New Incentive Compensation Rules Will Impact Banks and Their Boards

incentive-compensation-6-27-16.pngRecently, four of six regulators issued an inter-agency proposal for new rules on incentive compensation under §956 of the Dodd-Frank Act. The new rules replace the joint rules proposed in 2011, which never went into effect. Banks boards must approve incentive compensation plans for senior executives and “risk takers” under the framework of the law.

Four Key Differences
While some of the re-proposal is the same, there are important differences between the new rules and the 2011 rules. Here we touch on four key differences, and one important similarity.

1. The regulators have been “getting smart” on incentive compensation. While the 2011 rules seemed to have been proposed in a vacuum, the regulators have indicated that the new rules are based on their collective supervisory experiences gained over the last several years. The new rules incorporate practices that institutions and foreign regulators have adopted to address compensation practices that may have contributed to the financial crisis.

2. The new rules try to lessen the burden on smaller institutions by further dividing banks into categories based on assets and by scaling the requirements. The new rules recognize three categories each of which will be subject to varying levels of oversight:

  • Level 1 (greater than or equal to $250 billion);
  • Level 2 (greater than or equal to $50 billion and less than $250 billion); and
  • Level 3 (greater than or equal to $1 billion and less than $50 billion).

Institutions with average total consolidated assets of less than $1 billion will be subject only to the “safety and soundness” aspects described below. In most cases, the new rules apply the most stringent aspects only to Levels 1 and 2, while Level 3 just has primarily governance and recordkeeping obligations. However, regulators do have the discretion to subject Level 3 institutions to the rules applicable to Level 1 and 2 institutions.

3. The new rules get more specific about troublesome compensation designs. An incentive compensation arrangement will not be considered to appropriately balance risk and reward unless it:

  • Includes financial and non-financial measures of performance;
  • Is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate; and
  • Is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.

4. The new rules extend mandatory deferral and clawback periods for Level 1 and 2 institutions. At their most restrictive, the new rules will require deferral for at least four years of at least 60 percent of senior executive officers’ incentive compensation and at least 50 percent of significant risk-takers’ incentive compensation. In addition, the new rules will require clawback provisions that, at a minimum, allow the institution to recover incentive compensation from the same individuals for seven years following the date on which the compensation vests, if the institution determines that the individual engaged in misconduct, fraud or intentional misrepresentation of information.

One Similarity
In addition to the foregoing key differences from the 2011 proposal, one important aspect remains the same. Similar to the 2011 rules, the new rules will prohibit all institutions from establishing or maintaining incentive compensation plans that encourage inappropriate risk by providing excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution. In this regard, the new rules continue to rely on the bank regulators’ “safety and soundness” guidelines respecting all compensation arrangements. In particular, in assessing the balance of risk and reward with respect to any compensation arrangement, institutions should consider all relevant factors including:

  • The combined value of all compensation, fees, or benefits provided to a covered person;
  • The compensation history of the covered person and other individuals with comparable expertise at the covered institution;
  • The financial condition of the covered institution;
  • Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets;
  • For post-employment benefits, the projected total cost and benefit to the covered institution; and
  • Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution.

Effective Date and Transition
It is expected that the last two regulators will publish their version of the new rules in the coming weeks. Variation between versions is not expected. A comment period will follow publication by each of the regulators. The new rules will become effective approximately 18 months after being published in final form. The new rules will not apply to any incentive compensation plan with a performance period that begins before the final rules are effective.

Zions Bank Grapples with Regulation

In the wake of the financial crisis, all the big banks had to change executive compensation plans to reduce risks. Regulators are keeping a close eye on these plans and sometimes requiring a mountain of paperwork to document them. Here, Scott Law, the executive vice president and director of compensation at $58 billion asset Zions Bancorporation, talks about how the changes have impacted his company.

Trends Emerging in Compensation Policies for Bank Executives

Governance policies related to executive compensation are on the rise as a result of increased influence of bank regulators, shareholders and the Securities and Exchange Commission (SEC). These policies are intended to reduce compensation-related risk, encourage a long-term perspective and align executives with shareholder interests.

Meridian’s 2015 proxy research of banks with $10 billion to $400 billion in assets illustrates the prevalence of “standard” and “emerging” practices. Standard practices tend to be common regardless of asset size. Emerging practices are more prevalent at larger banks, but are likely to cascade to community banks over time.

Policies on Risk Adjusting Payoutsrisk-adjustment.PNG
Standard: Clawback Policies
Clawback policies allow the recovery of incentive compensation that has already been paid or vested when there has been a financial restatement and/or significant misconduct. Most banks currently have clawback policies; however, these may need to be revisited once the SEC issues final clawback rules. While many existing policies allow compensation committee discretion to seek recovery, the proposed rules (July 2015) would require a mandatory clawback of “excess” incentive pay in the event of an accounting restatement.

Emerging: Forfeiture Provisions
While clawback policies seek to recover awards already paid, forfeiture provisions provide for the reduction of incentive payouts and/or unvested awards based on negative risk outcomes such as  a lack of compliance with risk policies. While these provisions are standard at large banks that have faced significant regulatory scrutiny, they are only beginning to be used at smaller banks.

Policies on Use of Company Stockcompany-stock.PNG
Standard: Anti-Hedging Policies
Anti-hedging policies prevent executives and directors from participating in transactions that protect against or offset any decrease in the market value of company stock. Such transactions could create misalignment between shareholders and executives since executives would not suffer the same losses as shareholders if the share price drops.

The SEC’s proposed rule (issued February 2015) requires companies to disclose the types of hedging transactions (if any) allowed and the types prohibited for both employees and directors. As seen in our study, most banks already disclose formal anti-hedging policies.

Emerging: Pledging Policies
Pledging policies prevent or limit executives’ and directors’ ability to pledge company shares as collateral for loans. Pledged company stock creates a risk that executives may be forced to sell shares at a depressed stock price in order to raise cash to cover the loan margin, which could further the decline in stock price.

However, some companies allow limited pledging with pre-approval. Pledging enables executives to monetize share holdings without selling company stock. Since 2006, public companies have been required to disclose the amount of company stock pledged by executives and directors. Proxy advisory firms and shareholders typically criticize only significant levels of pledging.

Policies on Retention of Stock AwardsStock-retention.PNG
Standard: Stock Ownership Guidelines
Over 80 percent of banks in our study have stock ownership guidelines that require executives to maintain a minimum level of ownership. Ownership guidelines are typically defined as a multiple of base salary. For CEOs, the most common ownership requirement is five times base salary, while other executives range between one times and three times base salary.

Emerging: Post-Vesting Stock Holding Requirements
Many investors and shareholder advisory firms have started pushing for additional stock holding requirements. Holding requirements restrict executives from selling stock earned from equity awards or option exercises for a period of time after vesting or exercise. Some holding requirements require executives to hold a percentage of shares until ownership guidelines are met. More rigorous policies require executives to hold a percentage of shares for a set period of time (e.g., one year after vesting) or until (or even after) retirement.

Banks have been ahead of many industries in adopting these governance practices as a result of the regulatory scrutiny on compensation programs, and we expect the emerging practices will continue to gain in prevalence across banks of all sizes.

The Importance of Competitive Pay

1-14-15-Kaplan.pngIn the midst of the Great Recession, a number of community banks found themselves the beneficiary of an unexpected inflow of talent. In particular, veteran bankers and commercial lenders who were stuck in dead or dying institutions jumped ship to a safe port during this major storm. Obviously, this was highly beneficial to those institutions seeking new senior leaders or major producers, but in some cases it also created a false sense of “talent security”—the idea that a stream of good bankers would continually find their way to the bank.

While there are indeed some high performing community and regional banks that have become “destinations” for top talent, this remains the exception to the rule. Furthermore, given the demand for talented bankers and lenders in excess of the supply (in both rural and urban markets), compensation has returned as an important factor in bankers’ consideration of where to deploy their talents.

This is not to say that an executive’s primary motivation to pursue new opportunities is financial: all of the data affirms that this is not the case. We have observed, however, several evolving dynamics regarding executive compensation, which have significantly impacted the market for senior banking talent over the past several years:

  • Banks are increasingly locking in their high performers and senior leaders with tools such as equity grants that vest over time, phantom shares for private banks or deferred compensation. In this still uncertain economic climate, few executive level candidates are willing to walk away from real dollars for the privilege of joining another institution. Candidates are usually reticent to leave money on the table, and thus these retention tools designed to “handcuff” executives are working in many cases.
  • Career moves that are financially lateral are becoming increasingly rare. As institutional and regulatory risks remain uncertain—often impacting an executive’s willingness to consider a career move—the “change premium” needed to attract new senior talent has increased. In addition, the due diligence conducted by senior bankers on potential career destinations has never been more thorough. This often complicates negotiations, impacts offer terms, and in some cases even results in a banker’s decision to pass on a superior opportunity due to a bank’s regulatory status or cloudy future.
  • Institutions that do not have the liquid currency of equity to work into the compensation mix—including privately held banks, mutuals, institutions whose equity plans have expired and those under some form of regulatory agreement—often face a greater challenge in structuring an appropriate compensation package when in heavy recruiting mode. Making up for lost equity, pending bonus payments, and deferred compensation may be especially challenging when the sole or primary compensation tool available is cash.

As evidence of this shift in executive recruiting economics, nearly every CEO search assignment we have been involved with over the past five years has also involved the bank’s compensation consultant. We have partnered with our clients’ compensation advisor—firms such as Pearl Meyer, Meridian and McLagan—in order to ensure not only that the proper financial package can be designed, but that the structure of such packages is appropriate and defensible.

Talent is so important, that one of the prime reasons some banks sell to another bank is the lack of a succession plan or the limited availability of talent.  At the end of the day, talent drives the execution of strategy, and people are always the variable in a bank’s ability to execute that plan. Thus, banks that want to survive and thrive must have the strongest possible executive leadership, as well as a cadre of good lenders. Of course, “A” players always have the most options, while “B” players are more plentiful.  However, it is always the “A” players who move the needle in terms of performance, while also commanding market compensation. “B” players may be less expensive but rarely move the needle, and the savings in hiring a B player will never make up for the lower performance.

Compensation is always a sensitive issue in banking, particularly for publicly traded institutions. And yes, it often feels that the competition is always driving up the cost of talent, impacting the bank’s bottom line. In reality though, the two most vital ingredients for banks to succeed in this environment are capital and talent. In banking as in most businesses, you do get what you pay for most of the time. Banks that are willing to invest in competitive compensation packages will be better poised to attract the best talent, and win the never-ending battles in the marketplace.

Trends in Incentive Compensation: Risk and Deferrals

7-9-14-BCC.pngAs a result of the upheaval in the financial industry dating back to 2007, and as with most of the subsequent legislation, the community bank market has taken the brunt of the unintended consequences. This is no different in the area of compensation. The federal government has promulgated a flood of laws, regulation, and rules relating to the delivery of compensation within companies, but more directly within financial institutions.

Incentive Compensation
While compensation practices and payments have always had to fall within safe and sound banking practices, incentives, improperly structured, brought on problems. Some banks learned during the mid-1990s that incentive compensation structured solely to promote growth, particularly growth in the loan portfolio, was dangerous. That was especially true if the bank made the incentive payment immediately, or shortly after year-end. 

As a result, for a time after the mid-1990s, many banks were reluctant to delve into incentive compensation. As we have worked with banks since that time, more and more have been open to implementing annual incentives and deferred incentives so long as the structure implemented was flexible so that the incentives can/will be changed to address the current needs of the bank; addressed short-term, intermediate term and long-term risk associated with the incentive; and was compliant from a regulatory standpoint.

So that a bank has an incentive structure that provides flexibility, it is paramount to emphasize with the participants that the incentive program should not be expected year after year, and may change annually. Also, at implementation as well as each year thereafter, the participant should understand that the incentives absolutely will change based upon the environment the bank is operating in and the current needs of the bank. Goals can be bank-wide, branch-wide, individually based, or any combination of all three.

Risk with incentives has really been a hot topic with the regulators over the last six to seven years, beginning with the Troubled Asset Relief Program (TARP), when everything from bonuses to stock options were prohibited so long as TARP funds had not been repaid. Generally, the Interagency Guidance on Sound Incentive Compensation Policies, promulgated in June, 2010, set forth the expectation that some incentive compensation be at risk to the participant. Included in the guidance was the recommendation that for large banking organizations, some of the incentive should be subject to deferral. Deferrals have become a more common practice among community banks as well. Even without the new regulations, it seems more banks are looking to deferrals for the purpose of retention, as pay for performance has become a more significant component of the compensation packages of key hires.

Deferred Compensation
While deferred compensation for key personnel has existed for decades now, how that deferred compensation is being structured has evolved. Since the financial crisis, many banks are looking to other alternatives when it comes time to include the next generation of executives into some sort of deferred compensation program. In addition to using Supplemental Executive Retirement Plans (SERPs) or Salary Continuation Plans (SCPs), some banks are exploring using defined contribution structures. The reason for this is simple. With a defined benefit program, the bank is required to make liability accruals every year to the balance sheet for the SERP or SCP, which has with it a corresponding expense. Since the banking industry has recently gone through a period of struggle, being required to make deferred compensation accruals in a year where the bank may not be performing has been difficult. Therefore, by having a program that defines the contribution, the bank can have better control of determining when an accrual to the deferred compensation program occurs.

Many of our clients have asked us to design incentive compensation plans using Bank Owned Life Insurance (BOLI) to assist in offsetting the expense tied to the plans. This allows the compensation packages to be significant in value to the key employees, yet less significant in cost to the shareholders.

While there is more regulation to comply with following the financial crisis, if structured properly, banks can still implement creative and customized compensation programs unique to their institution to retain, recruit and reward key employees.

How Bank Boards Should Handle Regulatory Change

10-4-13-Manatt.pngBank directors should not think grimly about their service as a board member, even in the light of increased regulatory and shareholder pressure. While laws and regulations are constantly evolving, bank directors who approach their director work with clear focus, open lines of communication with management and a real understanding of the tenets of service as a director will be able to perform their functions at the highest levels that both regulators and shareholders have come to expect. Banks can, and must, build high performance boards that are ready to respond to the vast litany of responsibilities.

As a fundamental principal, the board must guide and set the overall strategic direction for a bank, and, in particular, establish the bank’s level of risk tolerance. How do high performance boards set that direction? They do that through approval of policies and procedures that set real standards for the scope and level of risk that a bank is willing to assume. Boards must ensure that this level of risk tolerance is communicated and adhered to at every level of the bank.

How can a board set this level of risk tolerance in responding to regulatory changes? Let’s take the Interagency Guidance on Sound Incentive Compensation Policies, which applies to all banks and thrifts. Incentive compensation benefits are used to attract key staff, induce better performance, promote employee retention and provide security to employees. In order to effectively analyze and ensure that incentive compensation arrangements at the board level take into account appropriate levels of risk, boards must clearly define an appropriate risk tolerance level which focuses on the long-term corporate health of an institution rather than quick, short-term gains. An incentive compensation policy should be structured around this framework.

How can you as a board member monitor management’s progress in both anticipating and responding to new regulations and assessing management’s ability to comply with new regulations? Ask questions in your board meetings and outside of your board meetings. Probe and challenge in a manner that is conducive to getting the information you need. Avail yourself of outside resources and advisors as appropriate.

Boards must also ensure that they have access to management and all employees at multiple levels. If boards are only getting information from their CEOs, they should be skeptical. Chief financial officers, chief credit officers, controllers and chief compliance officers, to name a few, all should all have the opportunity to present information to the board, and, as appropriate, be engaged in executive sessions where they can speak freely and openly about the supervisory and oversight process that management has provided.

In addition, boards must have independent sources of information separate and apart from management. In most board structures, for example, committees are devoted to overseeing various aspects of a bank’s overall operations. Audit committees can and should regularly interact with the bank’s independent auditors to make sure they are staying abreast of the latest developments. Similarly, compensation committees should leverage the work of outside counsel and advisors so that there is a complete understanding of significant changes in compensation rules and standards.

Finally, boards should consider charging committees with responsibility for overall risk management, whether at an executive committee level or with a specific risk management committee. Leveraging the work of committees can lessen the burden on any one particular director, as every director does not need to be an expert in every single field of exposure.

Building a high performance board today is not a luxury; it’s a requirement for success in an increasingly regulated and increasingly competitive environment.

Expect CEO Pay to Rise in 2013

6-21-13_Moss_Adams.pngWestern bank CEOs and their direct-report executives should expect average salary increases in the 3 to 5 percent range during 2013, according to a survey by assurance, consulting and tax firm Moss Adams LLP. Also, the industry should expect a nearly 50 percent reduction compared to 2012 in the number of institutions that continue to subject their executive officers to a salary freeze.

According to the 2012 Community Bank Compensation Survey conducted with Western Independent Bankers, the executive compensation banks are providing continues to show a strong correlation with the institution’s operating performance. The survey found compensation strategies continue to favor incentive-based compensation over salaries in order to place a greater emphasis on variable costs for the retention of key executive officers. However, as the economic recession gives way to recovery and many more banks return to profitability, we’re beginning to see more focus and attention given to executive compensation programs, particularly with respect to incentive pay components.

We also found that operating performance objectives, return measures and top-line growth continue to be primary considerations in establishing annual incentive compensation levels, while executive retention strategies are becoming more of a factor. While these compensation-related measures remain consistent from previous years and from bank to bank, nearly 50 percent expect to raise performance hurdles for measuring overall incentive compensation available in 2013. Long-term incentive award levels are also trending up modestly in 2013, with the award packages still relying heavily on time-vested restricted stock but increasingly including performance-vested stock awards.

In addition to these salary and incentive-based compensation expectations, the survey identified a number of emerging trends.

Increased Incentive Pay
Executive compensation is increasingly being delivered through incentive pay. It’s evident that there is a greater alignment of pay and performance, and incentive pay programs have a greater focus on long-term performance and risk outcomes. Equity-based incentives that defer compensation through multiyear vesting and mitigate compensation risk appear to be gaining favor.

More Performance Factors
Boards of directors and their compensation committees are taking a broader view of relevant performance factors in setting incentive-based compensation. An entirely discretionary approach to incentive compensation payouts is giving way to a formulaic approach dependent, in many cases, on multiple measures. Earnings measures remain the prominent factor, although returns on equity, capital levels, credit quality, and asset growth represent alternative metrics that are also considered.

Increased Documentation
When discretionary measures are used as the primary determinant for executive incentive compensation payouts, increased rigor and documentation is expected. We expect regulators to be more probing about the structure surrounding discretionary payouts to ensure decisions are justified and consistent. We expect compensation committees to refine their approach to discretionary payouts through the use of scorecards that will reflect absolute goals moderated by some subjective judgment tied indirectly to specific metrics or goals. Clawback provisions for incentive-compensation payments continue to be limited in application and complicated to enforce.

More Long-Term Incentive Strategies
Multiple long-term incentive strategies are expected to emerge with an increased use of performance-based vesting and increased responsiveness to shareholder interests and market trends. While performance-based incentive programs increase in application, time-based awards are expected to remain, balancing the mix if poor risk outcomes materialize prior to vesting.

More Transparency
More transparency in compensation reporting will become the norm, as say-on-pay provisions and public company advisory votes on executive compensation have raised reporting expectations. Proxy disclosures related to how compensation decisions are made, how performance criteria were established and how performance results led to incentive payments are expected to improve reporting clarity.

As boards of directors and their compensation committees continue to explore business planning strategies, risk tolerance measures, executive goal setting and the use of defined metrics in performance measurement, they will be better equipped to make even more meaningful connections between expected business performance and executive compensation in the future.

The Moss Adams annual survey was conducted in 2012 with Western Independent Bankers. The compensation report includes responses from 123 institutions that range in size from less than $50 million in total assets to over $2 billion across the western United States.

Trends in Incentive Compensation: How the Federal Reserve is Influencing Pay

5-14-13_Pearl_Meyer.pngIn the absence of final guidance from regulators on incentive compensation risk (Section 956 of the Dodd-Frank Act), the Federal Reserve is actively driving for changes in compensation practices and incentive use among the largest banks as part of its goal to mitigate risk-taking. Following adoption of joint regulatory guidance on incentive compensation approved by all banking agencies in June 2010, the Federal Reserve undertook a “horizontal” review of the 25 largest and most complex banking organizations. While the process has been ongoing, over the last year, the Fed has expanded its focus on the next tier of larger regional banks. We have learned much through this process that may change practices across the banking industry.

What are the themes coming from the Federal Reserve’s review of the largest banks and how might they influence bank compensation programs?

  1. Adjust Incentives for Risk: Whether payouts are discretionary or formulaic, regulators want to see incentive awards adjusted or deferred to better account for risk. Appropriate techniques include adjustments to the incentive “pool” or to specific awards. Deferral of awards is another appropriate approach when annual incentives comprise a significant portion of the pay package and/or are based on results that may change after the performance period. Deferral payouts are typically subject to additional performance criteria. 
  2. Reduce/Eliminate Stock Options:  Stock options have been attacked in recent years by many constituencies for various reasons, among them the view of regulators that they have the potential to drive risky behavior. But eliminating options altogether is a topic of debate among many compensation committees. Some believe options help align executives with shareholder value. The reality is that providing a very significant majority of pay in the form of stock options can motivate risk, but that used in smaller proportion, options are an appropriate vehicle within an overall portfolio of risk-balanced incentives.
  3. Limit Upside Leverage: Major shareholders and advisory firms like Institutional Shareholder Services have focused in recent years on driving stronger pay-performance alignment. However, regulators have expressed a preference for lower upside rewards for achieving performance above target, which can reduce the incentive for strong performance. Many of the largest banks have responded by reducing the caps on incentive pay to 150 percent of the target incentive, down from as much as 200 percent of target. It remains unclear what other program changes will be made over time to accommodate the regulators’ changes to program design. 
  4. Reduce/Eliminate Relative Performance: Regulators have also indicated their distaste for incentive awards that are based on relative performance—a narrow and prescriptive view that appears to be receiving more resistance from banks, for good reason. While short term plans typically focus on absolute goals that reflect annual budgets, long-term incentives often employ a three-year performance period. The problem is that the current economic and banking environment has made setting long-range goals a near impossibility. If banks are prohibited from considering relative performance, the unintended consequence is likely to be less challenging performance goals. In addition, because long-term plans often pay out in stock, to better align with shareholder value, consideration of a bank’s performance relative to industry peers is a valid perspective. That said, relative performance alone and without proper protections (e.g. performance gates) can result in inappropriate payouts. For example, at the start of the financial crisis, some banks rewarded for three-year total shareholder return (TSR) relative to a peer/industry index, such that higher rankings resulted in greater awards. Because those plans failed to account for the trend toward negative shareholder return, however, they also resulted in some high payouts for declining value—for being the best of the worst. Rather than eliminating relative performance altogether from long-term plans, banks should focus on better designed plans with features and discretionary adjustments designed to avoid such outcomes. 
  5. Define Discretion: Discretion remains a legitimate and appropriate means for adjusting pay and making award decisions in response to special circumstances, including the need to maintain sound risk management. However, the Securities and Exchange Commission and shareholder advisory firms are pushing companies to more clearly document and communicate the factors that were considered when discretion was employed in award payouts.

In the end, resorting to prescriptive or one-size-fits-all compensation designs will not meet the ultimate objectives regulators are seeking. Compensation programs must seek balance between:

  • Fixed and variable /performance pay
  • Cash and equity
  • Short and long-term perspective
  • Absolute and relative performance

Risk-taking generally results when performance-based plans are overly focused on a particular component of pay, or on a specific measure, rather than a broad view of performance.  A compensation program that balances the elements outlined above and provides a sound portfolio approach to incentives will be far less likely to drive inappropriate or excessive risk-taking, ultimately promoting good pay-performance alignment.

Regulatory Fatigue Syndrome: Identifying the Symptoms and Treating the Patient

Rx.jpgDuring the annual Bank Director Bank Executive & Board Compensation conference that was held recently in Chicago, Illinois, peer exchange sessions revealed that board members and executives alike are struggling to keep pace with an industry that continues to change. 

In the directors’ peer exchange meetings, directors often said that trying to keep up with the changing regulatory environment is as distracting as it is fatiguing. 

This year’s conference seemed focused on the stabilizing market, and from a director’s standpoint, establishing best practices for approving, monitoring and maintaining appropriate compensation programs, rather than on technical updates as in years past. While all this can make you feel like you’re battling the flu—proper “diagnosis and treatment” can help directors through this malady.

Symptoms of Regulatory Fatigue Syndrome

1. Blurry vision from prolonged reading of legislation, proposed regulations, guidance and advisor mailings.

2. Frequent headaches from balancing the need to eliminate risk in compensation programs to appease regulators while at the same time trying to increase the connection between pay and performance to appease institutional investors—though in many respects they can be diametrically opposed.

3. Intermittent nausea from endless board meetings that move from one regulatory issue to the next with little time for the consideration of strategic business issues.

4. General fatigue from worrying about missing one or more of the many new regulations that may or may not yet be effective.


1. Focus on current rules. Be aware of and consider proposed rulemaking, but specifically address rules that are in effect or issues that are before you today.  For example, is the bank subject to TARP or its legacy constraints? Is the bank in troubled condition and subject to the compensation limitations of Rule 359? Has the bank taken steps to implement the principles of the Guidance on Sound Incentive Compensation? Has the bank reviewed its compensation programs for its mortgage lenders, or does the bank need to publicly address a “no” vote recommendation from Institutional Shareholder Services or a bad result on a say on pay vote?

2. Review your charter. Review your compensation committee charter to ensure that your charter addresses the duties that are required of your committee based on current law. Your charter should reflect the committee’s duty to assess risk in your compensation programs and should provide for authority and funding to hire independent advisors.  Consider a committee checklist that will track the duties outlined in the charter in order to help ensure that the committee addresses each of its tasks at some time during each year.

3. Rely on your advisors. Work with your advisors to understand what regulatory changes may be coming and rely on them to let you know when you need to focus on each of the new rules. For example, do you need to deal with claw-back policies, CEO pay vs. performance disclosure, the CEO pay ratio relative to employee median pay disclosure, the compensation committee member and advisor independence requirements, or mortgage lender pay practices? 

4. Understand that risk mitigation is scalable. When trying to decipher all of the possible plan changes that might help manage, mitigate or eliminate risks, you should be mindful that the actions you take can be relative to the size and complexity of your bank and its compensation plans.  The actions taken by a $50-billion bank with complex plans are not necessarily the same that will be taken by a $1-billion bank with less complex and understandable compensation programs.  Many good practices will trickle down from the more complex organizations, but the risks are different, so your actions should be different as well.

5. Focus on establishing good procedures. Make sure you have good internal controls in place with respect to your compensation plans and that your senior risk officer is involved in the plans’ development and management. Your compensation committee should understand how the plans work, what the associated risks may be, and if changes should be made. The committee does not need to manage the plans (unless they apply to proxy officers), but they need to understand and manage the risks presented.

Certainly, this is a tongue-in-cheek approach, but fundamentally the advice is sound. Though there are many moving parts with the regulation of bank compensation practices, they can be addressed and understood by taking them one step at a time.  The old adage that “inch by inch life’s a cinch, but yard by yard it’s very hard” holds very true in trying to digest the multitude of compensation governance influences and constraints.

The Future of Executive Compensation

fortune-cookie.jpgEveryone from shareholders to regulators wants a “say on pay” these days, but compensation committees must continue to ensure their programs attract, retain and motivate executive talent in a way that is aligned with the bank’s strategy and culture.

Meridian recently completed a study of CEO compensation practices at 58 publicly-traded banks with assets between $1 and $5 billion. Based on our work with clients and the results of our research, we anticipate the following will be some of the key trends in executive pay as compensation committees work to balance competing expectations.

Increase in percentage of pay delivered through incentives.  In our study, on average, base salary comprised half of CEO total direct compensation (base salary, annual incentive and long-term incentives). Incentives have become a larger component of total pay over the past few years, and we anticipate that trend will continue as shareholders expect a more direct alignment of pay and performance. The majority of this increase will likely come through equity-based long-term incentives, which defer compensation through multi-year vesting and payment schedules and help mitigate the overall compensation risk.

Broader view of performance. With the rising regulatory focus on the perceived risk of compensation programs, committees are using a variety of performance factors to determine incentive payouts. Some committees use a fully discretionary approach to determining incentive payouts, which typically involves a holistic review of performance. Banks with formulaic approaches to annual incentives are increasingly using multiple measures, and we expect the trend to continue. Almost half of the banks in our study included four or five measures in their formula, while only 20 percent rely on just a single measure. While earnings measures (e.g. earnings per share) remain prominent, banks are also including measures focused on returns, capital levels, credit quality, and growth.

Increased rigor around discretion.  Regulators have recognized that discretion can play an important role in ensuring that payouts appropriately reflect risks taken during the performance period, as well as make it less likely that executives will manipulate performance results to increase payouts.  However, they expect sufficient structure around discretion so that decisions can be justified and made consistently. Shareholders and their advisors generally prefer formulaic plans, but will accept the use of discretion if it is reasonable and well explained. More than 80 percent of the banks in our study indicated that their committees use discretion in determining incentive payouts. We anticipate committees will refine their use of discretion to include the development of scorecards that reflect a variety of measures from both an absolute and relative perspective, as well as principled guidelines that specify the types of circumstances that will trigger discretionary adjustments.

Use of multiple long term incentives, with increasing use of performance-based vesting.  Among banks in our study, the prevalence of performance-based vesting on long-term incentives doubled from 17 percent to 34 percent between 2009 and 2011. We expect this trend to continue in response to shareholder expectations and broader industry trends. While we expect the use of performance-based long-term incentives to increase, we do not anticipate the elimination of time-based awards. We expect most banks will choose to grant a combination of awards—both performance-based and time-based. Many shareholders and their advisors expect a minimum of 50 percent of long-term awards to be performance-based, but the inclusion of time-based awards can help provide balance. Additionally, many time-based awards will likely begin to include provisions that provide for reductions if poor risk outcomes occur during the vesting period. 

More transparency.  Say-on-pay has given public company shareholders an advisory vote on executive compensation, and their expectations for insight into the committee’s decision making have increased. Likewise, the Securities and Exchange Commission is expecting clear disclosure of performance targets in most circumstances. We expect proxy disclosures to increase their clarity as to how compensation decisions are made, particularly how performance criteria were established and how those performance results led to incentive payouts.   

The banking industry continues to be on the forefront of change in executive compensation due to scrutiny from both regulators and shareholders. Compensation committees must remain vigilant to ensure their executive pay programs balance the increasing expectations of regulators and shareholders while continuing to support bank objectives.