Bank Compensation Limits, the Federal Reserve Follows Through

Last week’s late breaking news that the Federal Reserve was following through on its plan to change how it regulates bank compensation is being follow up by this week’s G-20 meeting on how bank compensation curbs can be internationally coordinated among the large economies.  Surprisingly, however, the media is acting as if regulating bank compensation is a new issue.  It isn’t new at all but rather a problem that they chose to forget about for the summer. 

If anyone was wondering what the Federal Reserve and the U.S. government has been thinking, the minutes of the House Financial Services Committee provide the answer.  On June 11, 2009, Scott G. Alvarez, General Counsel for the Fed, laid out the compensation plan. Interestingly, his words are almost identical to the breaking news that caused last week’s compensation firestorm. 

After you read the below excerpts of Mr. Alvarez’ June 11^th statement try taking the simple 6 question quiz I have prepared on bank compensation.  It is a basic bank test that you can use to see where you fit in the bank compensation debate.

Chairman Frank, Ranking Member Bachus, and other members of the Committee, thank you for the opportunity to offer some perspectives on the subject of incentive compensation in banking and financial services. Recent events have highlighted that improper compensation practices can contribute to safety and soundness problems at financial institutions and to financial instability.  Compensation practices were not the sole cause of the crisis, but they certainly were a contributing cause…

…As the events of the past 18 months demonstrate, compensation practices throughout a firm can incent even non-executive employees, either individually or as a group, to undertake imprudent risks that can significantly and adversely affect the risk profile of the firm….

…the Federal Reserve is developing enhanced and expanded supervisory guidance in this area to reflect the lessons learned in this financial crisis about ways in which compensation practices can encourage excessive or improper risk-taking….

…Compensation arrangements are critical tools in the successful management of financial institutions. They serve several important and worthy objectives, including attracting skilled staff, promoting better firm and employee performance, promoting employee retention, providing retirement security to employees, and allowing the firm’s personnel costs to move along with revenues…

…It is clear, however, that compensation arrangements at many financial institutions provided executives and employees with incentives to take excessive risks that were not consistent with the long-term health of the organization. Some managers and employees were offered large payments for producing sizable amounts of short-term revenue or profit for their financial institution despite the potentially substantial short- or long-term risks associated with those revenue or profits. Although the existence of misaligned incentives surely is not limited to financial institutions, they can pose special problems for financial institutions given the ability of financial institutions to quickly generate large volumes of transactions and the access of some institutions to the federal safety net…

…in some cases, the incentives created by incentive compensation programs to undertake excessive risk appear to have been powerful enough to overcome the restraining influence of these processes and risk controls…

…in many instances, risk-management frameworks did not adequately take account of the potential for compensation arrangements themselves to be a source of risk for the firm. The risk-management personnel and processes at financial institutions, thus, often played little or no role in decisions regarding compensation arrangements. It is possible that aggressive pursuit of highly skilled financial specialists in recent years caused some financial institutions to relax or forego usual safeguards and controls in the interest of hiring and retaining what they believed to be the best talent…

…These weaknesses were not limited just to financial institutions in this country. These types of problems were widespread among major financial institutions worldwide, a fact recognized by the governments comprising the Group of Twenty, international bodies such as the Financial Stability Board (FSB), and the industry…

…Correcting these weaknesses will require improvements in both corporate governance and risk management at financial institutions. Boards of directors and senior management of major financial institutions must act to limit the excessive risk-taking incentives within compensation structures and bolster the risk controls designed to prevent incentives from promoting excessive risk-taking. In many cases, boards of directors that have analyzed the connections between incentive compensation and risk-taking have focused only on a handful of top managers. However, incentive problems may have been more severe a few levels down the management structure than for chief executive officers (CEOs) and other top managers. Indeed, recent experience indicates that poorly designed compensation arrangements for business-line employees–such as mortgage brokers, investment bankers, and traders–may create substantial risks for some firms. Thus, boards of directors must expand the scope of their reviews of compensation arrangements…

…The Federal Reserve also is actively working to incorporate the lessons learned from recent experience into our supervision activities. As part of these efforts, we are in the process of developing enhanced guidance on compensation practices at U.S. banking organizations. The broad goal is to make incentives provided by compensation systems at bank holding companies consistent with prudent risk-taking and safety and soundness…

…First, shareholders cannot directly control the day-to-day operations of a firm–especially a large and complex firm–and must rely on the firm’s management to do so, subject to direction and oversight by shareholder-elected boards of directors. Incentive compensation arrangements are one way that firms can encourage managers to take actions that are in the interests of shareholders and the long-term health of the firm. However, compensation programs can incentivize employees to take additional risk beyond the firm’s tolerance for, or ability to manage, risk in the course of reaching for more revenue, profits, or other measures that increase employee compensation. Second, where managers have substantial influence over compensation arrangements, they may use that influence to create or administer incentive arrangements in ways that primarily advance the short-term interests of managers and other employees, rather than the long-term soundness of the firm…

…Since 1995, the Federal Reserve and the other federal banking agencies have had in place interagency standards for safety and soundness (Standards) for all insured depository institutions.² These Standards, which were adopted pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), prohibit as an unsafe or unsound practice both excessive compensation and any compensation that could lead to material financial loss to the insured depository institution. The Standards provide that compensation will be considered excessive if the amounts paid are unreasonable or disproportionate to the services performed by the relevant executive officer, employee, director, or principal shareholder and set forth a variety of factors that will be considered in determining whether compensation paid in a particular instance is unreasonable or disproportionate. Importantly, FDICIA specifically prohibits the agencies from using the Standards to prescribe a specific level or range of compensation permissible for directors, officers, or employees of insured depository institutions…

…More recently, in November 2008, the Federal Reserve, in conjunction with the other federal banking agencies, issued an interagency statement reminding banking organizations that they are expected to regularly review their management compensation policies to ensure that they are consistent with the longer-run objectives of the organization and sound lending and risk- management policies.³ This statement provides that management compensation policies should be aligned with the long-term prudential interests of the institution, should provide appropriate incentives for safe and sound behavior, and should structure compensation to prevent short-term payments for transactions with long-term horizons. In addition, it states that management compensation practices should balance the ongoing earnings capacity and financial resources of the banking organization, such as capital levels and reserves, with the need to retain and provide proper incentives for strong management…

…Broad Review of Compensation Practices. First, care must be taken to properly align the incentives of compensation paid to employees throughout an organization. It is not sufficient to focus only on compensation paid to senior executives…

…Making Compensation More Sensitive to Risk. Second, compensation practices should not reward employees with substantial financial awards for meeting or exceeding volume, revenue, or other performance targets without due regard for the risks of the activities or transactions that allowed these targets to be met. One key to achieving a more balanced approach between compensation and risk is for financial institutions to adjust compensation so that employees bear some of the risk associated with their activities as well as sharing in increased profit or revenue. An employee is less likely to take an imprudent risk if incentive payments are reduced or eliminated for activity that ends up imposing higher than expected losses on the firm…

…Risk Management and Corporate Governance. Third, more can and should be done to improve risk management and corporate governance as it relates to compensation practices. Our discussions with market participants and supervisory experience suggest that risk controls are a necessary complement to–and not a substitute for–prudent compensation systems in protecting against excessive risk-taking…

…Review of a firm’s compensation practices also must involve the board of directors. The board of directors provides an important link between the shareholders of a firm and its management and employees. Active engagement by the board of directors or, as appropriate, its compensation committee, in the design and implementation of compensation arrangements promotes alignment of the interests of employees with the long-term health of the organization…

…Boards of directors will need to take a more informed and active hand in making sure that compensation arrangements throughout the firm strike the proper balance between risk and profit, not only at the initiation of a compensation program, but on an ongoing basis…

…Improving compensation practices at financial institutions is important. Compensation arrangements must continue to allow financial institutions to attract, retain, and motivate talented employees, but they also must not provide incentives for managers and employees to take excessive risks. And while the issues and concerns associated with improperly designed compensation practices are common, no single compensation system will address all types of risks or work well in all types of firms. Each firm ultimately must determine how to address these matters in a way most suited to that firm’s business, structure, and risks…

Now for the quiz. 

Question #1 (True/False) – The Federal Reserve and Treasury’s plan for issuing updated guidelines relating to bank compensation is “new” breaking news?

Question #2 (True/False) – The Fed, FDIC and OCC have no legal authority whatsoever to regulate banker compensation and the regulation of banker compensation is a naked power grab by Federal bureaucrats who want to run and ruin the economy?

Question #3 (True/False) – The Fed Board and its staff don’t believe in capitalism and are socialists (just like Stalin, Mao and Ho Chi Min) who want to see Obama create a centrally planned economy?

Question #4 (True/False) –Obama wants to limit what bankers can earn because he wants to tax away their hard earned wages and use it to pay for health care benefits for his core constituents which are needed for reelection, i.e., illegal aliens?

Question #5 (True/False) – Major media pundits are against the regulation of banker pay because they are interested in truth and not their TV ratings?

Question #6 (True/False) – Experts who say that the Federal Reserve is executing an unconstitutional power grab have actually read the Constitution and Federal banking laws and have training in law and bank regulation?

I am pretty sure that some of the readers of this article will answer all of the above questions as “True”.  If you are one of those people, you should be applying for a job as a lobbyist for the banking industry because you want to be one of the people that control the debate on bank compensation. 

However, if you don’t aspire to work as a lobbyist (or believe that facts, figures and training are more important than dogma), then I think all of your answers are going to be “False” and you, like me, are disgusted with the behavior of the few that stole fortunes from the many.