Last Monday, six US federal regulators1 proposed rules to prohibit financial institutions from offering incentive-based compensation that could encourage excessive risk-taking by senior executive officers and other so-called significant risk takers. The rules, mandated by the Dodd Frank Act, will apply to a broader range of employees than the regulators’ 2011 joint proposal, which was never implemented. The new proposal introduces more stringent requirements for incentive compensation deferral and compensation recoupment (i.e., clawback).
The rule would apply to banks, asset managers, broker-dealers and other financial institutions with total consolidated assets of more than $1 billion. Larger institutions would have more stringent requirements in the new tiered approach, which classifies institutions into Level 1, those with $250 billion or more in assets, which would have the most stringent standards; Level 2 institutions with $50-$250 billion would have less stringent standards; and Level 3 institutions with $1-$50 billion (Level 3) would have easier requirements.
The revised rules apply to a larger swath of employees than the 2011 proposal. For example, the definition of “senior executive officers” has been expanded to cover roles including chief compliance officer, chief credit officer and the heads of control functions. The definition of “significant risk takers” such as loan officers and underwriters would also include employees who receive at least one-third of their pay from incentive compensation (excluding senior executive officers) and meet certain compensation tests, such as being among the top 5% of highest-compensated employees.
At Level 1 banks, the largest banks, senior executives would be required to defer at least 60% and other key risk takers at least 50% of their annual incentive compensation for at least four years. At Level 2 institutions, senior executives would defer 50% and other key risk takers 40%, for at least three years. Most large banks that require deferrals defer at least half of senior executives’ incentive compensation for three years, but few use a four-year period. During the deferral period, the awards would be subject to reduction and forfeiture in various adverse outcomes, including poor financial performance. Reducing compensation before it has vested is easier than clawing it backing it after it has been paid out.
To cover compensation that has already been paid out, tough clawback policies apply to 100% of incentive-based compensation for up to seven years after the awards have vested in cases of misconduct, including fraud, intentional misrepresentation of information used to determine the individual’s bonus compensation, and misconduct that resulted in significant financial or reputational harm to the bank. Most banks already have clawback polices in place, but clawback periods rarely extend beyond three years, and then only at the largest banks.
Most aspects of the proposal are credit positive, but the mandatory deferral and vesting periods may be too short to cover risks that only become apparent over say seven to ten years, as with fines and litigation.
Other jurisdictions, including the UK and Switzerland, require longer minimum deferral, vesting, and clawback periods, which we view favorably.
Because the proposal is largely consistent with current practice and interagency guidance, we expect larger banks will have little difficulty implementing the rules, with the possible exception of strengthening clawback polices and expanding the scope of covered employees. Smaller banks may face more difficulty adapting to the changes since their compensation practices vary more widely.
