Regulatory attention on incentive compensation is heightened following the Wells Fargo scandal, posing a greater burden to boards and management teams. Todd Leone and Gayle Appelbaum of McLagan, part of Aon plc, explain what tools banks should use to mitigate compensation risk and the questions boards should be asking about incentive compensation arrangements.
Increased Scrutiny on Compensation Plans
Tools to Mitigate Compensation Risk
Questions to Ask About Incentive Compensation
Balancing Compensation Risk with Attracting Talent
Before incentive programs can be determined, staffing needs are addressed and a succession plan is developed, a CEO needs to articulate a vision and communicate key priorities to his or her team. Gerry Cuddy, CEO of Beneficial Bank, Kent Ellert, CEO of Florida Community Bank and Chris Murphy, CEO of 1st Source Bank, explore what is capturing the attention and imaginations of bank CEOs today in this panel discussion from Bank Director’s 2016 Bank Executive & Board Compensation Conference, lead by Scott Petty, managing director, financial services at Chartwell Partners.
Highlights from this video:
Managing Talent in the Current Environment
Incentive Compensation After the Wells Fargo Scandal
Following up on Bank Director’s Bank Executive & Board Compensation conference last week, we asked attorneys for their opinions on the latest rules on compensation risk and whether they really found them necessary or helpful. In a word? No. Although the exact impact remains to be seen, many feel that these new rules will actually hurt more than they help.
Will the new federal rules on compensation risk make the banking industry safer?
In the context of banks that are too big to fail and too big to govern, the rules will have only a marginal impact. Clearly Jamie Dimon was as surprised as anyone when the London whale caused the bank a multibillion dollar portfolio trading loss, but to say that compensation rules lead to reckless speculation is to miss the point. The losses suffered by J.P. Morgan Chase & Co. were not a result of misplaced compensation incentives, but a lack of sufficient controls over activities which are culturally risk intensive. It is doubtful that the London whale would have avoided speculative trades if his contract penalized his poor performance or risk taking. Performance-based compensation trends and regulatory restrictions on incentive based compensation are in conflict. It is ironic that during a time when incentive-based compensation is on the rise, and scrutiny over peer comparisons and total shareholder returns is increasing, regulators would blame compensation arrangements as a cause of the crisis.
—Doug Faucette, Locke Lorde LLP
Not really. Changes in substance, if any, will occur on the outside edges, the extremes if you will, of prior bank compensation practices, which will impact very few community institutions. Compensation practices for community banks have never amounted to a threat to the industry or the insurance fund. For most institutions, there will be tweaks and changes that will occur to show responsiveness to the regulatory concerns, probably as much in the lower ranks (e.g., with respect to loan origination pay) as in the executive suite. Every institution is required to conduct a risk assessment of their incentive compensation programs, and this should be documented at the board level. We would recommend that every institution institute a clawback policy for executive compensation. This is a good citizenship move, makes sense from all angles, and is easy to implement. We also expect to see more incentive compensation paid in the form of restricted stock for public companies.
—John Gorman, Luse Gorman Pomerenk & Schick, PC
The interagency rules implementing Section 956 of Dodd-Frank limiting compensation in banks larger than $1 billion in assets are not finalized yet. It remains to be seen whether these rules will change the product mix offered by banks going forward under the guise of restricting compensation. It also remains to be seen whether there will be “trickle-down” of these rules to banks with assets of less than $1 billion. Another unintended consequence might be if the rules restrict compensation to an extent that some of the best and brightest minds leave the banking industry for greener pastures. Does that actually make the banking industry safer?
—John Podvin, Haynes and Boone, LLP
Fundamentally, this is less about safety than it is a criticism of board level supervision of executive pay levels. At least, compensation consultants are happy.
—Mark Nuccio, Ropes & Gray LLP
The regulation of incentive-based compensation practices is a key aspect of the Dodd-Frank Act. It is based on the view that executive and senior manager compensation practices at financial institutions during the years leading up to the financial crisis failed to properly align compensation with appropriate risk-taking, and may have led to practices and activities that were inconsistent with the long-term health of financial institutions. The financial regulatory agencies proposed incentive compensation standards and disclosure requirements 18 months ago, and these rules are expected to be adopted in final form in the relatively near term. To the extent that these rules encourage financial institutions’ directors and senior management to pay closer attention to the risk incentives created by compensation practices and activities, and take appropriate action to better reward behaviors that emphasize the longer-term health of a financial firm while discouraging activities that do not accomplish this objective, the new rules should assist in reducing inappropriate risk in financial firms.
Recently the Consumer Financial Protection Bureau (CFPB) issued a set of proposed rules on mortgage loan originations that include restrictions on compensation that will make it difficult for banks to structure bonus plans for their mortgage loan originators.
I wrote about this issue back in May, after the bureau had issued guidance stating that banks are permitted to make contributions to a mortgage loan originator’s 401(k) or some other type of qualified plan out of a profit pool derived from mortgage loan originations. However, the CFPB declined to indicate at the time whether banks could pay bonuses to originators based on the profitability of a pool of mortgage loans as part of a non-qualified incentive compensation plan. The distinction is important because in the case of a qualified plan like a 401(k) we’re talking about an individual’s future retirement income, while with a non-qualified bonus plan we’re talking about cash in their pocket today.
First a little bit of important background. Underlying this issue of mortgage originator bonuses is the focus of federal regulatory agencies—including the CFPB—on so-called compensation risk. During the subprime mortgage boom, originators often received extra compensation if they steered borrowers to higher cost loans, which often meant low-income borrowers paid more for their loans than they should have. The Federal Reserve Board proposed stricter rules on mortgage origination compensation in September 2010 under the Truth in Lending Act. Rulemaking authority for the Act was transferred to the bureau under the Dodd-Frank Act, and now the bureau is finishing what the Fed started.
Mortgage originators aren’t the only bankers impacted by all this attention on compensation risk. Banks are also being forced to change their incentive compensation practices for other kinds of lending activity, including commercial real estate and C&I lending. Generally speaking, the regulators don’t want lenders to be rewarded purely on volume; they want to see bonus payments spread out over a longer period of time than, say, just one quarter; and they want the size of the payout tied to the performance of the underlying loan portfolio over some reasonable period of time so lenders don’t get paid upfront for loans that later go bad. And in the case of mortgage originators, regulators don’t want them to be incentivized to screw their customers by pushing them unwittingly into high cost loans when they would qualify for a cheaper loan.
It was not clear last May whether the CFPB would allow banks to pay its mortgage originators any kind of bonus that wasn’t tied to a qualified plan. “Every bank is trying to do a better job of tying compensation to the profitability of the underlying business,” says Kristine Oliver, vice president at Pearl Meyer & Partners. But the bureau has now issued a proposed rule for non-qualified bonus plans that will make that goal much more difficult. Under the latest proposal, banks may pay employees a bonus derived from a pool of mortgage loans only if three conditions are met:
Compensation may not be based on the terms of the loans that were originated, so an employee can’t be rewarded for producing more of one kind of loan versus another.
The employee can’t have originated more than five mortgage transactions during the last 12 months.
However, if the individual’s transactions exceed five, the bonus pool can based on mortgage revenue limited to 25 or 50 percent of the overall revenue in the pool. The bureau has proposed two percentage cap alternatives, 25 percent and 50 percent.
The proposal does address the concern some people had that branch managers who originate an occasional mortgage might not be allowed to receive a bonus based on the profitability of their branches if the branch’s revenue included, say, points or mortgage origination fees. Now those individuals can receive a bonus even if the branch’s revenue includes some mortgage related revenue.
“The bureau has proposed a diminutive exemption,” says Richard Andreano, Jr., a partner in the Washington, D.C. office of Ballard Spahr LLP. “That would work for [occasional originators] but doesn’t work for someone who does more than five but still doesn’t do a whole lot of originations.” An example might be someone manages a mortgage production office and originates more than five loans a year, but is still a low volume producer compared to their rest of their team, so they don’t qualify for a bonus based on mortgage revenue.
More importantly, the proposed cap on the percentage of mortgage-derived revenue that can be included in a bonus or profit-sharing plan will make it impossible for banks to structure incentive compensation plans that will reward their originators solely on the profitability of their business. To get around the cap, banks will have to enlarge the categories of revenue that bonus payments are based on to include other kinds of loans in the mix. That would make it more of a company-wide incentive plan—especially if the cap is as low as 25 percent—which might be what the regulators prefer, but could be a less powerful incentive than a plan where mortgage originators were the only participants.
“That’s where the bureau wasn’t willing to go,” says Andreano.
Banks and other financial services companies that are impacted by the proposed rules have until Oct. 16 to submit their comments to the CFPB. Dodd-Frank requires the bureau to adopt final mortgage originator rules by Jan. 21, 2013, so banks should expect a final rule by then. Unfortunately, as Oliver points out, “People are starting to pull together their incentive plans for 2013,” so any assumptions they make now—like, for example, will the allowable cap be 25 percent or 50 percent—could be subject to change.
Effective June 2010, regulators covering the majority of banks in the U.S. jointly issued guidance requiring institutions to comprehensively review their compensation programs and ensure they do not motivate unnecessary risk taking. Emerging regulations under Dodd-Frank, due to be finalized later this year, will place even greater pressure on banks, particularly those over $1 billion in assets. There will be increased expectations that banks ensure proper board oversight, implement enhanced controls and policies, improve documentation and revise their incentive plans to consider risk mitigation strategies. To comply, bank directors, and in particular the compensation committee, must be fully involved, well-informed and possess an in-depth understanding of not just executive incentive arrangements, but incentives for all employees.
To determine whether the bank’s current risk assessment process is adequate to comply with regulations, directors should ask a few key questions regarding their bank’s current programs and processes:
Do we have a process to identify and document covered employees? Most banks already have identified a small number of executive and highly-paid employees, but that may no longer be enough. Banks also are expected to develop processes to identify and define employees whose incentive arrangements might, if not properly structured, pose a threat to the institution’s fiscal safety and soundness.
Do we have defined processes to identify, assess and document the risks considered in the compensation programs? Banks should have a systematic and documented approach to identify the full range of risks that could compromise the safety and soundness of the institution.
Do incentive plans incorporate risk adjustment features? While there is no “one-size-fits-all,” banks should consider for each role/function what type of risk adjustment features are most appropriate. Some approaches include:
Using quantitative and/or qualitative risk information to adjust incentive pools and/or awards. For example, where a lending officers’ production was based on a higher risk portfolio, payouts may be adjusted. If a bank felt earnings were a result of a higher risk profile, the overall incentive pool might be reduced.
Including risk-based performance measures such as risk adjusted return on capital, capital and/or asset quality factors. For example, lending officers may have a portion of their incentive paid (or deferred) based on the quality of the loan portfolio.
Deferring a portion of the incentive until long-term performance success (or failure) is known and reducing or eliminating the payout downward if performance is not sustained.
Using multi-year performance goals to reward performance to better align rewards with the time horizon of the risk.
Are risk-management and control personnel involved in the risk assessment process? To ensure effective risk assessment, these employees should be involved in the review as well as the design and monitoring of short and long-term incentives. Additionally, their own incentive arrangements should ensure objectivity and not be tied directly to the business units they monitor. The chief credit officer shouldn’t get paid incentives tied to the volume of loans, for example.
Do we have proper documentation? This is a key weakness of many banks where complete and clear documentation of all programs, policies, monitoring procedures and governance protocols is lacking. Banks should seek to document all incentive plans as well as monitoring and control procedures. Where discretion is applied, documentation of rationale should be included. Committee minutes should reflect discussions and considerations of risk relative to plan designs and payouts.
Have internal communications with the board and/or compensation committee changed? While the risk review is important, risk-related information must be shared between board committees and management to ensure proper oversight during discussions of incentive plan designs, goal-setting and award payouts.
As bank risk assessment standards evolve, their effectiveness will depend heavily on the quality of the risk assessment process used, the actions taken to reduce risk in the compensation programs, and the commitment of directors to strong governance of the process.
What Level is Your Risk Assessment Process?
Level 0 – No Assessment Process – Virtually all financial institutions are now required to conduct a risk review process and assess relative to the guidance provided in 2010 by all major bank regulators. If you haven’t yet started to review and document your plans, it is critical to start now.
Level 1 – Conduct Basic Review of Incentive Plans – The bank has reviewed incentive plans relative to the June Agency guidance at a high level and feels there is limited need to adjust programs. Documentation may be in process but not comprehensive.
Level 2 – Rigorous Process, Documentation and Oversight – The risk assessment process documents not only the programs, but also all covered employees, controls and risk mitigation techniques. Formal risk accountabilities and a review process have been defined. The board or its designated committee has oversight and some programs have been redesigned to mitigate/adjust for risk.
Level 3 – Comprehensive and Holistic Risk Assessment Framework – The board or its designated committee is actively engaged in overseeing risk. Risk assessment and mitigation is integrated into many compensation-related processes and risk management personnel play a vital role in ensuring compensation arrangements do not promote undue risk. Compensation programs have been adjusted to account for risk.
In today’s risk-focused environment, financial institutions must ensure that their incentive compensation plans are meeting regulatory requirements. In this short video, Kevin Blakely, senior vice president and chief risk officer at Huntington Bancshares of Columbus, Ohio, talks about how his institution addressed this challenge and shares his role in balancing compensation plans throughout the organization.
Are your institution’s compensation plans structured to benefit or hurt your shareholders? In this five-minute video, William Flynt Gallagher, president of Meyer-Chatfield Compensation Advisors, offers insight and advice on strategies the compensation committee can use to maximize benefits and structure executive agreements to actually enhance shareholder value.
In connection with another successful Bank Director & Bank Executive Compensation conference, I thought it would be helpful to recap three important issues raised by the attendees, as well as some of the action items that need to be addressed in the short time left before year-end.
You are Not Alone
During the day-long Peer Exchange held prior to the conference, compensation committee directors met in small groups to discuss issues of common interest. One of the universal feelings was that the directors are feeling awash in new regulations and regulatory guidance that are making it very difficult to do their jobs. One director noted, to everyone’s agreement, that focusing so heavily on all of the new rules has materially detracted from time spent on truly strategic matters.
Consistent with prior years, directors conveyed that their time commitment to board activities and the complexity of the rules they have to work through in compensation continue to increase. When this is combined with the minimal annual increases in director compensation and the increasing threat of personal liability, it is a wonder that these directors continue to be as focused and committed to their institutions as they are.
Succession Planning at the Board Level
Though most directors felt that their boards are in a position to actively oversee their senior executives, including the wherewithal to replace underperforming or otherwise problematic individuals, there was almost universal agreement that this is very difficult (and increasingly more difficult) to do so at the board level. The smaller the institution, the more likely it is that any given director may be either a founding investor, major business producer or both. Though many directors indicated they had some level of succession planning for their executive ranks, few have actively planned for succession at the board level, other than using a mandatory retirement age for directors, which only guarantees transition rather than improvement. This is consistent with the difficulties faced by many of our clients. We frequently meet with board members to discuss proper succession planning at both the executive and board levels.
The directors agreed that one of the best methods to surface these issues is to perform a review of each board member and the functionality of each committee. Prior to nominating board members for each successive term, a summary of these reviews should be considered by the board, or its nominations committee. If necessary, to arrive at the conclusion to remove a board member, it can be helpful to have a third party involved in the evaluation process. A third party can take an independent role in the process and may also have a much more robust review process than would otherwise be developed internally. The resulting evaluation report should be circulated to the relevant board members as part of the annual nominations process. One director noted at the Peer Exchange that after the first 360-degree review was completed at the board level, the CEO/chairman decided it was best to keep the results of future reviews confidential from the other board members, so as to avoid conflict. Unfortunately, this is not the end result you would hope for.
Risk is All Around Us
Not surprisingly, the general theme of the conference seemed to be risk. The issue of risk, as it relates to compensation, was raised and discussed in almost every presentation and each director exchange. This echoes our experience with our own clients over the past year. For public and private banks of all sizes, the universal set of rules applicable to incentive compensation and risk is the Joint Guidance on Sound Incentive Compensation Policies (effective June 2010). This guidance provides the principles-based approach to identifying, monitoring and mitigating risk as it may exist in your incentive compensation plans. Subsequent risk-based rules found in Section 956 of Dodd-Frank and the proposed Interagency Guidance on Incentive-Based Compensation Arrangements (proposed April 2011) provide great direction on how Congress and the regulatory bodies will look at the risk associated with incentive compensation plans for banks with assets in excess of $1 billion, though they are not all currently effective.
Consistent with the Joint Guidance that is currently effective, every banking organization should be reviewing their incentive compensation arrangements to assess the risk such arrangements may pose to the institution. The company should insure that proper oversight and controls are in place with respect to each plan to monitor ongoing risk and to participate in the design and development of new plans in a manner so that risk is fully understood and actively managed. Lastly, the board, or a committee of the board, should regularly meet with the individuals responsible for the oversight and controls of these plans and the board minutes should reflect this process. Together, they can properly judge whether changes need to be made to either the incentive compensation arrangements, or to the procedures and controls to monitor such programs, in order to protect the institution from unreasonable risk. The board must be actively engaged in this process and have a good understanding of each element of incentive compensation as it exists at the bank.