Systemic Risk and Executive Compensation Testimony Before the U.S. House Financial Services Committee
Jun 11, 2009
June 11, 2009
Gene Sperling, Counselor to the Secretary of the Treasury, Opening Statement before the U.S. House of Representatives Committee on Financial Services
Chairman Frank, Ranking Member Bachus, Members of the Committee, I appreciate the opportunity to testify before you on this important topic of systemic risk and executive compensation.
Each of us involved in economic policy has an obligation to fully understand the factors that contributed to this financial crisis and to make our best effort to find the policies that minimize the likelihood of its recurrence. There is little question that one contributing factor to the excessive risk taking that was central to the crisis was the prevalence of compensation practices at financial institutions that encouraged short-term gains to be realized with little regard to the potential economic damage such behavior could cause not only to those firms, but to the financial system and economy as a whole. As Secretary Geithner said yesterday, too often “incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.” Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a “canary in the coal mine.”
After one large investment bank suffered large losses, it acknowledged – properly reflecting on what it should have done differently – that it had skewed its employees’ incentives by simply measuring bonuses against gross revenue after personnel costs, with “no formal account taken of the quality or sustainability of those earnings.” And the potential harm caused by compensation arrangements based on short-term results with little account for long-term risks went beyond top executives. Indeed, across the subprime mortgage industry, brokers were often compensated in ways that placed a high premium on the volume of their lending without regard to whether borrowers had the ability to make their payments. As a result, lenders, whose compensation normally did not require them to internalize long-term risk, had a strong incentive to increase volume by targeting riskier and riskier borrowers – and they did, contributing to the problems that spurred our current crisis.
As we work to restore financial stability, the focus on executive compensation at companies that have received governmental assistance is appropriate and understandable. But what is most important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issue, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.
Yesterday, Secretary Geithner laid out a set of principles for moving forward with compensation reforms. Our goal is to help ensure that there is a much closer alignment between compensation, sound risk management and long-term value creation for firms and the economy as a whole. Our goal is not to have the government micromanage private sector compensation. As Secretary Geithner said yesterday, “We are not capping pay. We are not setting forth precise prescriptions for how companies should set compensation, which can often be counterproductive.” We also recognize these principles may evolve over time, and we look forward to engaging in a discussion with this Committee, the Congress, supervisors, academics and other compensation experts, shareholders and the business community about the best path. We begin this conversation recognizing that the reforms we put in place must be based not only on our best intentions, but also a clear-eyed understanding of the need to minimize unintended consequences. But we think these principles offer a promising way forward.
1. Compensation plans should properly measure and reward performance
There is little debate that compensation should be tied to performance in order to best align the incentives of executives with those of shareholders. But even compensation that is nominally performance-based has often rewarded failure or set benchmarks too low to have a meaningful impact.
There is increasing consensus in the expert community that performance-based compensation must involve a thoughtful combination of metrics that is indexed to relative performance as opposed to just following the ups and downs of the market. Performance pay based solely on stock price can on the one hand, “confuse brains for a bull-market” and in the other scenario, fail to recognize exceptional contributions by executives in difficult times. A thoughtful mix of performance metrics could include not only stock prices, but individual performance assessments, adherence to risk management and measures that account for the long-term soundness of the firm.
2. Compensation should be structured in line with the time horizon of risks
As I mention above, much of the damage caused by this crisis occurred when people were able to capture excessive and immediate gains without their compensation reflecting the long-term risks they were imposing on their companies, their shareholders, and ultimately, the economy as a whole. Financial firms offered incentives to invest heavily in complex financial instruments that yielded large gains in the short-term, but presented a “tail risk” of major losses. Inevitably, these practices contributed to an overwhelming focus on gains – as they allowed the payout of significant amounts of compensation today without any regard for the possible downside that might come tomorrow.
That is why we believe companies should seek to pay both executives and other employees in ways that are tightly aligned with the long-term value and soundness of the firm. One traditional way of doing so is to provide compensation for executives overwhelmingly in stock that must be held for a long period of time – even beyond retirement. Such compensation structures also reduce the risk that executives might walk away with large pay packages in one year only to see their firms crumble in the next year or two. In these cases, the dramatic decline in stock price would effectively “claw back” the previous year’s pay. Other firms keep bonuses “at risk,” so that if large profits in one year are followed by poor performance in the next, the bonuses will be reduced.
Yet, as Harvard Professor Lucian Bebchuk has written, compensation packages based on restricted stock are not a fool-proof means of ensuring alignment with long-term value, as such pay structures can still incentivize well-timed strategies to manipulate the value of common equity or take “heads I win a lot, tails I lose a little” bets depending on the capital structure and degree of leverage of the firm.
3. Compensation practices should be aligned with sound risk management
Ensuring that compensation fosters sound risk-management requires pay strategies that do not allow market participants to completely externalize their long-term risk, while also ensuring that those responsible for risk management receive the compensation and the authority within firms to provide a check on excessive risk-taking. As the Financial Stability Forum recently stated, “staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm.”
This authority and independence is all the more important in times of excessive optimism when consistent – though unsustainable – asset appreciation can temporarily make the reckless look wise and the prudent look overly risk-averse. Former Federal Reserve Chairman William McChesney Martin Jr. once said that “The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting.” Likewise, risk managers must have the independence, stature and pay to take the car keys away when they believe a temporary good-time may be creating even a small risk of a major financial accident down the road.
Yet there are several reports showing the degree to which risk managers lacked the appropriate authority during the run-up to this financial crisis. Accounts of one Wall Street firm discuss how risk managers who once roamed the trading floors to gain a better understanding of how the company worked and where weaknesses might exist were denied access to that necessary information and discouraged from expressing their concerns.
That is why we believe that compensation committees should conduct and publish a risk assessment of whether pay structures – not only for top executives, but for all employees – incentivize excessive risk-taking. As part of this process, committees should identify whether an employee or executive experiences a penalty if their exceptional performance is based on decisions that ultimately put the long-term health of the firm in danger. At the same time, managers should also have direct reporting access to the compensation committee to enhance their impact.
I should also note that in the rule we released yesterday concerning executive compensation for recipients of assistance through the Troubled Asset Relief Program, we put forward – as the Administration called for on February 4th – a requirement that compensation committees not only provide a full risk assessment for their compensation, but that they do so in a narrative form that explains the rationale for how their pay structure does not encourage excessive risk. We believe such a requirement not only increases transparency, but forces firms to think through the basic risk logic of their compensation plans, and we hope it will help begin an important discussion between shareholders, directors and risk managers about the relationship between compensation and risk.
4. We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders
While golden parachutes were created to align executives’ interests with those of shareholders during mergers, they have expanded in ways that may not be consistent with the long-term value of the firm, and – as of 2006 – were in place at over 80 percent of the largest firms. Likewise, supplemental retirement packages that are intended to provide financial security to employees are too often used obscure the full amount of “walkaway” pay due a top executive once they leave the firm. Indeed, Lucian Bebchuk and Jesse Fried have shown that there is substantial evidence that “firms use retirement benefits to provide executives with substantial amounts of ‘stealth compensation’ — compensation not transparent to shareholders – that is largely decoupled from performance.”
Examining these practices is all the more important because when workers who are losing their jobs see the top executives at their firms walking away with huge severance packages, it creates the understandable impression that there is a double-standard in which top executives are rewarded for failure at the same time working families are forced to sacrifice. As Secretary Geithner said yesterday, “we should reexamine how well these golden parachutes and supplemental retirement packages are aligned with shareholder interests, whether they truly incentivize performance and whether they reward top executives even if their shareholders lose value.”
5. We should promote transparency and accountability in setting compensation
Many of the excessive compensation practices in place during the financial crisis likely would have been discouraged or reexamined if they had been implemented by truly independent compensation committees and were transparent to a company’s owners – its shareholders. Companies often hire compensation consultants who also provide the firm millions of dollars in other services – creating conflicts of interest. According to one Congressional investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67 percent higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
That is why we hope to work with Chairman Frank and this committee to pass “say on pay” legislation, requiring all public companies to hold a non-binding shareholder resolution to approve executive compensation packages. We believe that “say on pay” will place a greater check on boards to ensure that their compensation packages are aligned with the interest of shareholders. Indeed, in Britain, where “say on pay” was implemented in 2002, it has – according to a study by Professor Stephen Davis at Yale’s Millstein Center for Corporate Governance and Performance – been associated with greater communication between boards and shareholders, while a recent paper by Fabrizio Ferri and David Maber of Harvard Business School has found that say on pay made CEO compensation more sensitive to negative results. As a result, the resolutions have gained more and more support, with 76 percent of Chartered Financial Analysts now in favor of say on pay.
In addition, we want to work with this committee and the Congress to pass legislation directing the SEC to put in place independence rules for compensation committees analogous to those required for audit committees as part of the Sarbanes-Oxley Act. Our goal is to move compensation committees from being independent in name to being independent in fact. Under this proposal, not only would committee members be truly independent, but they would also be given the authority to appoint and retain compensation consultants and legal counsel, along with the funding necessary to do so. This legislation would also instruct the SEC to create standards for ensuring the independence of compensation consultants, providing shareholders with the confidence that the compensation committee is receiving objective, expert advice.
I am pleased today to be testifying here alongside my colleagues from the SEC and the Fed. We are encouraged by the efforts of the SEC to seek greater transparency and disclosure on compensation, and by the commitment of the Federal Reserve and other bank supervisors to ensure compensation practices are consistent with their fundamental duty to promote the safety and soundness of our financial system. As Secretary Geithner announced yesterday, we also hope to work further with other agencies on this issue by asking the President’s Working Group on Financial Markets to provide an annual review of compensation practices to monitor whether they are creating excessive risks.
As we move to repair our financial system, get our economy growing again and pursue a broad agenda of regulatory reform, we must ensure that the compensation practices that contributed to this crisis no longer put our system and our economy at risk. I commend the committee for holding these hearings, and I look forward to approaching this difficult issue with a degree of seriousness, reflection and humility – seriousness over the harm excessive risk-taking has caused for so many innocent people; reflection over the lessons we have already learned; and humility in recognizing the complexity of this issue, its potential for unintended consequences, and the importance of testing each of our ideas against the most rigorous analysis.
 Quoted in Lucian Bebchuk and Robert J. Jackson, Jr., “Executive Pensions,” NBER Working Paper #11907, December 2005.
 House Oversight Committee Majority Staff, “Executive Pay: Conflicts of Interest Among Compensation Consultants,” Report Published December 2007.
 Stephen Davis, “Does ‘Say on Pay’ Work? Lessons on Making CEO Compensation Accountable,” Millstein Center Policy Briefing No. 1, 2007; Fabrizio Ferri and David Maber, “Say on Pay and CEO Compensation: Evidence from the UK,” Harvard Business School Working Paper, 2009.
 Keith L. Johnson and Daniel Summerfield, “Shareholder Say on Pay: Ten Points of Confusion,” Briefing Prepared for Shareholder Forum Program on Reconsidering “Say on Pay” Proposals, October 2008.
Scott G. Alvarez, General Counsel on Executive compensation
Presented Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C.
June 11, 2009
Chairman Frank, Ranking Member Bachus, and other members of the Committee, thank you for the opportunity to offer some perspectives on the subject of incentive compensation in banking and financial services. Recent events have highlighted that improper compensation practices can contribute to safety and soundness problems at financial institutions and to financial instability. Compensation practices were not the sole cause of the crisis, but they certainly were a contributing cause–a fact recognized by 98 percent of the respondents to a recent survey conducted by the Institute of International Finance of banking organizations engaged in wholesale banking activities.1 And, importantly, problematic compensation practices were not limited to the most senior executives at financial firms. As the events of the past 18 months demonstrate, compensation practices throughout a firm can incent even non-executive employees, either individually or as a group, to undertake imprudent risks that can significantly and adversely affect the risk profile of the firm.
Financial firms and supervisors have learned important lessons from this recent episode. Having witnessed the painful consequences that can result from misaligned incentives, many financial firms are now reexamining their compensation structures with the goal of better aligning the interests of managers and other employees with the long-term health of the firm. And we, as supervisors, have been reminded that risk management and internal control systems alone may not be sufficient to constrain excessive risk-taking if the firm’s compensation structure provides managers and employees with financial incentives to take such risks. Accordingly, the Federal Reserve is developing enhanced and expanded supervisory guidance in this area to reflect the lessons learned in this financial crisis about ways in which compensation practices can encourage excessive or improper risk-taking.
In my statement, I will review some of the compensation and related risk management and corporate governance deficiencies that contributed to the financial crisis. In addition, I will review some possible explanations as to why such problems exist–even when they run contrary to the long-term interests of shareholders and the organization. I also will outline the existing rules and guidelines that the Federal Reserve has in place to help address compensation problems at banking organizations that may pose a risk to safety and soundness. Finally, I will describe some of the elements that are key to the design and implementation of sound compensation systems at financial institutions.
Compensation and Corporate Governance and Risk Management Breakdowns
Compensation arrangements are critical tools in the successful management of financial institutions. They serve several important and worthy objectives, including attracting skilled staff, promoting better firm and employee performance, promoting employee retention, providing retirement security to employees, and allowing the firm’s personnel costs to move along with revenues.
It is clear, however, that compensation arrangements at many financial institutions provided executives and employees with incentives to take excessive risks that were not consistent with the long-term health of the organization. Some managers and employees were offered large payments for producing sizable amounts of short-term revenue or profit for their financial institution despite the potentially substantial short- or long-term risks associated with those revenue or profits. Although the existence of misaligned incentives surely is not limited to financial institutions, they can pose special problems for financial institutions given the ability of financial institutions to quickly generate large volumes of transactions and the access of some institutions to the federal safety net.
The compensation programs of many financial institutions incorporated payment features and oversight, control, and review processes intended to help restrain inappropriate risk-taking. Moreover, banking organizations, with the support and urging of federal supervisors, developed risk-management controls and frameworks to identify, assess, and manage the firm’s risk-taking.
However, in some cases, the incentives created by incentive compensation programs to undertake excessive risk appear to have been powerful enough to overcome the restraining influence of these processes and risk controls. In addition, the risk-management controls and frameworks of some financial institutions themselves suffered from deficiencies that limited their ability to act as a brake on excessive risk-taking. For example, the risk-management systems of many financial institutions did not fully recognize or “capture” all relevant risks with certain business activities, especially those associated with innovative or complex products, fast-growing business lines, or funding needs. And in many instances, risk-management frameworks did not adequately take account of the potential for compensation arrangements themselves to be a source of risk for the firm. The risk-management personnel and processes at financial institutions, thus, often played little or no role in decisions regarding compensation arrangements. It is possible that aggressive pursuit of highly skilled financial specialists in recent years caused some financial institutions to relax or forego usual safeguards and controls in the interest of hiring and retaining what they believed to be the best talent.
These weaknesses were not limited just to financial institutions in this country. These types of problems were widespread among major financial institutions worldwide, a fact recognized by the governments comprising the Group of Twenty, international bodies such as the Financial Stability Board (FSB), and the industry.
Need for Improvements
Looking forward, it is clear that more must be done by financial institutions and supervisors to better align compensation practices with sound operations and long-term performance. Major banking organizations appear to be aware of the need for better practices. The boards of directors and senior management of many organizations are taking a much-needed look at their existing compensation arrangements. In many cases, they are doing so with the strong encouragement of institutional investors and other shareholders.
Correcting these weaknesses will require improvements in both corporate governance and risk management at financial institutions. Boards of directors and senior management of major financial institutions must act to limit the excessive risk-taking incentives within compensation structures and bolster the risk controls designed to prevent incentives from promoting excessive risk-taking. In many cases, boards of directors that have analyzed the connections between incentive compensation and risk-taking have focused only on a handful of top managers. However, incentive problems may have been more severe a few levels down the management structure than for chief executive officers (CEOs) and other top managers. Indeed, recent experience indicates that poorly designed compensation arrangements for business-line employees–such as mortgage brokers, investment bankers, and traders–may create substantial risks for some firms. Thus, boards of directors must expand the scope of their reviews of compensation arrangements.
The Federal Reserve also is actively working to incorporate the lessons learned from recent experience into our supervision activities. As part of these efforts, we are in the process of developing enhanced guidance on compensation practices at U.S. banking organizations. The broad goal is to make incentives provided by compensation systems at bank holding companies consistent with prudent risk-taking and safety and soundness. In developing this guidance, we are giving careful thought to the fundamental sources of incentive problems, as well as to the rationale for, and role of, possible action by supervisors in this area. This process includes drawing on the broad range of expertise within the Federal Reserve, as well as on available research concerning the underlying economic forces at work and how they may influence the design, implementation, and likely effects of incentive compensation systems. In addition, we are drawing on our experience in implementing existing regulations and guidance in order to ensure that our efforts are balanced, effective, and work in concert with other supervisory and management tools in pursuit of prudent risk-taking.
Forces Giving Rise to Incentive Misalignment
At least two factors directly influence how compensation might affect the safety and soundness of financial institutions. First, shareholders cannot directly control the day-to-day operations of a firm–especially a large and complex firm–and must rely on the firm’s management to do so, subject to direction and oversight by shareholder-elected boards of directors. Incentive compensation arrangements are one way that firms can encourage managers to take actions that are in the interests of shareholders and the long-term health of the firm. However, compensation programs can incentivize employees to take additional risk beyond the firm’s tolerance for, or ability to manage, risk in the course of reaching for more revenue, profits, or other measures that increase employee compensation. Second, where managers have substantial influence over compensation arrangements, they may use that influence to create or administer incentive arrangements in ways that primarily advance the short-term interests of managers and other employees, rather than the long-term soundness of the firm.
Collective action or “first mover” problems may make it difficult for individual firms to act alone in addressing misaligned incentives. Even if the owners of an individual firm do not like the way compensation is structured at their firm, they may be unwilling to make unilateral changes because doing so might mean losing valuable employees and business to other firms. In this context, the problems are a side-effect of labor market competition, which itself has positive societal benefits.
Supervisors can play an important and constructive role in counteracting the impact of these forces on the safety and soundness of financial institutions. First, supervisors can press all financial institutions, especially those active in business lines for which incentive payments are common and large, to adopt sound compensation practices that restrain inappropriate incentives, but that each institution might be wary of adopting alone. By doing so, supervisors can help to better align the interests of managers and other employees with the long-term health of the organization, and also reduce firms’ concerns about the potential for adverse competitive consequences from prudently modifying their compensation arrangements. Second, supervisors can usefully add to the impetus for improvement in compensation practices that is already coming from shareholders, directors, and other stakeholders.
Existing Policies and Practices Related to Compensation
Our supervisory experience also provides important perspectives as we seek to move forward. Since 1995, the Federal Reserve and the other federal banking agencies have had in place interagency standards for safety and soundness (Standards) for all insured depository institutions.2 These Standards, which were adopted pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), prohibit as an unsafe or unsound practice both excessive compensation and any compensation that could lead to material financial loss to the insured depository institution. The Standards provide that compensation will be considered excessive if the amounts paid are unreasonable or disproportionate to the services performed by the relevant executive officer, employee, director, or principal shareholder and set forth a variety of factors that will be considered in determining whether compensation paid in a particular instance is unreasonable or disproportionate. Importantly, FDICIA specifically prohibits the agencies from using the Standards to prescribe a specific level or range of compensation permissible for directors, officers, or employees of insured depository institutions.
More recently, in November 2008, the Federal Reserve, in conjunction with the other federal banking agencies, issued an interagency statement reminding banking organizations that they are expected to regularly review their management compensation policies to ensure that they are consistent with the longer-run objectives of the organization and sound lending and risk- management policies.3 This statement provides that management compensation policies should be aligned with the long-term prudential interests of the institution, should provide appropriate incentives for safe and sound behavior, and should structure compensation to prevent short-term payments for transactions with long-term horizons. In addition, it states that management compensation practices should balance the ongoing earnings capacity and financial resources of the banking organization, such as capital levels and reserves, with the need to retain and provide proper incentives for strong management.
The Federal Reserve also was actively involved in the development of the Principles for Sound Compensation Practices issued by the Financial Stability Board in April 2009.4 These principles, which are aimed primarily at large financial institutions, establish a common set of guidelines designed to help address the compensation-related lessons learned from the crisis and ensure that compensation practices at large financial institutions do not encourage imprudent risk-taking. The international nature of the FSB is particularly important because competition among financial institutions–both for business and talent–is increasingly global in nature.
Enhancing Compensation Practices, Corporate Governance and the Risk-Sensitivity of Compensation Arrangements
Designing and implementing compensation arrangements that properly incent managers and employees to pursue the firm’s long-term well being is a highly complex task. Indeed, there is no generally accepted view as to the optimal way to achieve these objectives at an individual firm or across the financial sector. Our recent and continuing work in this area, however, suggests that there are certain key principles that can serve as important guides to efforts by financial institutions and supervisors to better align compensation practices with the safety and soundness of financial institutions.
Broad Review of Compensation Practices. First, care must be taken to properly align the incentives of compensation paid to employees throughout an organization. It is not sufficient to focus only on compensation paid to senior executives. Employees throughout a firm may expose the firm to significant risk, and improperly designed compensation programs may incent a wide range of employees to take on risk that, in the aggregate, is inappropriate or excessive. For example, sales employees who are compensated based on the volume of transactions without adjustments for noncompliance with legal requirements may be incented to ignore–or at least pay insufficient attention to–applicable laws and regulations.
Making Compensation More Sensitive to Risk. Second, compensation practices should not reward employees with substantial financial awards for meeting or exceeding volume, revenue, or other performance targets without due regard for the risks of the activities or transactions that allowed these targets to be met. One key to achieving a more balanced approach between compensation and risk is for financial institutions to adjust compensation so that employees bear some of the risk associated with their activities as well as sharing in increased profit or revenue. An employee is less likely to take an imprudent risk if incentive payments are reduced or eliminated for activity that ends up imposing higher than expected losses on the firm.
There are several ways that compensation can be adjusted for risk. For example, one approach involves deferring some or all of an incentive compensation award and reducing the amount ultimately paid if the earnings from the transactions or business giving rise to the award turn out to be less than had been projected. Another way to improve the risk sensitivity of compensation is to take explicit account of the risk associated with a business line or employee’s activities–such as loan origination or trading activities–in the performance measures and targets that determine the amount of incentive compensation initially awarded.
Both approaches offer promise, but both have important limitations as well. For example, ready job mobility poses a major challenge to deferral-oriented restraints on incentives, especially if the employee is able to receive some or all of the deferred amounts upon departure or the employee’s new firm is willing to provide a signing bonus equivalent in value to any deferred compensation left behind at the prior firm. Deferral arrangements also can pose a variety of contractual, legal, tax, and technical challenges. In addition, adjusting incentive compensation targets and amounts to account for risk requires an institution to have reasonably accurate indicators of all risks relevant to the business line or activity being rewarded. However, the quality of risk indicators is uneven across activities and types of risk. For example, substantial challenges exist to the development of reliable indicators for certain types of risk, such as reputational, liquidity, and compliance risk. The aggregation of different types of risks into a single risk metric also is a highly complex and difficult process that involves substantial judgments. Moreover, organizations, experts, and researchers to date have not focused much attention on how proper risk-adjusted compensation arrangements could be designed for the many lower-level employees outside the ranks of senior management. Developing and implementing an appropriately risk-sensitive compensation system across the full range of a large firm’s businesses will be a highly complicated and difficult task.
Firms have had some success in incorporating risk into deferred compensation, particularly for senior management, by paying performance awards in the form of company stock with multi-year vesting requirements. However, while this might be one important component of a sound incentive compensation system, stock-based compensation has not proven to be a panacea. Compensating top executives in the form of stock and deferring payouts through multi-year vesting and holding requirements did not prevent executives at some firms from permitting their firms to take on risks that endangered the firm’s health and, by implication, a substantial part of the executives’ own wealth. Experience suggests that it is difficult to incentivize senior managers to reduce risk by altering business practices that have been lucrative in the past or that appear to be profitable for competing firms. In addition, equity-based incentive compensation may be less effective in aligning the incentives of mid- and lower-level employees with the interests of the firm because these employees may view the outcome of their decisions as unlikely to have much effect on the firm or its stock price.
Let me be clear–these limitations do not suggest that supervisors and firms should not move quickly to improve compensation arrangements. Rather, they simply highlight that more work and attention must be devoted to understanding and developing compensation practices that promote the proper incentives, which will require some time and perhaps investment by the industry. It also means that judgment and common sense will and should play a continuing and important role in the compensation structures of financial institutions, particularly while institutions work towards developing better quantitative measures for risk-adjusting compensation. In addition, these limitations highlight the need for both experimentation and flexibility in approaches by financial institutions. One size certainly does not fit all, and institutions will need to have flexibility as they work toward implementing appropriate risk-sensitive incentive compensation across the wide diversity of their operations.
Risk Management and Corporate Governance. Third, more can and should be done to improve risk management and corporate governance as it relates to compensation practices. Our discussions with market participants and supervisory experience suggest that risk controls are a necessary complement to–and not a substitute for–prudent compensation systems in protecting against excessive risk-taking. Risk controls take many forms, but they can have their full effect only if governance processes are sound and risk managers have the influence, incentives, and resources to play their proper role. For these reasons, it is critical that the compensation for risk management and control functions at financial firms be adequate to attract personnel with appropriate expertise and that these personnel not be compensated based on the financial performance of the business line for which they are responsible.
Review of a firm’s compensation practices also must involve the board of directors. The board of directors provides an important link between the shareholders of a firm and its management and employees. Active engagement by the board of directors or, as appropriate, its compensation committee, in the design and implementation of compensation arrangements promotes alignment of the interests of employees with the long-term health of the organization.
Boards of directors will need to take a more informed and active hand in making sure that compensation arrangements throughout the firm strike the proper balance between risk and profit, not only at the initiation of a compensation program, but on an ongoing basis. For example, the role of the board of directors or, in appropriate circumstances, its compensation committee should include review and approval of the key elements of the firm’s compensation system, after-the-fact evaluations of how well the firm’s compensation systems have achieved their objectives, and an understanding and evaluation of the internal controls and risk-management processes related to compensation. For this engagement to be most effective, members of the boards of directors and, where appropriate, their compensation committees must have the experience, knowledge, and resources needed to understand and address the complex interactions and incentives created by compensation programs firm-wide.
Importantly, if incentive compensation arrangements are going to achieve their intended purposes–including managing risk and improving performance–the standards governing the arrangements at each firm must be regularly and symmetrically applied. Firms must not only provide rewards when performance standards are met or exceeded, they must also reduce compensation when standards are not met.
Improving compensation practices at financial institutions is important. Compensation arrangements must continue to allow financial institutions to attract, retain, and motivate talented employees, but they also must not provide incentives for managers and employees to take excessive risks. And while the issues and concerns associated with improperly designed compensation practices are common, no single compensation system will address all types of risks or work well in all types of firms. Each firm ultimately must determine how to address these matters in a way most suited to that firm’s business, structure, and risks.
Improvements in compensation practices are likely to be harder to make and take longer than anyone would like. Companies compete for talented employees in a global market. This creates a collective action problem: No firm wants to be the first to appear to reduce compensation even if that would be in the firm’s long-term interest. The risk of losing the firm’s best employees or being unable to hire new quality personnel is likely to appear too great.
Encouragement by supervisors, shareholders, and others can help alleviate this problem. However, regulation that is too severe and that does not recognize that the market for quality employees is global will threaten more harm than it will do good. The Federal Reserve currently is developing enhanced guidance that seeks to strike this balance and promote safe and sound compensation practices at financial institutions under our jurisdiction.
I appreciate the Committee’s interest in this important topic and am happy to answer any questions you may have.
3. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2008), “Interagency Statement on Meeting the Needs of Creditworthy Borrowers,” joint press release, November 12. Return to text
4. The FSB was established to address vulnerabilities and to develop and implement strong regulatory, supervisory, and other policies in the interest of financial stability. It is composed of senior representatives of national financial authorities (central banks, regulatory and supervisory authorities, and ministries of finance), international financial institutions, standard setting bodies, and committees of central bank experts. For more information on the FSB, see www.financialstabilityboard.org/index.htm. Return to text