Bank directors typically focus on executive compensation in the fourth quarter, when yearend performance assessments are made and compensation is set for the following year. In 2010, however, with Congress and financial industry regulators focused on compensation, the subject is likely to come up early, often and, quite likely, in your next bank examination.

Compensation issues historically have not been a high priority for regulators, leaving them largely in the hands of bank boards of directors.

The Federal Reserve Commercial Bank Examination Manual does not highlight compensation as an examination issue (other than the accounting for deferred compensation) any more than other expense categories. Exceptions have occurred when examiners uncovered bank compensation policies that had safety and soundness implications — such as bankers taking extravagant salaries or operating incentive compensation arrangements that threatened the bank's capital strength and financial viability. The growth of incentive-based compensation strategies began to attract closer regulatory scrutiny in part because some of the early incentive strategies ran counter to safety and soundness objectives. Examples abound. Some early incentive strategies rewarded loan growth or fee income growth without consideration of the impact on asset quality. As incentive-based compensation strategies became more prevalent, banks made greater efforts to align incentives with long-term goals.

Bank board members may recall the regulatory scrutiny that accompanied the awarding of bank stock options, but the issue then was consistency with generally accepted accounting principles rather than safety and soundness.

While salaries at large banks have raised eyebrows over the years, the enormous profits banks reported seemed to justify the amounts. Perceptions changed dramatically with the emergence of the notion, now largely unchallenged, that unbridled incentive compensation strategies were major causes of the recent financial crisis. Attempts by Wall Street executives to justify large bonuses while under or just after emerging from Tarp status only fueled public outrage.

Several legislative and regulatory initiatives address these concerns. Perhaps the most notable of these is the Wall Street Reform and Consumer Protection Act recently passed by the House. Among other provisions, the bill mandates the creation of an independent compensation committee, provides for the establishment of independence requirements for compensation consultants, and authorizes shareholder "say on pay" regarding compensation and golden parachute arrangements. The Senate Banking Committee has yet to complete work on its version of the legislation, but compensation issues are expected to be included in the Senate bill as well.

The bank regulators have also been active. Last October the Federal Reserve System issued for comment proposed guidance on sound incentive compensation policies.

The guidance is designed to align incentive compensation policies with prudent risk-taking and safety and soundness considerations and will be adopted in final form in the coming months. In addition, the Fed announced that it expects all banking organizations to evaluate their incentive compensation arrangements and related risk management, control and corporate governance processes and immediately address deficiencies. A review of incentive compensation practices will be part of the risk-focused examination process for banking organizations. For large complex banking organizations, the Fed has initiated a horizontal review comparing the practices of banking organizations in this category.

The FDIC also has taken action. On Jan. 12, the FDIC, in a split vote, approved an advance notice of proposed rulemaking. The notice seeks input on the issue of whether certain employee compensation structures pose risks that should be captured in the deposit insurance assessment program.

Prudent directors of banking organizations will make the review of compensation philosophies and procedures a priority. In doing so, they should keep a few principles in mind:

  • First, evaluate your bank's compensation policies through the regulator's lens by focusing on the organization's safety and soundness. The stronger an organization's capital position, core earnings, liquidity and risk profile, the more latitude will be allowed on compensation issues.
  • Second, the primary focus will be on incentive compensation strategies, since they are commonly blamed for the ruinous strategic directions taken by some institutions.
  • That said, a director review limited to incentive compensation will not be adequate. Compensation needs to be a component of total board governance, with internal controls that include employee hiring and evaluation policies.
  • Bank boards should consider establishing a board compensation committee that meets the independence standards proposed by the FDIC.
  • With the new focus on compensation policies, some boards may gravitate toward conservative strategies that help them avoid regulatory conflict but are detrimental to long-term goals. Even in a soft economy, key employees need to be appropriately compensated or are at risk of leaving. Bank boards should be willing to defend appropriate compensation.
  • Such defense, however, should be documented and, ideally, based on external benchmarks. Examples of appropriate benchmarks include the Financial Stability Board's recently adopted Sound Compensation Practices, which are now cited as standards. Comparison of bank performance standards among peer groups is another good benchmark. For example, banking organizations in the U.S. with assets ranging from $1 billion to $1.5 billion and returns on equity above 10% typically have total salary expense in the range of 1.5% to 2.5% of assets. Board members should exercise caution when their ratios are out of line with peers.
  • Finally, prudent directors should follow the progress of regulatory and legislative initiatives throughout the year, as the expectations for compensation oversight are likely to change.

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