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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 11th 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. 

Posted in: Bank Compensation, BANKS, Credit Crisis, economy, Federal Reserve, Finance, Politics, Public Policy, REGULATION, Regulatory Reform

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