Incentive Compensation Practices: A Report on the Horizontal Review of Practices at Large Banking Organizations, October 2011

Risk-taking incentives provided by incentive compensation arrangements in the financial services industry were a contributing factor to the financial crisis that began in 2007. To address such practices, the Federal Reserve first proposed guidance on incentive compensation in 2009 that was adopted by all of the federal banking agencies in June 2010. To foster implementation of improved practices, in late 2009 the Federal Reserve initiated a multidisciplinary, horizontal review of incentive compensation practices at 25 large, complex banking organizations. 1 One goal of this horizontal review was to help fill out our understanding of the range of incentive compensation practices across firms and categories of employees within firms. The second, more important goal was to guide each firm in implementing the interagency guidance. Given the variety of activities at these complex firms, and the number and range of employees who are in a position to assume significant risk, our approach has been to require each firm to develop, under our supervision, its own practices and governance mechanisms to ensure risk-appropriate incentive compensation that accords with the interagency guidance throughout the organization. Supervisors assessed areas of weakness at the firms, in response to which the firms have developed comprehensive plans outlining how those weaknesses will be addressed. These plans, as modified based on comments from supervisors, will be the basis for further progress and evaluation. As explained in more detail in this report, every firm in the review has made progress during the review in developing practices and procedures that will internalize the principles in the interagency guidance into the management systems in each firm. Many of these changes are already evident in the actual compensation arrangements of firms. For example, senior executives now have more than 60 percent of their incentive compensation deferred on average, higher than illustrative international guidelines agreed by the Financial Stability Board, and some of the most senior executives have more than 80 percent deferred with additional stock retention requirements after deferred stock vests. Moreover, firms are now attentive to risk-taking incentives for large numbers of employees below the executive level-at many firms thousands or tens of thousands of employees- which was not the case before the beginning of the horizontal review, when most firms paid little attention to risk-taking incentives, or were attentive only for the top employees. Yet every firm also needs to do more. As oversight of incentive compensation moves into the regular supervisory process, the Federal Reserve will continue to work to ensure progress continues both in the implementation of the firms’ plans and in the risk appropriate character of actual compensation practices.