the forms and levels of incentive compensation payments at 
banking organizations are expected to reflect the principles of the 
final guidance in a manner tailored to the business, risk profile, and 
other attributes of the banking organization. Incentive compensation 
structures that offer employees rewards for increasing short-term 
profit or revenue, without taking into account risk, may encourage 
imprudent risk-taking even if they meet formulaic levels or include or 
exclude certain forms of compensation. On the other hand, incentive 
compensation arrangements of various forms and levels may be properly 
structured so as not to encourage imprudent risk-taking.
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    \8\ See, Financial Stability Forum, FSF Principles for Sound 
Compensation Practices, in note 6; and Financial Stability Board 
(2009), FSB Principles for Sound Compensation Practices: 
Implementation Standards (35 KB PDF) (Basel, Switzerland: FSB, 
September), available at https://www.financialstabilityboard.org/publications/r_090925c.pdf.
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    In response to comments, the final guidance clarifies in a number 
of respects the expectation of the Agencies that the impact of the 
final guidance on

[[Page 36400]]

banking organizations will vary depending on the size and complexity of 
the organization and its level of usage of incentive compensation 
arrangements. It is expected that the guidance will generally have less 
impact on smaller banking organizations, which typically are less 
complex and make less use of incentive compensation arrangements than 
larger banking organizations. Because of the size and complexity of 
their operations, large banking organizations (LBOs) \9\ should have 
and adhere to systematic and formalized policies, procedures and 
processes. These are considered important in ensuring that incentive 
compensation arrangements for all covered employees are identified and 
reviewed by appropriate levels of management (including the board of 
directors where appropriate and control units), and that they 
appropriately balance risks and rewards . The final guidance highlights 
the types of policies, procedures, and systems that LBOs should have 
and maintain, but that are not expected of other banking organizations. 
It is expected that, particularly in the case of LBO's, adoption of 
this principles-based approach will require an iterative supervisory 
process to ensure that the embedded flexibility that allows for 
customized arrangements for each banking organization does not 
undermine effective implementation of the guidance.
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    \9\ For purposes of the final guidance, LBOs include, in the 
case of banking organizations supervised by (i) the Federal Reserve, 
large, complex banking organizations as identified by the Federal 
Reserve for supervisory purposes; (ii) the OCC, the largest and most 
complex national banks as defined in the Large Bank Supervision 
booklet of the Comptroller's Handbook; (iii) the FDIC, large complex 
insured depository institutions (IDIs); and (iv) the OTS, the 
largest and most complex savings associations and savings and loan 
holding companies. The term ``smaller banking organizations'' is 
used to refer to banking organizations that are not LBOs under the 
relevant agency's standard.
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    With respect to U.S. operations of foreign banks, incentive 
compensation policies, including management, review, and approval 
requirements for a foreign bank's U.S. operations should be coordinated 
with the foreign banking organization's group-wide policies developed 
in accordance with the rules of the foreign banking organization's home 
country supervisor. These policies and practices should be consistent 
with the foreign bank's overall corporate and management structure and 
its framework for risk-management and internal controls, as well as 
with the final guidance.

B. Balanced Incentive Compensation Arrangements

    The first principle of the final guidance is that incentive 
compensation arrangements should provide employees incentives that 
appropriately balance risks and rewards in a manner that does not 
encourage imprudent risk-taking. The amounts of incentive pay flowing 
to covered employees should take account of and adjust for the risks 
and losses--as well as gains--associated with employees' activities, so 
that employees do not have incentives to take imprudent risk. The 
formulation of this principle is slightly different from that used in 
the proposed guidance, which stated that organizations should provide 
employees incentives that do not encourage imprudent risk-taking beyond 
the organization's ability to effectively identify and manage risk. 
This change was made to clarify that risk-management procedures and 
control functions that ordinarily limit risk-taking do not obviate the 
need to identify covered employees and to develop incentive 
compensation arrangements that properly balance risk-taking incentives. 
To be fully effective, balancing adjustments to incentive compensation 
arrangements should take account of the full range of risks that 
employees' activities may pose for the organization, including credit, 
market, liquidity, operational, legal, compliance, and reputational 
risks.
    A number of commenters expressed the view that increased controls 
could mitigate a lack of balance in incentive compensation 
arrangements. Under this view, unbalanced incentive compensation 
arrangements could be addressed either through the modification of the 
incentive compensation arrangements or through the application of 
additional or more effective risk controls to the business. The final 
guidance recognizes that strong and effective risk-management and 
internal control functions are critical to the safety and soundness of 
banking organizations. However, the Agencies believe that poorly 
designed or managed incentive compensation arrangements can themselves 
be a source of risk to banking organizations and undermine the controls 
in place. Unbalanced incentive compensation arrangements can place 
substantial strain on the risk-management and internal control 
functions of even well-managed organizations. Furthermore, poorly 
balanced incentive compensation arrangements can encourage employees to 
take affirmative actions to weaken the organization's risk-management 
or internal control functions.
    The final guidance, like the proposed guidance, outlines four 
methods that are currently in use to make compensation more sensitive 
to risk. These are risk adjustment of awards; deferral of payment; 
longer performance periods; and reduced sensitivity to short-term 
performance. Each method has advantages and disadvantages. For example, 
incentive compensation arrangements for senior executives at LBOs are 
likely to be better balanced if they involve deferral of a substantial 
portion of the executives' incentive compensation over a multi-year 
period, with payment made in the form of stock or other equity-based 
instruments and with the number of instruments ultimately received 
dependent on the performance of the organization (or, ideally, the 
performance of the executive) during the deferral period. Deferral, 
however, may not be effective in constraining the incentives of 
employees who may have the ability to expose the organization to long-
term risks, as these risks may not be realized during a reasonable 
deferral period. For this reason, the final guidance recognizes that in 
some cases, two or more methods may be needed in combination (e.g., 
risk adjustment of awards and deferral of payment) to achieve an 
incentive compensation arrangement that properly balances risk and 
reward.
    Furthermore, the few methods noted in the final guidance are not 
exclusive, and other effective methods or variations may exist or be 
developed. Methods for achieving balanced compensation arrangements at 
one organization may not be effective at another organization. Each 
organization is responsible for ensuring that its incentive 
compensation arrangements are consistent with the safety and soundness 
of the organization. The guidance clarifies that LBOs should actively 
monitor industry, academic, and regulatory developments in incentive 
compensation practices and theory and be prepared to incorporate into 
their incentive compensation systems new or emerging methods that are 
likely to improve the organization's long-term financial well-being and 
safety and soundness.
    In response to a question asked in the proposed guidance, several 
commenters requested that certain types of compensation plans be 
treated as beyond the scope of the final guidance because commenters 
believed these plans do not threaten the safety and soundness of 
banking organizations. These included organization-wide profit sharing 
plans, 401(k) plans, defined benefit plans, and ERISA plans.

[[Page 36401]]

    The final guidance does not exempt any broad categories of 
compensation plans based on their tax structure, corporate form, or 
status as a retirement or other employee benefit plans, because any 
type of incentive compensation plan may be implemented in a way that 
increases risk inappropriately. In response to these comments, however, 
the final guidance recognizes that the term ``incentive compensation'' 
does not include arrangements that are based solely on the employees' 
level of compensation and that do not vary based on one or more 
performance metrics (e.g., a 401(k) plan under which the organization 
contributes a set percentage of an employee's salary). In addition, the 
final guidance notes that incentive compensation plans that provide for 
awards based solely on overall organization-wide performance are 
unlikely to provide employees, other than senior executives and 
individuals who have the ability to materially affect the 
organization's overall performance, with unbalanced risk-taking 
incentives.
    In many cases, there were comments on both sides of an issue, with 
some wanting less or no guidance and others wanting tough, or very 
specific prohibitions. For example, a number of commenters argued that 
the use of ``golden parachutes'' and similar retention and recruitment 
provisions to retain employees should be prohibited because such 
provisions have been abused in the past.\10\ A larger number of 
commenters, however, argued against a per se ban on such arrangements, 
stating that these provisions were in some cases essential elements of 
effective recruiting and retention packages and are not necessarily a 
threat to safety and soundness. One commenter stated that golden 
parachute payments triggered by changes in control of a banking 
organization are too speculative to encourage imprudent risk-taking by 
employees.
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    \10\ Arrangements that provide for an employee (typically a 
senior executive), upon departure from an 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 are sometimes called ``golden parachutes.''
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    The final guidance, like the proposed guidance, provides that 
banking organizations should carefully consider the potential for 
golden parachutes and similar arrangements to affect the risk-taking 
behavior of employees. The final guidance adds language noting that 
arrangements that provide an employee with a guaranteed payout upon 
departure from an organization regardless of performance may neutralize 
the effect of any balancing features included in the arrangement to 
help prevent imprudent risk-taking. Organizations should consider 
including balancing features--such as risk adjustments or deferral 
requirements--in golden parachutes and similar arrangements to mitigate 
the potential for the arrangements to encourage imprudent risk-taking.
    Provisions that require a departing employee to forfeit deferred 
incentive compensation payments may also weaken the effectiveness of a 
deferral arrangement if the departing employee is able to negotiate a 
``golden handshake'' arrangement with the employee's new 
organization.\11\ Golden handshake provisions present special issues 
for banking organizations and supervisors, some of which are discussed 
in the final guidance, because it is the action of the employee's new 
employer--which may not be a regulated institution--that can affect the 
current employer's ability to properly align the employee's interest 
with the organization's long-term health. The final guidance states 
that LBOs should monitor whether golden handshake arrangements are 
materially weakening the organization's efforts to constrain the risk-
taking incentives of employees. The Agencies will continue to work with 
banking organizations and others to develop appropriate methods for 
addressing any effect that such arrangements may have on the safety and 
soundness of banking organizations.
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    \11\ Golden handshakes are arrangements that compensate an 
employee for some or all of the estimated, non-adjusted value of 
deferred incentive compensation that would have been forfeited upon 
departure from the employee's previous employment.
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C. Compatibility With Effective Controls and Risk-Management

    The second principle of the final guidance states that 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 
integrate incentive compensation arrangements into their risk-
management and internal control frameworks to ensure that balance is 
achieved. In particular, banking organizations should have appropriate 
controls to ensure that processes for achieving balance are followed. 
Appropriate personnel, including risk-management personnel, should have 
input in the design and assessment of incentive compensation 
arrangements. Compensation for risk-management and control personnel 
should be sufficient to attract and retain appropriately qualified 
personnel and such compensation should not be based substantially on 
the financial performance of the business unit that they review. 
Rather, their performance should be based primarily on the achievement 
of the objectives of their functions (e.g., adherence to internal 
controls).
    Banking organizations should monitor incentive compensation awards, 
risks taken and actual risk outcomes to determine whether incentive 
compensation payments to employees are reduced to reflect adverse risk 
outcomes. Incentive compensation arrangements that are found not to 
appropriately reflect risk should be modified as necessary. 
Organizations should not only provide rewards when performance 
standards are met or exceeded, they should also reduce compensation 
when standards are not met. If senior executives or other employees are 
paid substantially all of their potential incentive compensation when 
risk outcomes are materially worse than expected, employees may be 
encouraged to take large risks in the hope of substantially increasing 
their personal compensation, knowing that their downside risks are 
limited. Simply put, incentive compensation arrangements should not 
create a ``heads I win, tails the firm loses'' expectation.
    A significant number of comments expressed concerns about the scope 
of the applicability of the proposed guidance to smaller banking 
organizations as well as the burden the proposed guidance would impose 
on these organizations. In response to these comments, the final 
guidance has made more explicit the Agencies' view that the monitoring 
methods and processes used by a banking organization should be 
commensurate with the size and complexity of the organization, as well 
as its use of incentive compensation. Thus, for example, a smaller 
organization that uses incentive compensation only to a limited extent 
may find that it can appropriately monitor its arrangements through 
normal management processes. The final guidance also discusses specific 
aspects of policies and procedures related to controls and risk-
management that are applicable to LBOs and are not expected of other 
banking organizations.

D. Strong Corporate Governance

    The third principle of the final guidance is that incentive 
compensation programs at banking organizations should be supported by 
strong corporate governance, including active and effective oversight 
by the organization's

[[Page 36402]]

board of directors.\12\ The board of directors of an organization is 
ultimately responsible for ensuring that the organization's incentive 
compensation arrangements for all covered employees--not solely senior 
executives--are appropriately balanced and do not jeopardize the safety 
and soundness of the organization. Boards of directors should receive 
data and analysis from management or other sources that are sufficient 
to allow the board to assess whether the overall design and performance 
of the organization's incentive compensation arrangements are 
consistent with the organization's safety and soundness. These reviews 
and reports should be appropriately scoped to reflect the size and 
complexity of the banking organization's activities and the prevalence 
and scope of its incentive compensation arrangements. The structure, 
composition, and resources of the board of directors should be 
constructed to permit effective oversight of incentive compensation. 
The board of directors should, for example, have, or have access to, a 
level of expertise and experience in risk-management and compensation 
practices in the financial services sector that is appropriate for the 
nature, scope, and complexity of the organization's activities.\13\
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    \12\ In the case of foreign banking organizations (FBOs), the 
term ``board of directors'' refers to the relevant oversight body 
for the firm's U.S. operations, consistent with the FBO's overall 
corporate and management structure.
    \13\ Savings associations should also refer to OTS's rule on 
directors, officers, and employees. 12 CFR 563.33.
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    Given the key role of senior executives in managing the overall 
risk-taking activities of an organization, the board of directors 
should directly approve compensation arrangements involving senior 
executives and closely monitor such payments and their sensitivity to 
risk outcomes. If the compensation arrangements for a senior executive 
include a deferral of payment or ``clawback'' provision, then the 
review should include sufficient information to determine if the 
provision has been triggered and executed as planned. The board also 
should approve and document any material exceptions or adjustments to 
the incentive compensation arrangements established for senior 
executives and should carefully consider and monitor the effects of any 
approved exceptions or adjustments to the arrangements.
    In response to comments expressing concern about the impact of the 
proposed guidance on smaller banking organizations, the final guidance 
identifies specific aspects of the corporate governance provisions of 
the final guidance that are applicable to LBOs or other organizations 
that use incentive compensation to a significant degree, and are not 
expected of other banking organizations. In particular, boards of 
directors of LBOs and other organizations that use incentive 
compensation to a significant degree should actively oversee the 
development and operation of the organization's incentive compensation 
policies, systems and related control processes. If such an 
organization does not already have a compensation committee, reporting 
to the full board, with primary responsibility for incentive 
compensation arrangements, the board should consider establishing one. 
LBOs, in particular, should follow a systematic approach, outlined in 
the final guidance, in developing compensation systems that have 
balanced incentive compensation arrangements.
    Several commenters expressed concern that the proposed guidance 
appeared to create a new substantive qualification for boards of 
directors that requires the boards of all banking organizations to have 
members with expertise in compensation and risk-management issues. A 
group of commenters noted that such a requirement could limit an 
already small pool of people suitable to serve on boards of directors 
of banking organizations and that smaller organizations may not have 
access to, or the resources to compensate, directors meeting these 
additional requirements. Some commenters also stated that terms such as 
``closely monitor'' and ``actively oversee'' could be read to impose a 
higher standard on directors for their oversight of incentive 
compensation issues. On the other hand, one commenter noted that 
current law requires financial expertise on the boards of directors and 
audit committees of public companies and recommended that specialized 
risk-management competencies be required on the boards of all banking 
organizations.
    To address concerns raised by these commenters, the final guidance 
clarifies that risk-management and compensation expertise and 
experience at the board level may be present collectively among the 
members of the board, and may come from formal training or from 
experience in addressing risk-management and compensation issues, 
including as a director, or may be obtained from advice received from 
outside counsel, consultants, or other experts with expertise in 
incentive compensation and risk-management. Furthermore, the final 
guidance recognizes that smaller organizations with less complex and 
extensive incentive compensation arrangements may not find it necessary 
or appropriate to require specially tailored board expertise or to 
retain and use outside experts in this area.
    A banking organization's disclosure practices should support safe 
and sound incentive compensation arrangements. Specifically, a banking 
organization should supply an appropriate amount of information 
concerning its incentive compensation arrangements and related risk-
management, control, and governance processes to shareholders to allow 
them to monitor and, where appropriate, take actions to restrain the 
potential for such arrangements to encourage employees to take 
imprudent risks.
    While some commenters supported increased public disclosure of the 
incentive compensation practices of banking organizations, a greater 
number expressed concerns that any required disclosures of incentive 
compensation information by banking organizations be tailored to 
protect the privacy of employees and take account of the impact of such 
disclosures on the ability of organizations to attract and retain 
talent. Several commenters supported an alignment of required 
disclosures with existing requirements for public companies, arguing 
that additional requirements would add to the regulatory burden on 
banking organizations.
    The proposed guidance did not impose specific disclosure 
requirements on banking organizations. The final guidance makes no 
significant changes from the proposed guidance with regard to 
disclosures, and states that the scope and level of information 
disclosed by a banking organization should be tailored to the nature 
and complexity of the organization and its incentive compensation 
arrangements. The final guidance notes that banking organizations 
should comply with the incentive compensation disclosure requirements 
of the Federal securities law and other laws, as applicable.
    A number of commenters supported additional governance requirements 
for banking organizations, such as ``say on pay'' provisions requiring 
shareholder approval of compensation plans, separation of the board 
chair and chief executive officer positions, majority voting for 
directors, annual elections for all directors, and improvements to the 
audit function. Some of these comments seek changes in Federal laws 
beyond the jurisdiction of the Agencies; others

[[Page 36403]]

address issues--such as ``say on pay'' requirements--that are currently 
under consideration by the Congress. The final guidance does not 
preempt or preclude these proposals, and indicates that the Agencies 
expect organizations to comply with all applicable statutory 
disclosure, voting and other requirements.

E. Continuing Supervisory Initiatives

    The horizontal review of incentive compensation practices at LBOs 
is well underway. While this initiative is being led by the Federal 
Reserve, the other Federal banking agencies are participating in the 
work. Supervisory teams have collected substantial information from 
LBOs concerning existing incentive compensation practices and related 
risk-management and corporate governance processes. In addition, LBOs 
have submitted analyses of shortcomings or ``gaps'' in existing 
practices relative to the principles contained in the proposed 
guidance, as well as plans for addressing identified weaknesses. Some 
organizations already have implemented changes to make their incentive 
compensation arrangements more risk sensitive. Indeed, many 
organizations are recognizing that strong risk-management and control 
systems are not sufficient to protect the organization from undue 
risks, including risks arising from unbalanced incentive compensation 
arrangements. Other organizations have considerably more work to do, 
such as developing processes that can effectively compare incentive 
compensation payments to risks and risk outcomes. The Agencies intend 
to continue to regularly review incentive compensation arrangements and 
related risk-management, control, and corporate governance practices of 
LBOs and to work with these organizations through the supervisory 
process to promptly correct any deficiencies that may be inconsistent 
with safety and soundness.\14\
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    \14\ For smaller banking organizations, the Federal Reserve is 
gathering consistent information through regularly scheduled 
examinations and the normal supervisory process. The focus of the 
data gathering is to identify the types of incentive plans in place, 
the job types covered and the characteristics, prevalence and level 
of documentation available for those incentive compensation plans. 
After comparing and analyzing the information collected, supervisory 
efforts and expectations will be scaled appropriately to the size 
and complexity of the organization and its incentive compensation 
arrangements. For these smaller banking organizations, the 
expectation is that there will be very limited, if any, targeted 
examination work or supervisory follow-up. To the extent that any of 
these organizations has incentive compensation arrangements, the 
policies and systems necessary to monitor these arrangements are 
expected to be substantially less extensive, formalized and detailed 
than those of larger, more complex organizations.
---------------------------------------------------------------------------

    The Agencies intend to actively monitor the actions being taken by 
banking organizations with respect to incentive compensation 
arrangements and will review and update this guidance as appropriate to 
incorporate best practices that emerge. In addition, in order to 
monitor and encourage improvements, Federal Reserve staff will prepare 
a report, in consultation with the other Federal banking agencies, 
after the conclusion of 2010 on trends and developments in compensation 
practices at banking organizations.

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 Agencies have 
determined that certain aspects of the final guidance constitute a 
collection of information. The Board made this determination under the 
authority delegated to the Board by the Office of Management and Budget 
(OMB).
    An agency 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. 
Any changes to the Agencies' 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 final guidance includes provisions that state large banking 
organizations (LBOs) 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 OCC, FDIC, and OTS have obtained emergency approval under 5 CFR 
1320.13 for issuance of the guidance and will issue a Federal Register 
notice shortly for 60 days of comment as part of the regular PRA 
clearance process. During the regular PRA clearance process the 
estimated average response time may be re-evaluated.
    The Board has approved the collection of information under its 
delegated authority. As discussed earlier in this notice, on October 
27, 2009, the Board published in the Federal Register a notice 
requesting comment on the proposed Guidance on Sound Incentive 
Compensation Policies (74 FR 55227). The comment period for this notice 
expired November 27, 2009. The Board received three comments that 
specifically addressed paperwork burden. The commenters asserted that 
the hourly estimate of the cost of compliance should be considerably 
higher than the Board projected.
    The final guidance clarifies in a number of respects the 
expectation that the effect of the final guidance on banking 
organizations will vary depending on the size and complexity of the 
organization and its level of use of incentive compensation 
arrangements. For example, the final guidance makes more explicit the 
view that the monitoring methods and processes used by a banking 
organization should be commensurate with the size and complexity of the 
organization, as well as its use of incentive compensation. In 
addition, the final guidance highlights the types of policies, 
procedures, systems, and specific aspects of corporate governance that 
LBOs should have and maintain, but that are not expected of other 
banking organizations.
    In response to comments and taking into account the considerations 
discussed above, the Board is increasing the burden estimate for 
implementing or modifying policies and procedures to monitor incentive 
compensation. For this purpose, consideration of burden is limited to 
items in the final guidance constituting an information collection 
within the meaning of the PRA. The Board estimates that 1,502 large 
respondents would take, on average, 480 hours (two months) to modify 
policies and procedures to monitor incentive compensation. The Board 
estimates that 5,058 small respondents would take, on average, 80 hours 
(two business weeks)

[[Page 36404]]

to establish or modify policies and procedures to monitor incentive 
compensation. The total one-time burden is estimated to be 1,125,600 
hours. In addition, the Board estimates that, on a continuing basis, 
respondents would take, on average, 40 hours (one business week) each 
year to maintain policies and procedures to monitor incentive 
compensation arrangements and estimates the annual on-going burden to 
be 262,400 hours. The total annual PRA burden for this information 
collection is estimated to be 1,388,000 hours.

General Description of Report

    This information collection is authorized pursuant to:
    Board--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)).
    OCC--12 U.S.C. 161, and Section 39 of the Federal Deposit Insurance 
Act (12 U.S.C. 1831p-1).
    FDIC--Section 39 of the Federal Deposit Insurance Act (12 U.S.C. 
1831p-1).
    OTS--Section 39 of the Federal Deposit Insurance Act (12 U.S.C. 
1831p-1) and Sections 4, 5, and 10 of the Home Owners' Loan Act (12 
U.S.C. 1463, 1464, and 1467a).
    The Agencies expect to review the policies and procedures for