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
