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Federal Reserve
Incentive Compensation
Initiative
Mark Carey
Federal Reserve Board
January 2012
This presentation and my remarks represent my own opinions, not those of the
Board of Governors or the Federal Reserve System.
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Fed’s Compensation Initiative
• Change banks’ employee compensation practices
– Limit incentives to take imprudent risks
– All employees who take or influence risk, not just
senior executives (typically 1000s at large banks)
• Not level of pay, but pay practices related to risktaking incentives
• Via supervisory reviews, using safety-andsoundness authority
• Principles-based, not fomulaic
• All banking organizations, but so far mainly large
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Suggested Takeaways
• Risk works differently at financial firms, so
incentives should too
• Almost everything the Fed is doing appears
compatible with traditional shareholder views
– No-upside LTIPs might be an exception
• Shareholders must still be attentive
– Prudential regulator
• Evidence of change mostly down in the weeds
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Timeline
• Commenced late summer 2009
• Supervisory guidance Oct 2009 (for comment)
– Written description of sound practices
• Major supervisory exercise commenced Nov
2009
– Iterative process still ongoing…banks submit plans,
supervisors review and react, new plan submitted,
etc.
– Migrating to normal supervisory process
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Which Banks So Far?
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16 domestic, 9 foreign with major ops in US
JPMC Citi BAC GS MS StateStreet BNYM
Wells USB PNC Suntrust NorthernTrust
Ally/GMAC, CapOne, Amex, Discover
RBC; RBS Barclays HSBC; UBS CS; DB; Socgen
BNPP
• Now rolling out to next tier of domestic banks
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Financial Firms Are Different
• Take as given that higher earnings tend to be rewarded
with higher bonuses
• Simplified nonfinancial firm:
– Risk-taking via investment that takes time to fruition
– Reduces earnings in short run, increases later
– Must incentivize risk-taking, esp. by senior execs
• Financial firm
– More risk now means more revenue now, losses later
– Higher cash bonus, without regard to risks-taken, may
incentivize imprudent risk-taking
– At large firms, risk-taking decisions are delegated and
diffuse, and control systems are imperfect and subject to
distortion
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Pre-crisis
• The archetype: An individual:
– With a bonus driven by short-run profit-and-loss (P&L)
– the P&L may not reflect all risk outcomes, even in short run
– Who puts on significant long-term risk, esp. tail risk
– Who puts pressure on controls and risk management
– Containment only by controls, limits, etc. is like
driving with both the gas and brake pedals down
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Three Principles
• Balanced risk-taking incentives: Provide
employees with incentives that do not
encourage imprudent risk-taking.
• Be compatible with effective controls and risk
management
• Be supported by strong corporate
governance, including active and effective
oversight by the organization’s board of
directors for lots of employees, not just NEOs
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What is the Fed not doing?
• Not the level of pay.
• Not a backdoor way of dictating risk appetite.
• Not reviewing or approving individual pay
packages. Focus is on the pay system.
• Not dictating the structure of pay. Diversity is
essential.
– Firms, and employees within firms, differ in the
types and extent of risks taken, and in other ways.
– Firms should fix it.
• Not backward-looking. Fix it going forward.
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What was wrong with pre-crisis
methods?
• Risk-taking largely ignored in the pay process
• Mechanically, no targeted way to cut pay in response
to poor risk outcomes
• Bonus awards must incentivize performance-year activity,
and retention is an issue. So awards not reduced for
legacy loss realizations…awards stay high after the crash.
• Vesting of deferred pay was conditional only on
employment. Exposure was only via the stock price.
• But most employees don’t think their decisions impact the stock
price
• And stock ownership offers both upside and downside
• Limited shareholder attention below the NEOs
• Mistake. Controls are never perfect, incentives matter
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How to do it:
Main “balancing” methods
• Upfront risk adjustment
• Performance based deferral
• (Pay structure is not the only thing that drives
the relationship between risks-taken and paydelivered)
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Upfront risk adjustments to
bonuses
• Formulaic way
– Measure the risks taken during the performance year and
subtract a risk charge from P&L
• Example: $10 economic capital allocated to $100 loan, 15%
required cost of capital…subtract 150bps from spread
– Pro: Predictable, consistent
– Con: Caveat capture all risk taking
• Judgmental way
– Assess risks taken and judgmentally adjust P&L or bonus
– Pro: Flexible, inclusive
– Con: Hard to get consistency
• Do both
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Deferral
• If employees get paid whole bonus in cash
upfront, risk-taking incentives are strong due
to limited future exposure
• Deferring a fraction helps, but by itself is not
enough
– In cash: exposed only to failure
– In stock: yes downside exposure, but upside
exposure works to offset
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Vesting Should Depend
on Performance
• “Malus” versus “clawback”
• Forfeit unvested for very bad outcomes, not
ordinary P&L blips
• NOT the same as a typical LTIP
– Most incentivize high financial performance
– Typically offers upside as well as downside based on
ROE or another measure
– Relative measures: Lake Woebegone effect
– LTIP structure OK, but Fed actively discouraging setups
with upside and relative measures alone
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Fraction deferred
• Material, but high fraction is not a panacea
• Example of EU formula
– 60% deferred
• Half in stock (with what malus? Just failure?)
• Half in cash (with what malus? Just failure? Not really much
exposure in most setups)
– 40% upfront
• Half in stock with 6-12 month retention
– Not much time for news to arrive
• Half in cash…that must be used to pay taxes?
– Overall: delay, but only 30% really exposed
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Vesting Triggers
• Formulaic way
• Trigger + Judgmental process way
• Triggers should be customized to the
employee’s business
– Not just for senior executives
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Six-step program
1) Which employees take material risk?
2) What risks does each take (not forgetting tail),
with what time horizons?
3) Do performance measures capture risk and risk
outcomes? How much of a gap?
4) Design and implement risk adjustments, deferral
arrangements, etc. if needed.
5) Tell the employees how it works.
6) Track awards, payments, risk, and risk outcomes,
analyze them, and improve over time.
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Some Parts Are Unfamiliar to
Compensation Community
• Not used to systematic, holistic thinking about
risk…involvement of risk professionals essential
• Financial firms are fundamentally different from
nonfinancial firms
• Deferred compensation, LTIPs, some other
structures are not enough, or even may harm
• Much of what the Fed is doing appears to be in
the shareholders interest…but we are focused on
the public interest
• Good news: It’s doable, with patience and dialog
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Challenges
• Get the idea across…new, different
• Get the right people to work together and pay
attention
• Getting past fears it’s politically motivated
– It’s not. Technical. Complement risk
management.
• International differences
– Some European initiatives have a different focus
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Fed’s Next Steps
• Mainly, keep it up
– Changing systems takes time. Keep the pressure
on
– Roll out to next tiers of banks
• Dodd Frank 956 Rule
– Core is similar to the supervisory guidance…a nonevent for big banks
– Gives SEC authority for investment managers,
broker dealers
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