As financial institutions close on Treasury purchases through the Troubled Asset Relief Program and the Capital Purchase Program, management and compensation committees now turn to the task of implementing the related executive compensation restrictions.

The restrictions announced Feb. 4 encourage all public financial institutions to review their compensation programs to ensure sound risk management. Though participating community banks are healthy organizations, many of the requirements are expected to cascade beyond Tarp participants, just as the Enron/WorldCom scandals drove broad regulatory requirements across all industries.

One of the most challenging mandates will be the requirement that institutions take steps to ensure incentive plans do not encourage "unnecessary and excessive risk-taking."

Absent specific Treasury guidance or precedent in this area, we suggest that Tarp participants take the following steps within 90 days of purchase. We also believe this framework should be considered a best practice for all companies.

  • The compensation committee should identify the senior risk officer and other constituencies that handle the risk assessment process — e.g., the CEO, human resources, legal counsel, or outside advisers.
  • The risk officer should be briefed by the committee, management, or the committee's independent advisers on the company's compensation philosophy, incentive plan approach, performance measurements, and process for assessing performance and setting award levels.
  • The risk officer should identify any programs or practices that could promote excessive risk-taking, such as performance measurements with significant focus/weight in the total compensation program.
  • The committee and senior risk officer should review the assessment and determine if changes are needed to reduce the potential for excessive risk-taking.
  • The committee should report its findings and recommendations to the CEO and the full board.
  • For public companies, the committee should work with management and/or outside advisers to disclose the risk assessment process in their proxy's compensation discussion and analysis.
  • The committee must certify in the compensation committee report or to appropriate regulators (if the company is not public) that it has conducted this process.

The CEO must also certify to the Treasury's Tarp chief compliance officer within 120 days of purchase that the review has taken place. Annually, within 135 days following the fiscal yearend, the CEO must certify to the Tarp chief compliance officer that the committee met with the senior risk officer during the prior fiscal year to discuss executive incentive pay arrangements. The bank must maintain records of these certifications for six years.The following questions are critical to any assessment of risk and should be considered best practices for all companies, Tarp participants or not. Tarp participants are required to review incentive compensation arrangements only for the senior executive officers, but the Treasury's comments suggested that all companywide compensation strategies should also be reviewed.
What risks could threaten the institution's value? The committee and senior risk officer should review the business strategy, risk profile, and potential business risks to identify risk areas that might directly or indirectly affect performance and payouts.

Do incentive metrics reflect the institution's business strategy? Awards should support the institution's overall strategy and desired risk profile.

Is the leverage and ratio of incentive compensation appropriate? The committee should understand the amount and range of potential incentives, as well as the proportion of total pay that is based on performance. Highly leveraged incentive plans are a flag for further review.

Have we examined the full range of upside/downside payouts? Projecting potential payouts under multiple scenarios, including threshold, target, and maximum performance, helps ensure that maximum payouts are reasonable and unlikely to motivate excessive risk-taking.

Do plans have multiple performance perspectives and a defined maximum payout? Performance measurements that are significant drivers of total compensation, particularly if used in both short- and long-term plans, may overemphasize those aspects of performance and promote excessive risk.

Do plans focus executives on long-term performance that aligns with shareholder interests? Approaches include implementing stock ownership/retention requirements such as "hold to retirement" and "past retirement"; withholding a portion of annual incentives pending sustained performance; and providing incentive awards above a certain level (e.g. target) in restricted stock or unvested deferred compensation.

Do programs allow directors any discretion? No compensation program can predict all possible situations, and in some cases common sense should prevail over formula-driven payouts.

Institutions should remember that some element of risk-taking is inherent in the banking business, and that eliminating risk altogether would undermine the potential for innovation and outstanding shareholder returns. Compensation-related risk is a double-edged sword that ideally motivates appropriate risk-taking without encouraging or rewarding excessive risk.

Most community bank compensation committees will conclude that their programs do not rise to the level of promoting "unnecessary and excessive risk." Regardless of Tarp/CPP requirements, however, better understanding of risk and the relationship between pay and performance is a best practice critical to all institutions' long-term success.

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