Committees : Compensation

Why the Compensation Committee Matters So Much Right Now

One of the most significant developments in bank governance since the financial crisis has been the rise in the importance of the compensation committee.

It is not an exaggeration to say the bank compensation committee now ranks in equal importance with the audit committee, which has long been the workhorse on most bank boards. And in both instances, the driving force was a crisis that resulted in new Congressional mandates that expanded their responsibilities and authority.

For the audit committee, the catalyst was a series of corporate accounting scandals in the late 1990s and early 2000s — typified by the Enron debacle — that led to passage of the Sarbanes-Oxley Act of 2002. Under SOX, public company audit committees are responsible for the integrity of all financial reports. Included among their many duties is the responsibility to hire, compensate and oversee the company’s external auditor.

The catalyst for the compensation committee’s elevation was the 2008 subprime mortgage crisis. Contributing to the crisis were the compensation practices of many subprime mortgage lenders, which rewarded loan production over credit quality. Mortgage originators had little incentive to worry about the long-term performance of individual loans — especially if they were bundled with other loans and turned into securities for sale to institutional investors. Although some of the most abusive origination practices were found at nonbank mortgage companies, many bank lenders were also guilty of rewarding production over quality.

Interestingly, Section 956 of the Dodd-Frank Act of 2010 did address this issue of compensation risk. It has never been finalized, even though it was re-proposed with significant changes in 2016. The regulatory initiative that did address the issue of compensation risk was guidance — known as Sound Incentive Compensation Policies, or SICP — issued by the three federal prudential bank regulators in 2010.

These requirements, which remain in effect today and apply to all depository institutions, are intended to assist banks in the design and implementation of incentive compensation arrangements that do not encourage imprudent risk taking, thereby protecting the safety and soundness of the country’s financial system.

The guidance is principles-based, so each bank must apply it to their own situation — a responsibility that generally falls to the compensation committee. At the heart of SICP are three core principles. Incentive compensation arrangements should:

  • Provide employees with incentives that appropriately balance risk and reward.
  • Be compatible with effective controls and risk management.
  • Be supported by strong corporate governance, including active oversight by the institution’s board of directors.

The requirements apply to three groups of individuals who are often referred to as covered employees, beginning with senior executives and others who are responsible for oversight of the bank’s firm-wide activities or material business lines. This would include the CEO and other senior executives in the organization.

Also covered are individual employees whose activities could expose the bank to material risk, like a trader who manages a large securities position. And the third group are employees that have the same or similar compensation arrangements and who collectively could expose the bank to material risk, like a team of lenders.

Every bank is required to perform an annual review to ensure that its compensation arrangements are not creating a safety and soundness risk for the organization. The compensation committee owns the process, although there should be an open line of communication with either the audit or risk committee, depending on where the responsibility for risk governance lies on the board. The latter has the responsibility to monitor credit trends within the bank’s loan portfolios, which is a key factor in the evaluation of compensation risk.

The SICP guidance has had a significant impact on the design of bank incentive compensation plans, although the “say on pay” phenomenon has also brought heightened scrutiny to the industry’s pay practices. Since the crisis, most plans now incorporate some type of credit quality metric in determining the plan’s payout. Rather than being incented entirely on profit or volume, the individual is also being rewarded based on the quality of the underlying business.

Today, the plans can have as many as three to five goals, including profit goals, business objectives and risk management goals. Leverage in most annual executive plans for regional and community banks is typically 150% from target to maximum, down from as high as 400% prior to the financial crisis. Long-term plans often stretch payouts over a multi-year period.

These are not easy plans for the compensation committee to design: they must balance meaningful incentives aligned with the bank’s long-term strategic objectives while creating protections against undisciplined risk taking. Since the financial crisis, compensation committees have been mandated to help safeguard the safety and soundness of the country’s banking system, with the knowledge that federal regulators are watching over their shoulders.