The federal banking supervisors have jointly published 285 pages of proposed rules on incentive-based compensation practices, as required by the Dodd-Frank legislation enacted in 2010. The proposed rules only apply to banks with $1 billion or more in assets, and use a tiered approach that applies provisions to covered financial institutions according to three categories of average total consolidated assets:

• Level 1 - $250 billion or more;
• Level 2 - $50 billion to less than $250 billion; and
• Level 3 - $1 billion to less than $50 billion.

Even though the proposed rules do not apply to banks with less than $1 billion in assets, there are a number of principles in the rules that banks and other covered financial institutions of any size should observe when designing and implementing incentive-based compensation plans.

What’s NOT Incentive Compensation

The proposed rules clarify that hiring bonuses and compensation tied solely to continued employment are not “incentive-based compensation.” Likewise, compensation tied solely to achieving a professional certification or educational achievement would not be covered.

What is Specifically Prohibited

The proposed rules are aimed at discouraging banks from taking inappropriate risks that can cause material losses. Therefore, performance measures that are tied closely to short-term revenues or profit would be barred unless there were mechanisms for adjustment for long term effects. The proposed rules contain two specific prohibitions on performance metrics:

• No performance measures would be allowed that are based solely on industry peers’ performance. This has traditionally been a very common metric used for compensation at banks. In effect, incentives based on peer performance risk rewarding employees for answering yes to the age old question: “If your friends jumped off a bridge would you too?”
• No measures would be permitted if they were based solely on transaction volume without regard to quality. For example, this would likely bar incentive plans based on loan production without regard to the actual performance of the loans.

In addition, the proposed rule would prohibit Level 1 and Level 2 covered institutions from purchasing hedging instruments or similar instruments to hedge or offset any decrease in the value incentive-based compensation for covered persons. It is important to note that this prohibition would apply to all covered persons at a Level 1 or Level 2 covered institution, not just senior executive officers and significant risk-takers.  Furthermore, this prohibition would not limit a covered institution’s ability to hedge its own exposure in deferred compensation obligations. 

Additional Requirements

In addition to prohibiting certain behaviors, the proposed rules have certain requirements that must be met.  The requirements contained in the proposed regulations include but are not limited to the following:

• Level 1 or Level 2 covered institutions must make unpaid and unvested incentive compensation subject to the risk of downward adjustments or forfeiture;
• Level 1 or Level 2 covered institutions must include “clawback” provisions that, at a minimum, allow the covered institution to recover incentive-based compensation for seven years following the date on which such compensation vests; and
• Level 1 and Level 2 institutions will have to develop detailed policies and procedures for the incentive compensation plans to ensure compliance with the rule.

What Governance Controls Must be in Place

The proposed rules require that bank boards and management have controls in place over the governance of incentive-based compensation plans. At the top of the house, such controls would require that boards of directors actively “engage” with management on the design and implementation of incentive compensation plans and “challenge” management’s assessments and recommendations. Too often boards simply accept what management recommends when it comes to executive compensation, because the subject is so personal in nature.   We recommend that board minutes reflect active engagement.

Governance controls would also include having in place some management-level independent oversight of incentive compensation plans. At community banks, this might mean internal auditors who, at least for purposes of executive compensation, report directly to the board and are not themselves participants in the incentive compensation plans being overseen.

Even if your bank is below $1 billion in assets, your examiners will likely be asking for copies of your incentive-based compensation plans and will likely be comparing your practices with those at larger banks.

The proposed rules were published in the Federal Register on June 10, 2016. Public comment will close on July 22, 2016. Depending on the date of publication, the proposed rules would allow at least 18 months and in most cases more than two years for covered institutions to become compliant.