Interagency Guidance on Incentive Compensation

Jean C. Brooks
July 16, 2010

The Federal Reserve System, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation (the “Agencies”) recently issued its “Final Guidance on Sound Incentive Compensation Policies” (the “Guidance”). Intended to assist banking organizations in designing and implementing incentive compensation arrangements and related policies and procedures that effectively consider potential risks and risk outcomes, the Guidance will form the basis for supervisory examinations of a banking organization’s incentive compensation practices and will influence CAMELs ratings.

WHAT AND WHO IS AFFECTED

Banking Organizations

The Guidance applies to:

National banks

State member banks

State non-member banks

Savings associations

U.S. bank holding companies

S&L holding companies

Edge and agreement corporations

U.S. operations of foreign banking organizations with a branch, agency or commercial lending company in the U.S.

Excluded organizations

Credit unions

Insurance companies

Mortgage companies

Broker dealers

Other entities not regulated by the Agencies

The Guidance places additonal requirements on "Large Banking Operations ("LBO"). LBOs are those classified as "large, complex banking organizations" for supervisory purposes by the Agencies. The Agencies believe that LBOS and other significant users of incentive compensation warrant the most intensive supervisory attention because flawed compensation arrangements at these organizations are more likely to adversely effect the broader financial system. While each Agency has its own definition of “large and complex”, LBOs will most likely include the top 25-30 insured depository institutions (ones with the most assets) and the 25-30 largest and most complex bank holding companies. The additional requirements for LBOs are woven throughout the Guidance. They are discussed in a separate addendum to this document.

Affected Personnel

The Guidance applies broadly to incentive compensation for executive and non-executive employees who, individually or as a group, are in a position to expose an organization to material risks.

Senior executive officers 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 organization to material amounts of risk; and

Groups of employees who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, may expose the organization to material amounts of risk, even if no individual employee is likely to expose the organization 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).

Incentive Compensation

In the Guidance, 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., level of sales, revenue or income). Incentive compensation does not include compensation that is awarded solely for, and the payment of which is solely tied to, continued employment (e.g., salary). In addition, the term does not include compensation arrangements that are determined based solely on an employee’s level of compensation and does 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). However, broad-based pension plans may be considered incentive plans if contributions or benefits are based on a formula that includes stock compensation or performance-based cash awards.

The attached article discusses principles of a sound compensation system including balanced risk-taking incentives, compatibility with effective controls and risk management, and strong corporate governance as well as suggestions on what to do now to prepare for your next regulatory exam.

Additional Documents