Daniel K Tarullo: Incentive compensation, risk management, and safety
and soundness
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the US Federal
Reserve System, at the University of Maryland's Robert H. Smith School of Business
Roundtable "Executive Compensation: Practices and Reforms", Washington DC,
2 November 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
It is a pleasure to be here this afternoon to give the closing address at this very timely
conference on executive compensation. Executive compensation has for some time been an
important part of academic and policy discussions of corporate law and governance. The
public's attention to the subject has periodically increased. Such heightened interest is not
often part of corporate governance debates, but rather in response to high compensation
levels for certain executives, or the contrast between rising executive compensation and
sluggish overall wage growth. I think it fair to say, however, that public scrutiny has never
been more intense than in the past year. And never has it been more concentrated on a
particular industry than in the current focus on large financial services firms.
The interest and role of the Federal Reserve is both broader and more targeted than the
issue of executive compensation as such. It is more targeted in that our concern with
compensation matters rests squarely on our statutory responsibility to ensure the safety and
soundness of the banking organizations we regulate. It is broader in that we are concerned
not only with the compensation of executives, but also with compensation arrangements of
employees other than executives where those arrangements may adversely affect the safety
and soundness of their firms. In the remainder of my remarks, I will first elaborate a bit on
how our safety and soundness mandate both defines and limits the scope of our activities on
compensation. Then I will turn to the supervisory approach we have taken in the proposed
guidance we issued 10 days ago, before closing with an explanation of the specific
supervisory processes we intend to follow in putting this guidance into practice.1
Compensation as a safety and soundness issue
Previous speakers have touched on some of the reasons why compensation arrangements
of corporate employees can be a public policy matter. As I have already suggested, the
compensation packages of employees - particularly senior executives - implicate the
principal-agent concerns that inform much of corporate law. Shareholders have interests
both in providing employees with incentives to maximize shareholder value and in restraining
employees from using their direct control over the firm's resources to take more than is
necessary to attract and motivate quality employees. Additionally, as evidenced by the very
fact of Ken Feinberg's job as special master, the public has an interest in appropriate
compensation arrangements at firms in which the government has made significant
investments.
Broader issues of fairness may also be raised by high compensation levels for some
employees. Of course, these issues can quickly involve rather fundamental considerations of
political philosophy and political economy. At present, the public debate over the fairness of
compensation levels in financial firms has a more specific focus. Many would argue that the
bonuses that may be collected this year by employees of some financial firms and, for that
matter, the profits accruing to the firms themselves, are possible only because the
government rescued the entire financial system through a series of actions beginning last
year. Seen in this light, the bonuses and profits appear to some observers as an unfair
channeling of gains to private actors, after potentially devastating losses to those same firms
and employees were avoided by placing taxpayer funds at risk.
Each of the foregoing perspectives on compensation raises important policy issues. But the
regulatory framework established by statute makes them relevant to the supervisory
functions of the Federal Reserve only to the extent they affect the safety and soundness of
financial institutions. An evaluation of some compensation practices at banking organizations
preceding the financial crisis reveals that they did, in fact, contribute to safety and soundness
problems. Indeed, financial firms have themselves identified compensation practices as a
factor. In this regard, I was struck by the results of a survey conducted earlier this year on
behalf of the Institute of International Finance.2 Of the 37 large banking organizations
engaged in wholesale banking activities that responded, 36 agreed that compensation
practices were a factor underlying the crisis.
Of particular note are incentive compensation arrangements for employees in a position to
expose the firm to substantial risk that failed to align the employees' interests with those of
the firm. For example, some firms gave loan officers incentives to write a lot of loans, or
traders incentives to generate high levels of trading revenues, without sufficient regard for
the risks associated with those activities. The revenues that served as the basis for
calculating bonuses were generated immediately, while the risks might not have been
realized for months or years after the transactions were completed. When these or similarly
misaligned incentive compensation arrangements were common in a firm, the very
foundation of sound risk management could be undermined by the actions of employees
seeking to maximize their own pay.
There is thus significant overlap between the interests of shareholders and of supervisors in
the area of employee compensation. That is why, as I will explain in a moment, we include
an emphasis on sound corporate governance measures in our proposed guidance. Indeed,
supervisory initiatives can reinforce the impetus for change already coming from
shareholders and other market participants. By requiring banking organizations to
incorporate a thorough, risk-appropriate approach to incentive compensation arrangements,
supervisors can help address concerns that these firms face a kind of collective action
problem, which may make a firm reluctant to rectify misaligned arrangements for fear that
other firms will poach the best employees with promises of substantial near-term bonuses.
This concern exists at the international, as well as national, level, which is one of the reasons
why the Financial Stability Board has devoted so much attention to the issue in the past year.
However, it is important to note that the interests of shareholders and supervisors,
representing the public, are not wholly congruent. Because of the federal safety net - as
manifested in the deposit insurance system, the availability of discount window lending, and
too-big-to-fail perceptions - shareholders may at times be willing to tolerate a degree of risk
in a firm's activities that does not fully reflect the costs of that risk to society as a whole.
Thus, even if banking organizations were able to achieve full harmonization of employee and
shareholder interests in their incentive compensation arrangements, supervisory oversight
would still be warranted.
Proposed supervisory guidance
The proposed guidance recently issued by the Federal Reserve is informed by the
considerations I have just set forth.3 Our rationale for the guidance is grounded in safety and
soundness concerns. Our supervisory approach emphasizes the need to integrate
compensation policy into the overall risk-management framework of financial firms. This dual
focus on safety and soundness aims and risk-management capacities has been a recurring
theme of supervisory efforts in the wake of the crisis. Our compensation guidance is just one
piece of a broad program of regulatory and supervisory reforms, which include strengthened
capital and liquidity requirements and a more coordinated, "horizontal" approach to large-firm
supervision.
The Federal Reserve's guidance is based on three fundamental principles. First, incentive
compensation arrangements at a banking organization should not provide employees with
incentives to take risks that are beyond the organization's ability to effectively identify and
manage. The amounts of incentive pay flowing to employees should reflect the risks and
potential losses - as well as gains - associated with their activities. Employees are less likely
to take imprudent risks if their incentive payments are reduced or eliminated for activities that
end up imposing significant losses on the firm.
The guidance identifies four methods that have been most often identified by firms,
consultants, and others as useful in aligning incentive compensation with risk. These include
adjusting performance awards to reflect the risks of employee activities, deferring payments
of awards and adjusting actual payments to reflect risk outcomes, using longer periods for
measuring the performance on which awards are based, and reducing the sensitivity of
performance measures to short-term revenues or profits. Our expectation is that each
banking organization will use these and possibly other methods, either individually or in
combination, to achieve risk-appropriate incentive compensation practices throughout the
firm.
To be fully effective, risk adjustments to compensation should take account of the full range
of risks that the activities of employees may pose for the firm, including credit, market,
compliance, reputational, and liquidity risks. Moreover, these adjustments need to be
implemented in practice so that actual payments vary based on risks or risk outcomes. If
employees are paid substantially all of their potential incentive compensation when risk or
risk outcomes are materially worse than expected, employees may have an incentive to take
large risks in hopes of substantially increasing their personal compensation, knowing that
their downside risks are limited. Simply put, incentive compensation arrangements should
not create "heads I win, tails the firm loses" expectations.
The second core principle is that incentive compensation arrangements should be
compatible with effective risk management and controls. Banking organizations should
ensure that risk-management personnel have an appropriate role in designing incentive
compensation arrangements and assessing their effectiveness in restraining excessive
risktaking. Risk-management breakdowns often occurred in firms not because risk-management
officers were unaware of problems, but because they were not adequately integrated into the
firm's strategic and operational decisionmaking processes related to compensation. In
addition, a banking organization should have strong controls governing its process for
designing, implementing, and monitoring incentive compensation arrangements to help
prevent employees from circumventing or weakening these processes in ways designed to
increase their personal compensation.
The third core principle is that incentive compensation arrangements at banking
organizations should be supported by strong corporate governance practice, including active
and effective oversight by boards of directors. This oversight should go beyond reviewing
and approving the compensation arrangements for senior executives. Boards of directors, or
their compensation committees, should regularly review the design and functioning of the
firm's incentive compensation practices to ensure their consistency with safety and
soundness.
In developing these principles, we were guided by two key considerations. The first, as I
noted earlier, is that problematic compensation practices were not limited to the most senior
executives at financial firms. Traders with large position limits and loan officers who, as a
group, originate loans accounting for a material amount of an organization's credit risk, are
two examples of non-executive personnel who have the ability to expose a banking
organization to material amounts of risk. For this reason, our guidance extends beyond the
senior executives at banking organizations to include all other employees who, individually or
as a group, may expose the firm to material amounts of risk.
Second, in drafting this guidance we opted for principles, rather than generally applicable
rules. The complex and varying nature of financial activities, particularly those of large
banking organizations, suggested that uniform requirements for compensation arrangements
were not well-advised, at least not on the basis of our present knowledge and experience.
Activities and risks, as well as the reliability of related risk measures, may differ significantly
across banking organizations and across employee groups within one banking organization.
In these circumstances, we concluded that use of a single, formulaic approach to making
incentive compensation arrangements risk-sensitive would likely not be effective in
adequately containing risky behavior.
As discussed in the guidance, incentive compensation arrangements for senior executives at
a large, complex organization are likely to be better balanced if they involve deferral of a
substantial portion of the executives' incentive compensation over a multiyear period, with
payment made in some form of equity that is ultimately calculated with reference to the
performance of the firm during the deferral period. However, the use of equity-based
incentive compensation may not be effective in aligning the incentives of mid- and lower-level
employees with the interests of the firm, because these employees may view the outcomes
of their decisions as unlikely to have much effect on the firm or its stock price. Moreover,
deferral may not be effective in constraining the incentives of employees who have the ability
to expose the firm to long-term or "bad tail" risks, as these risks are unlikely to be realized
during a reasonable deferral period. Consider, for example, how different the incentive
compensation packages might need to be for a trader who deals in only one kind of highly
structured, long-term instrument, as compared to the arrangements for the firm's chief
executive officers.
Supervisory initiatives
In issuing the proposed guidance, the Federal Reserve also announced two separate
supervisory initiatives to ensure that the principles are incorporated by banking organizations
in their compensation arrangements. These initiatives are also intended to help identify and
promote emerging best practices in the industry. Like the principles themselves, the separate
supervisory programs recognize the differences among the many banking organizations we
supervise.
The first initiative applies to the institutions we classify for general supervisory purposes as
large, complex banking organizations (LCBOs). LCBOs warrant special supervisory attention
because they are significant users of incentive compensation arrangements and because
flawed practices at these institutions are more likely to have adverse effects on the broader
financial system. The challenge with respect to these institutions was that while we did not
want to impose inflexible, and possibly ineffective, practices across the wide range of
compensation arrangements, we also did not want there to be insufficient attention paid to
the very particulars that led us to adopt this approach in the first place. Accordingly, we
decided to place the burden on each of these LCBOs to develop a plan that would, with
appropriate specificity, implement the principles we have identified into the firm's
compensation policies and practices. A rigorous process of planning and implementation,
with accompanying supervisory oversight, makes it possible for these firms to customize their
compensation arrangements.
Our supervisory approach to compensation practices at LCBOs will include an extensive
horizontal review process, in keeping with our increased emphasis on this approach for the
supervision of the largest institutions. This horizontal review, which we expect to commence
shortly, will be led by a multidisciplinary coordinating group of Federal Reserve staff. We
anticipate that it will include staff from the Board, from Reserve Banks that supervise LCBOs,
and from other financial regulators. This group also will serve as a resource for supervisory
staff across the Federal Reserve System on incentive compensation matters.
This review process will enhance our understanding of existing incentive compensation
practices, identify existing or emerging best practices across the organizations, and provide
an informed framework for evaluating firms' plans for improving their practices. In this regard,
each LCBO will be expected to develop and present to the Federal Reserve a plan that
identifies where improvements to the organization's compensation arrangements and related
practices are needed to bring them in line with the principles embodied in the guidance.
These submissions must include the firm's plans, including relevant timetables, for achieving
meaningful and effective improvements to the risk-sensitivity of its incentive compensation
arrangements and the firm's related risk management, controls, and corporate governance
processes. We expect to work with each organization through the supervisory process in
refining its plan. Once finalized, implementation of the plan will become part of the
supervisory expectations for the banking organization. As with other supervisory
expectations, failure to submit or implement a satisfactory plan could be the basis for
enforcement action.
We issued the compensation guidance in proposed form and will be accepting comments on
the guidance through November 27. While we may well make changes in some aspects of
the guidance based on comments we receive, it is critical that the incentives created by
compensation arrangements be reviewed and adjusted to ensure the safe and sound
operation of financial firms. Indeed, in light of the experience of recent years, the safety and
soundness implications of incentive compensation arrangements would be an appropriate
matter for supervisory oversight even in the absence of any specific guidance. For these
reasons, we are not waiting to begin the process of gathering information about
compensation practices from LCBOs. Today, in discussions across the country, we are
communicating our plans and expectations to these firms, with particular attention to
beginning this information gathering.
A separate program will apply to the thousands of other organizations supervised by the
Federal Reserve, including community and regional banking organizations. Supervisory staff
will review incentive compensation arrangements at these organizations as part of the
regular risk-focused examination process, in connection with reviews of the organizations'
risk management, internal controls, and corporate governance. These reviews, as well as our
supervisory expectations for these organizations, will be tailored to reflect the more limited
scope and complexity of these organizations' activities - a fact also recognized in various
aspects of our guidance. For example, we certainly do not expect smaller banking
organizations that use incentive compensation arrangements on a limited basis to have the
same type of formalized and detailed program for managing the risks of such arrangements
as we expect to see at LCBOs. We will also have an ongoing coordination process for
developing and clarifying guidance for the non-LCBO institutions.
Conclusion
We expect that our supervisory practice in this area will evolve. We will have to build on the
principles we have set forth and we may, over time, identify standards that should be
universally applied to certain classes of employees. We will surely face questions from firms
that we have not anticipated. But even as we can expect a rapid accretion of knowledge and
significant elaboration of desirable policies and practices, the constant in our compensation
oversight will be the emphasis on safety and soundness and supporting risk-management
practices, which have been the foundation for our supervisory approach.