FR4027 Incentive Compensation Guidance Q & A

Federal Reserve Proposed Incentive Compensation Guidance
Questions and Answers
1. What is a guidance? What does it do? How is it enforced?
Supervisory guidance is one of the Federal Reserve’s most important supervisory tools for
focusing attention on risk issues and for articulating supervisory expectations to the banking
organizations that it supervises. It is particularly useful in addressing risks in areas where there
may be significant differences among banking organizations or a variety of approaches that may
be used by banking organizations to achieve the desired goal. In such cases, a formal rule runs
the risk of being potentially too broad or too narrow.
This guidance sets clear expectations for banking organizations concerning their incentive
compensation arrangements and related risk-management, control, and governance processes.
As explained in the guidance, Federal Reserve examiners will review whether the arrangements
and processes of banking organizations are consistent with the guidance and safety and
soundness. Deficiencies will be factored into the organization’s supervisory ratings, which can
affect the organization’s ability to make acquisitions or take other actions. In addition, the
Federal Reserve in appropriate circumstances may take enforcement action against a banking
organization. Such an action may require the organization to develop and promptly implement a
plan to correct deficiencies in its incentive compensation arrangements or related processes.

2. What happens next?
The Board will accept comments on the guidance for 30 days. Nevertheless, the Board
expects banking organizations to immediately review their incentive compensation arrangements
to ensure that they do not encourage excessive risk-taking and to implement corrective programs
where needed.
To help spur action, the Federal Reserve also will move forward with the two supervisory
initiatives outlined in the guidance. For example, as part of a horizontal review, large, complex
banking organizations (LCBOs) will provide the Federal Reserve with information and
documentation that clearly describes their plans, including relevant timetables, for improving the
risk-sensitivity of incentive compensation arrangements and related risk management, controls,
and corporate governance practices. We will work closely with the LCBOs on these plans and
will monitor their adherence to the plans and associated timetables.

3. Why is the Federal Reserve not suggesting a pay cap or outlawing particular

practices?

As noted in the Principles for Sound Compensation Practices issued by the Financial
Stability Board in April 2009, “one size does not fit all” firms or employees. Best practices for

balancing risk and rewards in incentive compensation programs continue to develop and are
likely to evolve significantly in the coming years.
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. 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. Further experience may reveal specific compensation practices that may
appropriately be required or prohibited. In the Federal Register notice proposing the guidance,
the Federal Reserve has asked for comment on this point.

4. Why is the Fed doing this? What authority does the Fed have to oversee

compensation?

Recent events have highlighted that inappropriate compensation practices can contribute to
safety and soundness problems at banking organizations and to financial instability.
Traditionally, banking organizations and supervisors relied on strong risk management, internal
controls and corporate governance to help constrain risk-taking. However, the financial crisis
has illustrated that the incentives created by poorly designed and implemented incentive
compensation arrangements can be powerful enough to overcome risk controls.
While organizations, their shareholders and others are examining compensation practices, the
Federal Reserve has an important role to play as well. Because of the presence of the federal
safety net, shareholders of a banking organization may be willing to tolerate a degree of risk that
is inconsistent with the organization’s safety and soundness. Thus, aligning the interests of
employees and shareholders may not be sufficient to protect the safety and soundness of the
organization or financial stability.
Supervisors also can play a critical role in addressing the "first mover" problem that may
make it difficult for individual firms to act alone in addressing misaligned incentives for fear of
losing valuable employees and business to other firms. Supervisors can help counteract these
forces by promoting the coordinated movement of the industry toward better practices.
The Federal Reserve has clear authority to act in this area. Section 8 of the Federal Deposit
Insurance Act authorizes the Federal Reserve to take action against a banking organization if the
organization is engaged, or is about to engage in, any unsafe or unsound practice. The Federal
Reserve and the other Federal banking agencies regularly issue supervisory guidance based on
the authority in section 8 of the FDI Act. Guidance is used to identify practices that the agencies
believe would ordinarily constitute an unsafe or unsound practice and identify risk-management
systems, controls, or other practices that the agencies believe would ordinarily assist banking
organizations in ensuring that they operate in a safe and sound manner.

5. Who will be subject to this compensation guidance?
The guidance will apply to all banking organizations supervised by the Federal Reserve.
This 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.
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, the guidance
applies to incentive compensation arrangements for:
 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 (for example, 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 (for example, loan officers who, as a group, originate loans
that account for a material amount of the organization’s credit risk).

6. How is this guidance related to recent work by international bodies like the Group
of Twenty or the Financial Stability Board?
The guidance is consistent with the Financial Stability Board’s (FSB) Principles for Sound
Compensation Practices issued in April 2009 and with the FSB’s recent Implementation
Standards. Both documents mention a number of possible methods of improving compensation
arrangements for individual employees. The Federal Reserve will focus on whether
compensation arrangements provide employees incentives to take excessive risks that could
threaten the safety and soundness of the banking organization. The Federal Reserve will
continue to work with representatives of other nations to achieve a level playing field with
respect to compensation incentives.