In October 2009, the Federal Reserve published its "Proposed Guidance on Sound Incentive Compensation Policies" and began actively regulating executive compensation practices for banks. The guidance was finalized in June 2010 and founded on three key principles: provide employees incentives that appropriately balance risk and reward; be compatible with effective controls and risk management; and be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. Subsequent to publishing the guidance, the Fed has been reviewing incentive compensation arrangements at covered financial institutions and assessing their effectiveness in complying, with an initial report on progress among the largest banks published in October 2011.

As the Fed has interacted with banks to assess compliance with the guidance, it has begun to move beyond the core principles to more prescriptive views on what compensation practices are desirable or not desirable. From our perspective as compensation professionals, it is not clear that they are on the right track. As we see it, a key challenge for the Fed is to recognize and balance its concerns regarding risk with the objectives of bank shareholders. We are concerned that the Fed's regulatory interventions could lead to unanticipated outcomes.

Past attempts at government regulation of executive compensation have not been pretty. Two of the best known reforms were attempts to limit golden parachute payments and an attempt to cap compensation levels back in the 1990s. Both are famous as examples of regulations that led to unintended consequences in the form of increased golden parachutes and higher executive pay levels. Our primary concern about the Fed's input is a potential for weakening alignment with shareholders and pay for performance.

The Fed's guidance principles required improvements in the corporate governance of incentive compensation. As a result, banks covered by the guidance have incorporated risk management into compensation design. Compensation committees are provided with robust updates on the firm's risk performance and evaluate executive performance in the context of risk management. Chief risk officers present information to compensation committees on the overall risk profile of the organization, as well as on the performance of individual executives in managing risk and complying with corporate risk policies. As a result of the Fed's input, compensation committees have better tools (e.g., risk-adjusted metrics, risk scorecards) to ensure that compensation reflects risk management performance and risk outcomes.

Further, under the guidance banks are required to ensure that a significant portion of incentive compensation is paid out and vested over a multiple-year timeframe and retain the ability to cancel the vesting of deferred compensation if certain risk events occur (e.g., loss in a business unit or company or individual actions outside of risk tolerances, etc.). These features create a risk culture and remind executives that the long-term performance of the organization matters as much as near-term earnings.

As the Fed is auditing incentive compensation practices, they have moved beyond the core principles into more specific recommendations on compensation design. Based on what we have observed to date, the Fed appears to dislike design elements such as formulaic incentives, stock options, aggressive performance targets, highly leveraged incentives and relative performance measurements, while it prefers to see deferred compensation, risk adjustments, longer performance periods and equity compensation.

Many design features the Fed dislikes are favored by shareholders because they align management's interests with shareholders and ensure that pay is aligned with performance. As the Fed audits pay, it needs to be careful to ensure that incentive compensation continues to function as an incentive for performance. The more that compensation designs depend on discretionary or subjective judgments rather than actual financial results, the less effective they are as an incentive for performance.

Fortunately, compensation committees are acutely aware of shareholder interests. Thus far, most bank committees have maintained aspects of compensation programs that are critical to addressing shareholder concerns. Committees recognize that much is achieved delivering a substantial portion of compensation in the form of company stock. Compensation committees have retained relative performance measurements, as they recognize that shareholders benchmark their financial and stock price performance to peers and expect compensation levels to align with relative performance.

The process of interaction with the Fed has been iterative as the regulators refine their thinking about what incentive practices are of particular concern and what is desirable or at least acceptable. It is our hope that they will actively engage with compensation committee chairs, management and investors directly to understand their concerns. The progress that banks have made in improving risk management processes and the governance of compensation is significant and can serve as a foundation for further refinement of incentive compensation design.

In the future, we believe there are opportunities to enhance the transparency of incentive compensation design and strengthen the pay-for-performance relationship, while maintaining effective risk management. In our view, formulaic compensation programs with significant upside leverage and relative performance metrics play an important role in incentive compensation design. However, it is critical that these be implemented within an overall incentive compensation structure that has effective risk-mitigating features, including a robust risk management process, risk-based performance measures, deferrals and clawbacks in the event of negative risk outcomes.

Eric Hosken and Rose Marie Orens are partners at Compensation Advisory Partners, an independent consulting firm specializing in executive and director compensation program design, and related corporate governance matters.