Lost in all the talk about Dodd-Frank Act's various regulatory pieces is a looming — and transformational — rule around compensation.
Section 956 of the Dodd-Frank Act requires that the largest and most complex financial institutions show that their incentive compensation arrangements do not "encourage inappropriate risk" or include excessive compensation, fees, or benefits. As a result, banks are required to comply with enhanced policies, procedures and disclosure of incentive-based compensation arrangements.
But instead of focusing on just the compensation of the top five or 100 executives, as has been the case in the past, Section 956 extends oversight to anyone paid an incentive for performance. That is likely 25,000 people or more at large banks.
Congress's goal was to create a transparent, consistent and documented way for regulators to oversee incentive compensation anywhere it can introduce risk into the banking system. Failure to comply will result in enforcement action, including the strong possibility of fines, additional capital requirements, and factor negatively into the organization’s supervisory rating. There's more coming in this area as well, with the Financial Stability Board looking at formulating new standards globally.
As evidenced by the Federal Reserve's horizontal reviews at the largest banks, many do not currently possess the capabilities necessary to report on incentive compensation plans and policies across the bank in a synthesized way. This initial step — identifying covered employees, the compensation they receive and the transactions generating this compensation — is only one of the challenges banks will likely face.
Consolidations in the industry have resulted in many business architectures and technology infrastructures composed of disparate systems and processes. This does not easily support obtaining accurate, timely and detailed compensation data across multiple lines of business.
At the same time, shrinking incentive pools, difficulty in attracting and retaining valuable workers, evolving generational needs and appetite for a flexible, virtual workplace environment are creating the need for innovative compensation arrangements. A technology upgrade can be used to provide information to federal regulators, and it can also form a platform for designing comp plans to support initiatives around revenue growth and address concerns on compensation overpayments and payment inaccuracies.
So here's what banks should be thinking through today.
First, banks should develop an integrated compensation governance structure — covering all lines of business — to assess what they already know about current practices, the systems supporting them, and what they are able to capture currently in the performance and risk data against regulatory reporting requirements.
Second, banks must determine how they will evaluate the risk for each covered person. A covered person associated with a given product portfolio, for example, may not be assigned the entire risk value of that portfolio — that is, there may be a difference between the risk value of a given portfolio, and the amount of risk credited to a given covered person. Without accurate information about compensation payments, this second step is herculean.
Finally, banks should look at how packaged technology solutions, which can include compensation administration and reporting capabilities, could provide an integrated incentive compensation management platform across the bank. A number of these are flexible and powerful enough to manage incentive compensation arrangements across large, multi-national institutions with a variety of disparate lines of business. The reporting requirements banks need to comply with make this level of technology fundamental.
Covering lines of business and products across the bank will likely add significant complexity, time and the risk of financial non-compliance penalties for compensation administrators, who already are juggling an assortment of other challenges.