Executive compensation has been grabbing the headlines for the past couple of years, not always for the right reasons. Amid the cacophony, international standard-setting bodies and the Federal Reserve Board have been quietly but fundamentally changing how financial institutions will make compensation decisions.

Over the past 18 months, supervisors in the U.S. and abroad have been issuing compensation guidelines with increasing clarity and detail. Looming in the short horizon is the Fed's final guidance on compensation. That guidance, along with the latest Basel Committee guidelines on compensation, will provide a firm basis for U.S. supervisory expectations on compensation.

Many institutions have already given serious thought to the general issue of executive compensation and are implementing certain changes in pay practices, but the new requirements will necessitate making even greater changes.

At the heart of these supervisory initiatives is the mandate to align incentive compensation with risks taken. Putting it differently, banking organizations will need to develop an approach based on quantitative and judgmental factors that ties incentive pay to risks so that remuneration is balanced between the profit earned and the risk assumed in generating the profit. This concept is elegant and simple, but risk measurement remains an art even at top institutions. Therefore, we expect that most institutions will need to take time, careful planning and some trial and error to develop and implement sound risk-adjusted approaches to compensation.

Other changes to industry practice will include:

Governance. Board oversight will become very important, not only of C-level executive compensation, but of the entire approach to incentive compensation.

To prepare for new supervisory expectations, compensation committees should ensure that the suite of compensation reports they receive include information about how risk-taking and risk outcomes are reflected in compensation. For example, compensation committees may want to see reports on projected bonus pools adjusted for actual performance as well as projected bonus pools as described in strategic plans.

Boards may also wish to review their collective expertise on compensation and risk management matters. If the board determines that more expertise is needed, several options may be explored, including training, increased coordination between compensation committees and risk committees and recruitment of new members.

Role of risk management and control functions. Risk management executives will need to become an integral part of compensation processes and provide relevant information to human resources executives regarding the firm's risk profile, risk tolerances, risk assessment results and policy violations.

Likewise, finance will need to provide advice on linking pay decisions to risk-related metrics, such as earnings at risk and return on risk capital. Other appropriate roles for finance include simulating various compensation alternatives, ensuring appropriate financial controls around compensation and incorporating compensation results and forecasts into capital-planning processes.

Further, internal audit needs to ensure that its audit universe covers the firm's compliance with new compensation policies and processes, including: the integrity of compensation-related controls; the end-to-end implementation of the board's compensation philosophy, policy and decisions; and analysis of the firm's compensation approach within the context of evolving compensation practices at comparable institutions and regulatory expectations.

Preparation for supervisory review. Best-practices firms will plan in advance for supervisory review of their compensation practices. Such planning could include updating the overall compensation framework — such as charters and policies — in accordance with new regulatory expectations. Preparation could also include designating a multidisciplinary team representing human resources, finance and risk management to develop and document updated compensation practices.

Recent supervisory guidance on compensation is firmly rooted in risk management. While it is an innovative supervisory concept, it also presents practical challenges to the industry. In 2010 and beyond, financial institutions will need to define and implement their approaches to applying risk management to pay decisions.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.