Banking Industry Pay Regulations: Has Change Really Happened?

BNA s Banking Report Reproduced with permission from BNA s Banking Report, 98 BNKR 776, 5/1/12, 05/01/2012. Copyright 2012 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com COMPENSATION In the previous article in this three-part series, we set context and provided background for the sweeping changes in the banking industry and the impact that these changes have had on compensation a critical issue given the attraction, retention and engagement implications of pay in this particular industry. This second article in the series summarizes what companies have done to respond to regulatory requirements and whether the changes that have occurred are likely to mitigate or enhance risk. Banking Industry Pay Regulations: Has Change Really Happened? BY MIKE CURRAN AND PETER GUNDY, TOWERS WATSON Current Regulatory and Legislative Premise T he current wave of global regulation and legislation contain a premise that politicians and regulators deem inarguable: that greed, in the form of incentive compensation, was the culprit that drove excessive risk-taking in the pre-crisis era and led to the global financial meltdown. Fat bonus checks, large stock awards, and particularly extravagant severance plans quickly became the focal point for the debate on Peter Gundy and Mike Curran are senior consultants with Towers Watson, a global professional services company. how to fix the global banking system and, by extension, the economy. That there should be any change in regulation at all, as some argue, is a moot point. Billions of dollars were lost during the crisis and we continue to deal with the fallout today. This has macro implications for the global economy and more micro implications for the banking industry and the talent that drives it, so the context is far-reaching and likely to stay that way for some time. It is unlikely that any government irrespective of political affiliation would view the circumstances as they were in 2008 and conclude that regulatory intervention was inappropriate. That incentive pay might not have been the cause of the excessive and inappropriate risk taking is also a moot point, as there is no debate available or tenable in the current political environment. Pay reform has necessarily been thrust upon the banking industry and the only discussion currently relevant is whether the reforms are appropriate (broadly speaking) and whether COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 0891-0634

2 the specific regulations do in fact deliver on their intended purpose. And this breeds the question that if not, how are we to respond and where is the industry then headed? The Beginnings of Reform In late 2008 and throughout 2009, regulators and legislators around the world began to discuss how the banking system and banking compensation in particular needed to change given the massive losses and the requirement to bail out numerous financial institutions. Notably, European actions tended to be more proscriptive (i.e., rules based) and to date U.S. efforts have been more principles based (i.e., more directional). Differences in the two approaches are material in concept, but less so in practice, as many banks have implemented consistent changes to their pay programs globally. (This article focuses on U.S. actions with some reference to European activity as relevant.) In the U.S., incentive pay was subject to new legislative and regulatory scrutiny beginning with the Troubled Asset Relief Program ( TARP ) in October of 2008 as part of the Emergency Economic Stabilization Act. New regulations were followed by the Federal Reserve Guidance on Incentive Compensation (proposed in October 2009) and later the Dodd-Frank Act in 2010. The Dodd-Frank Act built on prior regulations and proposed still other limitations on incentive compensation design, along with new requirements for disclosure and shareholder involvement in the compensation process. In large measure, the new laws and regulations in the U.S. imposed few specific rules on incentive pay (although the Dodd-Frank Act did include prohibitions on the manner in which mortgage originators could be paid), but rather defined key principles that all banking and related organizations needed to follow. In contrast, as noted, regulations and legislation in Europe did indeed impose specific rules and prohibitions related to incentive compensation design. In 2011, the FDIC became the first agency to not only adopt the provisions of the Dodd-Frank Act, but also to add a mandatory deferral provision to executive incentives at banks with $50 billion or more in assets. Specifically, the FDIC required at these institutions a mandatory deferral of no less than 50 percent of the incentive for executive officers and other key employees. (See the sidebar on the current regulations governing compensation.) What Did The Regulators Ask Banks to Do? The U.S. regulations were grounded in three main principles related to how banks design and administer compensation. These principles included the mutually supportive notions that incentive compensation plans balance risk and financial results in a manner that does not motivate employees to take excessive risks on behalf of the banking organization; that risk-management processes and internal controls reinforce and support the development and maintenance of balanced incentive compensation arrangements; and that strong and effective corporate governance is put in place to help ensure sound compensation practices. How was this designed to play out tactically? Based on the above principles, the U.S. regulations required banks to: s Identify employee populations that are in a position to take material risks, ranging from the most senior executives, to high-profile individual contributor roles, to groups that may generate small discrete risks but which in the aggregate represent large risks; s Determine the types and time horizons of the risks to the organization from the activities of these material risk-taking populations; s Assess the incentive compensation programs of these groups and identify the potential of the rewards, performance measures, governance or other plan features to encourage inappropriate risk taking; s Implement new performance measures and features to ensure that these incentive plans are appropriately balanced; s Communicate to employees the ways in which their incentive compensation awards or payments will be adjusted to reflect the risks of their activities to the organization; and s Monitor incentive compensation awards, payments, risks taken, and risk outcomes for these employees and modify the arrangements as needed and appropriate. In connection with this guidance, U.S. regulators launched an initial, focused review of how large, complex banking organizations (28 so-called LCBOs) were complying with the new proposed regulations. All other banking organizations would be subject to a similar review, but only as part of routine, risk-focused bank examinations. The purpose of this horizontal review was four-fold, and intended to: s Enhance the regulators understanding of current practices, as well as steps taken or proposed to be taken by banking organizations toward compliance with the guidance; s Assess the strength of controls, and whether actual payouts under incentive compensation arrangements are effectively monitored relative to actual risk outcomes; s Understand the role played by boards of directors, compensation committees, and risk-management functions in designing, approving, and monitoring incentive compensation systems; and s Identify emerging best practices through comparison of practices across organizations and business lines. How Did The Banks Respond? To achieve compliance, the largest banks undertook an exhaustive review of their organization overall and indeed at division, unit, and even trading desk levels as well as compensation policies and plans, and the processes associated with managing risk and pay. Additionally, each bank reviewed its corporate governance policies and approach. To identify populations of material risk-takers ( MRTs or covered employees ), organizations reviewed specific roles, job definitions, and other factors like the amount of risk capital allocated to business units. This review process resulted in thousands of employees per major bank being identified as material risk takers. 5-1-12 COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN 0891-0634

3 In the spirit of providing guiding principles (versus rules) as referenced earlier, the various U.S. regulators notably the Federal Reserve Bank did not define specific good or bad practices in any of the areas of risk taking, risk management, or pay management. Consequently, there have been many philosophical discussions in each bank, and with their Boards and their advisors, about what the regulators meant by material risk taking and whether banks were better served taking a broad view (e.g., the entire organization) or a more narrow view. Over time, and in response to Fed comments, it became clear that the regulators were not looking for a broad, generic view. Rather they sought to have each bank examine their business carefully and identify MRTs that aligned with their specific business model and practices instead of broad definition of MRTs. Ultimately, the practice that has emerged favors a more narrow view, with most large banks identifying approximately 3-5 percent of their employees (and slightly higher for regional banks 10-15 percent). Banks took varying approaches to evaluating their incentive compensation plans and supporting processes. What they all had in common, however, was that the reviews were multi-disciplinary, cutting across the major control functions of Risk, Compliance, Legal, and HR. The approaches used to evaluate incentive plans can be categorized as: s Qualitative assessment: A minority of banks took this approach, which generally involved a questionnaire or checklist geared toward identifying features of selected incentive plans that may drive inappropriate risk-taking based on their design or governance parameters. s Quantitative audit: Favored by many banks in ensuring a rigorous, systematic approach. This type of approach was often technology-assisted given the magnitude of incentive plans maintained by large banks (in some cases several hundred plans). The approach: Identifies inherent risks in each business unit and maps back to positions and incentive plans; Identifies features of selected incentive plans that may drive inappropriate risk-taking based on their design or governance parameters; Evaluate governance and operational processes against best practices; Results in a score for each plan that helps to prioritize areas for further review. The major areas covered in these assessments included plan design features, risk profiles of the business in which the plan resided, composition of the incentive plan participants (i.e., covered employee vs. non-covered employee), and governance associated with business processes and incentive plan administrative processes. (See the case study on specific actions taken by some of the larger banking institutions.) What Were The Outcomes? In October 2011, the Federal Reserve Bank published a report summarizing the key changes to compensation practices they had observed from the initial horizontal review. The changes they highlighted included: s Implementation of risk adjustments to bonus pools; s Increased use of deferrals eligibility for deferrals has broadened and the amount deferred has increased (they also applauded the use of share retention requirements that extend beyond the deferral period); s Adoption of claw-back provisions that included claw-backs related to both financial performance and malfeasance; s Use of scenario analyses and back testing to assess the potential impact of risk outcomes; s Improved governance and oversight at both the Board and management levels. The tone of the Fed s report was generally positive. However, privately the Fed suggested to virtually every bank that this was only a good step on an evolutionary journey and that more work was/is to be done. Separately, we have been encouraged to see banks taking additional steps that seem to have received less notice and recognition by the regulators. These steps include: s Modifying the bank s overall pay philosophy (Board-reviewed and approved) that underscores the role of risk in compensation and ways in which that risk is addressed through compensation. To us, this is an important step in signaling to the organization how seriously leadership views risk management in compensation; s Redesigning performance leverage in incentive plans to moderate the upside and downside of rewards relative to performance, as a way of discouraging the temptation to take on undue risk; s Lowering performance thresholds of selected incentive plans based on an assessment of the degree of difficulty in achieving the threshold; s Incorporating corporate performance modifiers in business unit incentive formulas and even corporate measures as a mechanism for promoting a long-term alignment with risk outcomes; and s Reviewing and adjusting the salary-to-incentive mix in light of the risk assessment. In some cases, base salaries were increased as a way of mitigating an over-reliance on incentive earnings. These actions were controversial and, in some cases, criticized by shareholders, because while they responded to broader public concerns, these actions increased the divide between pay and performance and also reduced flexibility in managing costs for a notoriously cyclical industry. Has Change Really Happened? The changes to the pay model have been significant, sweeping and global in nature and the wave of change may not yet be over. Additionally, the specific reform to compensation programs (e.g., bonus claw backs) that we have seen in the banking industry may in the future extend to non-bank financial organizations. Indeed the current wave of regulation intends to target other financial sectors include insurance and asset management (organizations labeled as systemically influential financial institutions, or SIFIs). Did the risk assessments motivated by the new regulations actually lead to productive changes that indeed balanced risk and rewards? We believe the answer is BANKING REPORT ISSN 0891-0634 BNA 5-1-12

4 largely yes, they did. As a result of the changes, at least when compared to pre-crisis levels: s Greater corporate control and oversight procedures of incentive compensation; s Greater information flow about plan designs and the type of business taken on; s Performance review processes make clear the importance of risk taking and risk-adjusted results over prior emphasis on revenues and market share metrics; s Many problematic incentive designs have been identified and either eliminated or have had their problematic features remediated; and s There is broader awareness at all levels of the organization of the issues associated with incenting inappropriate levels of risk. However, concerns still remain about whether the reform will really have a sustained impact on the banking model. Among them: s Compensation itself hasn t fundamentally changed professionals are still paid with a base salary, a cash incentive, and a long-term (often equity based) incentive. No new interesting or credible alternatives have emerged (e.g., payments in company debt have been discussed but have not been truly implemented partly because regulators are not sure that they understand how they would work); s These refined incentive models are not likely to work any better during Black Swan events than the old ones; s While most companies have back-tested incentive plans and conducted scenario analyses, it is not clear whether the new pay model will work across a range of business cycles; and s For companies that have made salary increases to rebalance the compensation mix, the jury is still out on whether these changes were effective. Some companies (and shareholders) have questioned whether the reduced flexibility and cost management is worthwhile. In summary, we see that even as regulation was forced upon the industry, banks were quick (by necessity) to comply with new principles and, perhaps more importantly, take the initiative to develop their own platforms for change. Time will tell how this integrated approach impacts the long-term performance of the industry in terms of profits and risk profile. Sidebar: Banking Compensation Regulations In the wake of the financial crisis, numerous agencies around the world began to consider how compensation should be regulated. Today, each country has adopted a regulatory standard based on the different guidance that has emerged over the past several years and there are indeed differences by country. For organizations that are represented in multiple countries, this has made for a complex exercise in compliance. Banks must follow the regulations of their headquarters company but must also comply with local regulations of the countries in which they operate. Case Study Sidebar: An Insider s View of the Pay Changes at Global Banking Institutions The report issued by the Federal Reserve in October 2011 described the efforts of the 25 of the 28 LCBO organizations, summarizing over two years of intensive efforts at these organizations. As mentioned in the accompanying article, in contrast to the European regulations, the U.S. regulations did not provide specific rules for compliance. Rather, the guidance provided by regulators created a flurry of activity at LCBOs where each attempted to render their own interpretation of compliance. When the Federal Reserve Board issued its proposed guidance in October of 2009 (finalized in July of 2010), the expectation was that LCBOs were to make significant progress toward consistency with interagency guidance in 2010 and to achieve substantial conformance by the end of 2011. Over many months that followed, the LCBOs focused the major control functions on this effort and documented their progress to the Federal Reserve. The Federal Reserve, in turn, provided feedback on the actions the organizations had taken, but no definitive decisions about whether compliance was achieved or not. The cycle thus continued on until the end of 2011. Our organization was engaged to work on many of these issues throughout these changes. Our observation is that one can argue whether the guess what I m thinking back-and-forth between the LCBOs and the regulators was productive or not. Had there been specific rules, the compliance challenge might have been much simpler. The lack of rules should have provided the LCBOs with more flexibility to structure pay than was available to European counterparts. Interestingly, though, many of the structural pay changes at U.S. banks mirrored (or at least were largely similar) to those that occurred at European banks. Nonetheless, in our work with many of these LCBOs, we observed that these organizations committed substantial resources and labor hours to analyzing their business, reviewing their incentive compensation plans, their organization design, their information systems, and control processes to achieve conformance. Their Boards are more informed than ever before about the nature and substance of compensation arrangements within the organization. Some of the areas in which we saw banks respond to the guidance included: Identifying Material Risk Takers The most confounding area of the Fed guidance was in determining what was meant by the term material in determining an organization s material risk takers (or covered employees ). This term permeated the guidance and yet it did not offer any specific criterion for determining materiality. In contrast, the guidance did provide specificity for the different types or risk, and seven were identified: credit, market, liquidity, operational, legal, compliance, and reputational risk. In identifying its material risk-takers, a number of LCBOs proceeded by conducting two levels of evaluation: s Business-level segmentation: The banks categorized their business in different ways with financial metrics, such as economic capital, and isolated those businesses to which the largest amounts were allocated. s Job-level analysis: The tasks and activities of each role within a business were analyzed to determine 5-1-12 COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN 0891-0634

5 Country Authority/Legislation Key Provisions Switzerland FinMa-circular 1 0/1 (Oct. Principle-based approach that follows the guidance of the 21 2009) FSB Germany Instituts Vergütungsverordnung (Oct. 13, 2010) France Spain Enacted CRD III Enacted CRD III Follows the approach developed by CEBS in the Capital Requirements Directive III (July 2010) Must identify material-risk-takers ( Identified Staff ) Incentive plans for Identified Staff must include: Risk adjusted performance measures taking into account the cost of capital Payment awards in prescribed proportions of cash and instruments Prescribed minimum deferral and retention periods and vesting schedule Clawback policies Formal policies on caps A requirement of a fully flexible bonus policy (i.e., no minimum bonus levels) Additional rules apply to the composition of the Remuneration Committee, personal hedging policies, severance, and pension design United Kingdom FSA Remuneration Code (Dec. 17, 2010) U.S.A. Dodd-Frank Act (Jul. 10 2010) FDIC Proposed Rules (Mar. 2011) and rank the degree to which their actions contribute to or influence each of the seven risk areas. Evaluating Incentive Programs Most LCBOs and universal banking organizations in general maintain multiple incentive plans. Indeed it is common for a global organization to have several hundred incentive plans given the complexity of operations, nuances of different regulatory models in various countries, and the number of acquisitions that have been made. The sheer volume of plans made a systematic review a daunting task. Some LCBOs opted for a technology-driven, score-based approach to evaluating their plans that allowed them to speed the process without sacrificing thoughtfulness or rigor. Further, a scorebased approach allowed for effective relative comparison of incentive plans and promoted effective management- and board-level reporting not only of the evaluation itself, but of progress on remediating problematic incentive plans. Such an approach typically Principle-based approach that follows the guidance of the FSB Dodd-Frank Act limits the types of performance measures that can be used for mortgage originators FDIC rules propose a mandatory three-year deferral for executives and key employees of organizations with over $50 billion in consolidated assets evaluated six areas and covered 40-50 questions per plan: s Incentive plan design: Factors assessing the degree to which selected plan design features affect inappropriate or excessive risk-taking; s Strategic alignment & goal setting: Factors assessing the alignment of the incentive metrics with enterprise strategy and the degree to which realistic goals can be set; s Pay opportunity: Factors assessing the degree to which competitive compensation data were used to establish overall pay opportunity; s Process: Factors assessing the checks and balances in evaluating business results that are used to calculate individual awards or bonus pools and the individual award approval process; s Monitoring: Factors assessing the extent to which an appropriate number of plans are administered BANKING REPORT ISSN 0891-0634 BNA 5-1-12

6 and monitored (Note that, in our experience, incentive plans that have only a few five or fewer participants are often the result of negotiated agreements and can be problematic when compared to plans designed to cover larger units; and s Administrative: Factors assessing amongst others the degree to which plan information is documented and reviewed for legal implications, and the degree to which plan calculations are automated. Improving Incentive Compensation Governance In addition to shoring up the process and information that is provided to the Board of Directors about compensation, LCBOs also made significant changes to internal management controls and processes. Many overhauled the manner in which incentive plans are designed and administered, in many cases forming global oversight committees supported by regional local committees or teams (it should be noted that overlapping authority between global and regional Committees creates its own set of challenges and potential for things to slip between the cracks ). The changes to incentive compensation governance focused on ensuring rigor in four key areas: s Structure: A specific organizing approach, reporting relationships and operational and financial accountabilities that best support the execution of the governance model; s Roles: Clear definition on what roles have a stake in the core incentive compensation practices; s Decision Authorities: Clarity on what each role can do or decide for each incentive compensation practice; and s Practices & Quality Standards: Specific, core practices and standards that the enterprise assures and assesses for each incentive plan. 5-1-12 COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN 0891-0634