New Compensation Rules and Their Impact on Small Banks

The Dodd Frank Wall Street Reform and Consumer Protection Act has an expansive collection of provisions that impact financial institutions.  Perhaps the most hotly debated part of the legislation is Section 956, which addresses incentive-based compensation.  The requirements of Section 956 are applicable to banks and other financial institutions of $1 billion in assets or more.  So, does that mean that financial institutions of less than $1 billion are not impacted?

A key element of Section 956 is its reliance on current standards for all banks established under Section 39 the Federal Deposit Insurance Act (FDIA) relative to employee, executive and director compensation It requires federal agencies to establish standards prohibiting any unsafe and unsound practice relative to any compensatory arrangement that could lead to material financial loss to an institution, including standards that specify when compensation is excessive.

Some of the considerations of federal agencies in determining if compensation is excessive include:

  1. the combined value of all cash and noncash benefits provided to the individual;
  2. the compensation history of the individual and other individuals with comparable expertise at the institution;
  3. the financial condition of the institution;
  4. compensation practices at comparable institutions, based upon such factors as asset size, geographic location and the complexity of the loan portfolio or other assets;
  5. for postemployment benefits, the projected total cost and benefit to the institution;
  6. any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the institution; and
  7. any other factors the agencies determine to be relevant.  

So, while institutions less than $1 billion in size currently do not have to comply with the specific rules of Section 956 of Dodd-Frank, the current guidelines for all banks would indicate that some Section 956-like actions are warranted in identifying excessive compensation.  Some of the technical aspects of Section 956 may seem burdensome; however, other requirements are practical and, in some cases, just good common sense.

Below are some of the key provisions of Section 956 that may not be enforceable for institutions under $1 billion but may serve as guidance for best practices:

The institution is required to adopt written policies and procedures to ensure and monitor compliance with the rules. 

Having written policies and procedures to provide guidance and maintain control of your compensation programs is a no-brainer.  Formally documenting your plans to address elements of risk and the guidance in the FDIA demonstrates to regulators you have a framework for meaningful and effective control.

Covered institutions are to submit an annual report to their primary regulator. 

A methodical and periodic review of your plans and documentation of their adherence to your policies and risk management procedures will demonstrate appropriate management oversight. 

Strong corporate governance and an active role by the compensation committee or board are required. 

Establish processes whereby your compensation committee or board takes an active role in all matters relating to compensation.  This will institute a best practices approach, providing for better risk management, effective internal controls and regulatory compliance.          

The proposed regulations provide suggested ways to balance risk and reward performance.

These approaches to balancing risk and rewarding performance make sense for banks of all sizes and will help limit risk as well as lessen the need for clawbacks.  Some of the suggested approaches include:

  • Payment Deferrals: allows for adjustment of the compensation through the deferral period;
  • Risk Adjustment: awards are adjusted to account for the risk posed to the bank;
  • Longer Performance Periods : longer measurement periods better reflect ultimate financial outcomes; and
  • Reduced Sensitivity to Short-Term Performance: reduced rates of reward for higher performance levels over the short-term.

Does Section 956 of Dodd-Frank apply to banks under $1 billion?  Technically, no.  However, banks under $1 billion should certainly be aware of its impact, since all financial institutions should adhere to established best practices.  The primary focus for bank compensation will continue to be safety and soundness, monitoring and controlling compensation programs, and managing risk while matching compensation to performance.