Not to be outdone by the Federal Reserve, which in December proposed incentive pay restrictions for financial institutions under its supervision, the FDIC recently waded into waters increasingly crowded by rulemakers in the United States and abroad proposing to regulate employee compensation.

On January 12, by a split 3-2 vote, the FDIC issued an Advance Notice of Proposed Rulemaking on Employee Compensation (the "Advance Notice") that considers how to incorporate employee compensation criteria into the FDIC's risk-based assessment system to compensate the Deposit Insurance Fund (DIF) adequately for the risks inherent in certain compensation programs. The FDIC invites comments on all aspects of its proposed rulemaking, including its stated goals and features of compensation programs that meet such goals. Comments are due by February 18.

FDIC initiative to set voluntary compensation standards

The Advance Notice notes that the FDIC is not looking to establish mandatory minimum supervisory standards for compensation programs, which has been the Fed's approach to date with respect to financial institutions, and more generally, the tack adopted by legislators and regulators seeking to regulate executive pay and limit excessive risk-taking in compensation plan design. Nor, says the Advance Notice, is the FDIC trying to limit the amount of compensation that may be paid by a financial institution.

Rather, the FDIC is seeking to develop voluntary higher compensation standards which a financial institution would be free to ignore in designing its compensation plans. Eschewing those higher standards, however, will come at a price, in the form of higher insurance premiums charged by the FDIC to the financial institution, which are intended to compensate the DIF for the increased risk to which such pay practices theoretically expose the financial institution and thus the DIF.

Compensation plan design to be new factor in FDIC's risk-based assessment system

In support of the FDIC's proposed rulemaking, the Advance Notice ties the current initiative to the FDIC's legislative mandate. Under Section 7 of the Federal Deposit Insurance Act, the FDIC is required to establish a risk-based assessment system for depository institutions that incorporates all factors the FDIC determines are relevant to assessing the probability that the DIF will incur a loss with respect to an institution.

Traditionally, the FDIC has not considered compensation risk as one of the elements affecting the risk of loss to the DIF. It instead has based deposit insurance premiums on such factors as its assessment of management and capital adequacy and other elements of a bank's CAMELS rating. More recently, the FDIC has indicated it will charge higher premiums to banks that rely too heavily on funding from the Federal Home Loan banks or brokered deposits.

The FDIC now proposes to add the design of employee compensation to factors relevant to assessing the risk of loss. In support of that proposal, the Advance Notice cites studies that, it says, "almost universally find that poorly designed employee compensation programs provide incentives to take risks that can significantly and adversely affect a firm beyond the period when the compensation is earned or awarded."

Notably, however, dissenting members of the FDIC board questioned whether sufficient empirical research had been done to establish a link between incentive compensation and excessive risk-taking that causes a loss to the DIF as it relates to most financial institutions. They suggested the proposed action was premature and should await further study and resolution of other legislative and regulatory initiatives.

Goals of FDIC rulemaking

The FDIC identified three primary goals of its planned rulemaking:

• Adequately compensating the DIF through risk-based assessment rates for the risks of certain compensation programs
• Using the risk-based rates to provide incentives for depository institutions and their holding companies to adopt compensation programs that "align employees' interests with those of the insured depository institution's other stakeholders, including the FDIC
• Promoting the use of compensation programs that encourage employees to focus on risk management.

The Advance Notice indicates that the FDIC seeks to develop criteria that, when used in assessing institutional risk posed by compensation plans, are "straightforward" and would allow the FDIC to make a "yes or no" determination regarding whether an institution has adopted a compensation plan that meets a defined standard or does not.

Limiting the impact of compensation in FDIC assessments

In the Advance Notice, the FDIC previewed a potential safe harbor from an adverse compensation plan design determination. Compensation programs that meet the FDIC's goals may include the follow features:

• Where employees' activities present significant risk to the institution and those employees receive performance-based compensation, a significant portion of their compensation should be in the form of restricted, non-discounted stock which is subject to vesting over a period of years.
• Significant awards of company stock would be subject to a multi-year vesting requirement and subject to clawback for adverse results from risks taken in earlier periods.
• The compensation program would be administered by an independent board committee with input from compensation professionals.

Programs meeting these criteria would be subject to lower risk-based assessment rates. Alternatively, those institutions that cannot attest to these features would face a higher risk-based assessment.

Many questions remain for FDIC reflection

In soliciting comments on the proposal, the FDIC poses 15 questions relating to compensation structures. These questions preview many of the challenges the FDIC faces in implementing a risk-based assessment scheme, including:

• What size institutions should be subject to applicable limit?
• How should the FDIC measure and assess the effectiveness of board oversight?
• Should the holding company be considered if employees are paid by both the holding company and the depository institution?
• Which employees should be subject to analysis for purposes of fixing risk-based assessment rates?
• What would be considered compensation?
• How should various bonus practices impact risk-based assessment rates?
• Should the assessment system reward banks with lower risk compensation programs or penalize those with higher risk programs?

The path forward on compensation

It is apparent that federal banking regulators have no plans to sit idly by and let Congress determine whether and how to regulate incentive compensation affecting depository institutions. Like the Federal Reserve, the FDIC expects bank and holding company boards to avoid compensation design that may give rise to excessive risk taking and to maintain strong processes and controls to keep risk in check. While the Federal Reserve approaches this from a principles-based point of view, rather than the monetary carrot-and-stick approach to be employed by the FDIC, their objectives appear to have substantial overlap. Smaller, community banks may enjoy less scrutiny than their larger brethren, but will not be free from supervisory oversight.

Bank and holding company directors who have not yet been exposed to this percolating area of regulatory interest, through TARP or SEC regulations or otherwise, should begin to prepare themselves for changes in regulatory oversight of the compensation area. Prudent directors will have commenced this process already as a matter of good governance and risk-management oversight. One would expect this process to include elements of the following:

    Inventory of existing employee compensation programs. The scope of this inventory should not be limited to executive pay arrangements, but should consider all programs in which even lower-level employees participate.

    Inventory primary sources of risk which the enterprise encounters. A crucial step in any risk management process is not only identifying the primary and material risks which the enterprise confronts, but also assessing the enterprise's appetite for these and other risks. These risks may be operational, financial, regulatory or reputational in nature. A variety of enterprise stakeholders will be critical to this evaluation process, including the board of directors, various levels of management, external advisors and, depending on the circumstances, shareholders and regulators.

    Evaluation of compensation programs for appropriate risk balance. Boards and managers should give thoughtful reflection to the nature and degree of risk posed to the institution by its compensation arrangements. This inquiry should take into account whether and how a compensation scheme rewards risk-taking by one or more individuals or encourages behavior among groups of employees which, in the aggregate, creates inappropriate risk.

    Possible adoption of one or more compensation design features believed to mitigate risk. Compensation design features thought to tend to lessen risk include, among other things, pay in equity rather than cash, coupled with holding periods; longer performance periods; mandatory deferrals of incentive pay; and clawbacks.

    Re-assessment of institution's risk management and internal controls. Directors should examine whether the institution's core risk-management structures are sufficiently robust to manage systemic risk. This probe would include a re-assessment of the strength of the institution's internal controls to check employee risk-taking that strays outside established tolerances.