Banking Regulators Say Banks Encouraged “Imprudent Risks” With Flawed Pay Incentives

Regulators Tell Bankers That Pay Should Be “Risk Adjusted”

June 21, 2010 – The nation’s top banking regulators today moved to curb flawed incentive compensation plans that encouraged banking employees to take imprudent risks.  Citing pay practices that contributed to the recent financial crisis, regulators issued financial institutions final guidance  to ensure that incentive compensation to employees properly balances risk with the “safety and soundness of the organization”.

The guidelines were issued by the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC) after an in-depth analysis of incentive compensation practices at large banking organizations by the Federal Reserve.  The Federal Reserve last month notified banking organizations of areas related to incentive compensation that required “prompt attention”.

Federal Reserve Governor Daniel Tarullo noted that “Many large banking organizations have already implemented some changes in their incentive compensation policies, but more work clearly needs to be done.   The Federal Reserve expects firms to make material progress this year on the matters identified as we work toward the ultimate goal of ensuring that incentive compensation programs are risk appropriate and are supported by strong corporate governance.”

Regulators made it clear  that financial organizations had offered employees financial incentive to take “imprudent risks” that were not consistent with the long term financial health of the organization.  Rewarding employees who generated large short term profits without regard to long term risks was one of many reasons for the financial crisis and the failure of many financial institutions.

The new Agency guidelines require financial institutions to identify employees who may expose the organization to material risks and to assess the potential that incentive compensation may have on encouraging imprudent risk taking.   Employees should be apprised that their final compensation will be risk adjusted and in those cases where the risk is deemed excessive, compensation will be reduced accordingly.

Regulators cited three key principles that were embodied in their final guidance on incentive compensation to financial institutions:

(1) incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk;

(2) these arrangements should be compatible with effective controls and risk-management; and

(3) these arrangements should be supported by strong corporate governance, including active and effective
oversight by the organization’s board of directors.

In the next stage of their review, the Federal Reserve will examine compensation policies of banking organizations for specific groups of employees, such as mortgage originators.  In addition, the agencies will look at compensation plans of smaller financial firms as part of their routine banking audits.

The compensation guidelines issued today apply to all banking organizations supervised by the Federal Reserve, OCC, OTS and the FDIC.

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