Bank Compensation Committees Lose a Whole Lot of Discretion

A lot has changed since Bank Director hosted its first compensation conference 10 years ago. I was at the inaugural conference in Dallas in 2005, and back then, the big issues in bank compensation were the competitiveness of CEO pay plans, proxy trends, the attitudes of institutional shareholders, and the structuring of incentive compensation plan for executives.

As we all know, 2005 was still something of an age of innocence for the banking industry. The financial crisis, which was in full bloom two years later, changed everything. Congress and the bank regulatory agencies responded to the crisis with an avalanche of new requirements and restrictions, including many that targeted the industry’s compensation practices. It was taken as an article of faith in Washington that out-of-control pay practices in the financial services industry during the home mortgage boom helped precipitate the crisis, and bank incentive compensation practices are now under tight regulatory scrutiny. The compensation committee was a fairly uneventful assignment for bank directors prior to the crisis, but now rivals the audit committee for regulatory complexity. Serving on the compensation committee was once analogous to a military posting well behind the front lines, but now it is the front line from a governance perspective.

At the front lines this year, Bank Director hosts its annual Bank Executive and Board Compensation Conference Nov. 10-11 in Chicago at the Swissotel. Granted, this is a time of year when the weather is so unpredictable, it might be warm or it might be snowing.

While the weather might be uncertain, the change in compensation committee responsibilities will be pretty clear.

The initial barrage of regulations occurred in 2010, when the four bank regulatory agencies—led by the Federal Reserve—issued joint guidance on what has come to be called Sound Incentive Compensation Practices, or SICP. This guidance focused on the relationship between risk and compensation and has had several practical results, including a new emphasis on compensation risk management (banks are required to perform an annual risk analysis of their incentive compensation programs); a much longer payout of incentive awards; and a significant reduction in the use of stock options, which the regulators generally frown upon because they might promote risky behavior, as stock prices generally have to rise for the options to be worth anything.

Another big shoe that is about to fall is a series of new requirements that are part of the Dodd-Frank Act of 2010, which was the U.S. Congress’ signature response to the financial crisis. Although far reaching in its scope, Dodd-Frank did address bank compensation practices as well. Some of its compensation-related provisions—including public company mandated, nonbinding shareholder votes on executive compensation and independence requirements for compensation committees—have already been put into place. Other requirements that will apply to all public companies, including disclosure of the ratio of the CEO’s total compensation to the median compensation for all of a company’s employees, and a clawback provision that allows companies to recover incentive compensation paid to executives if it was based on inaccurate financial statements, are expected to take effect in 2016 or 2017.

Perhaps the greatest difference between service on a compensation committee today compared to 2005 is the loss of discretion, and this cuts across the entire industry even though the most serious compensation abuses leading up to the crisis were found at the big banks, or at unregulated financial companies operating outside of the banking industry. Bank boards must be able to justify their compensation decisions to the institution’s primary regulator, who are standing at their shoulder like a shop floor supervisor. There might still be some element of discretion left when it comes to the specifics of an incentive compensation award to a senior bank executive, but it’s certainly much less than it used to be. In the banking industry today, the regulators are the primary drivers of incentive compensation for senior executives, and the greatest challenge for compensation committees is compliance.

As for the weather in Chicago, what are a few snow flurries to compensation committees buried under a blizzard of regulations?