Sound Incentive Compensation and Risk Implementation

During the most recent Operational Risk/ERM Audio Conference, Rob Northway, partner at McLagan, and Greg Camarco, director of executive compensation at McLagan, indicated that there is no "silver bullet" for interpreting the regulatory guidance concerning incentive compensation policies. However, in order to adhere to Fed guidance, institutions need to follow three guiding principles:

  1. Strike a balance with incentive compensation arrangements.
  2. Foster compatibility with effective controls and risk management.
  3. Build a strong corporate governance.  

As a framework for building a sound incentive and compensation program, Northway and Camarco offered the six areas in which the Fed has focused its regulatory efforts.

  1. Governance Structure for Managing Compensation

The FRB has strongly encouraged the Compensation Committees to review and approve a framework/policy statement that sets forth the board's expectations of how compensation, including incentive compensation, is managed within the organization and is aligned to the overall risk appetite statement.

  1. Identification of Covered Employees

The FRB requires firms to implement a systematic, documentable methodology for the identification of those individuals who are subject to the oversight of the FRB. This classification process must identify individuals and jobs, which individually and/or collectively expose the firm to material amounts of risk. Risk and HR jointly own the process and engage other control functions as necessary.

  1. Incentive Plan Design to Mitigate Risk

Firms need to develop an approach by which they review and assess incentive plans for covered employees to ensure that each plan accounts for the risks that are inherent in the roles covered by the plan. This assessment must align to the overall governance structure outlined by the firm and must occur on a regular basis.

  1. Balancing Total Compensation

Given that different roles expose the firm to varying types of risk, different compensation schemes should be used to address the risks. Regulators expect deferrals of compensation to be over time frames that align to risk horizons, and clawback and forfeiture provisions to be broad and address instances of adverse risk outcomes.

  1. Monitoring and Validation of Compensation Outcomes

For plans with discretion, the FRB requires firms to monitor and back-test the plans to demonstrate strong governance and control around the use of discretion. The FRB expects several tests performed as part of the back test, including:

  • Risk taken/risk outcomes.
  • Incentive compensation payouts at the pool level.
  • Examination of some aspect of individual level awards or payouts against financial and risk performance.
  • Identification of adverse risk outcomes, including the relationship with incentive compensation awarded and/or paid out to individuals.

  1. Training and Documentation

Regulators have a heightened expectation that compensation decisions are well documented to make auditing the process and outcomes possible. Additionally, they expect that compensation decision makers are well versed in accounting for risk when making their compensation decisions.

For more information on timely ORM and ERM topics such as this, register today for RMA's Governance, Compliance, and Operational Risk Conference (GCOR X), April 20–21, Cambridge, MA.

Join us for the next offering in the Operational Risk/ERM Audio Conference Series, Modeling Risk Management on March 15. All ORM/ERM sessions are scheduled for the third Tuesday of each month through June at 1 p.m. ET.

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