posted on 27 November 2016
Evidence Suggests That Incentive Compensation Practices In The Financial Services Industry Did Encourage Inappropriate Risk-taking
from the Atlanta Fed
-- this post authored by Madeline Marsden
In the aftermath of the financial crisis, incentive compensation arrangements in the financial industry were closely examined. These practices are an important element in attracting and retaining staff and in helping build high performance organizations. Appropriately structured arrangements align the interests of employees with those of the employer and benefit both parties. Inappropriate arrangements can lead to a disconnect between employee and firm success, such as when employees take ill-considered long-term risks in order to gain short-term rewards. The employee and the firm may show immediate profit, but the risk can come back to haunt the firm’s performance.
Evidence suggests that incentive compensation practices in the financial services industry did encourage inappropriate risk-taking, which contributed to the financial crisis. The balance between risk and reward for employees and the firms they worked for was misaligned.
In order to address this issue, the Board began a horizontal study of incentive compensation practices at the largest institutions in 2009. Interagency guidance was issued in June 2010. The guidance was based on three principles:
In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act passed. Section 956 requires the agencies to jointly prescribe regulations or guidelines with respect to incentive-based compensation practices at financial institutions with $1 billion or more in total assets. The rules must prohibit all covered institutions from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk-taking by providing covered persons with excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution.
The agencies first proposed a Dodd-Frank Incentive Compensation rule in April 2011; the proposed rule was based on the interagency guidance released in 2010. Since then, incentive-based compensation practices have evolved, and the agencies have gained additional supervisory experience. In May 2016, a revised proposal that includes new, more specific and more stringent requirements, especially for the largest institutions, was released for comment. The proposed rule would apply to financial institutions with total assets of $1 billion or more (covered institutions). All covered institutions would be subject to general prohibitions on incentive-based compensation arrangements that could encourage inappropriate risk-taking by providing excessive compensation or that could lead to a material financial loss.
The requirements are tailored based on assets, and covered institutions would be divided into three categories:
Smaller covered institutions with assets between $1 and $50 billion (Level 3) would be required to maintain records documenting their incentive-based compensation arrangements and to ensure that those arrangements:
Covered institutions with $50 billion or more in consolidated assets (Level 1 and Level 2) would be subject to mandatory deferral, forfeiture, and claw-back requirements. The mandatory deferral requirements for Level 1 covered institutions would be higher than for Level 2 covered institutions. Level 1 and Level 2 covered institutions would also be subject to more detailed and rigorous requirements for incentive-based compensation arrangements, risk management frameworks, governance, policies and procedures, and recordkeeping and disclosure requirements.
Covered persons are defined as:
Significant risk-takers are defined as:
To prevent evasion of the proposed rule, individuals who have the authority to commit or expose 0.5 percent or more a covered institution's capital would be significant risk-takers even if they were employed by an affiliate of the covered institution, regardless of whether that affiliate was itself a covered institution (for example, an affiliate with less than $1 billion in consolidated assets). Agencies could designate additional individuals as significant risk-takers because of their ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution's size, capital, or overall risk tolerance. Covered institutions could also designate additional individuals as significant risk-takers.
Compensation, fees, and benefits will be considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including:
The comment period ended in July. The agencies are considering the comments received.
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