Pay check: New proposed regulations

How we got here

The six agencies that are required to formulate incentive compensation regulations under Section 956 of the Dodd-Frank Act proposed an original set of rules in 2011. The intent behind the rules, then as now, is to prevent compensation arrangements from encouraging “inappropriate risks” that either provide an individual with excessive compensation or could lead to “material financial loss.”

Their mission under the Dodd-Frank Act was twofold:

1. To force institutions to disclose all incentive-based compensation arrangements to regulators
2. To prohibit arrangements that could encourage risky behavior or expose companies to financial loss

The original version was largely principles-based and left areas of substance open to interpretation. Many banks took action then—developing procedures to identify covered employees, balancing risk-taking incentives, and revising risk-management controls and corporate governance.

But these discrete policies and procedures are only part of the necessary approach to balance risk and reward and prohibit inappropriate risk-taking behaviors. Culture is an indispensable means to not only drive compliance with rules on compensation, but also to drive behaviors that are beneficial to the enterprise.

In April and May 2016, the six controlling agencies “re-proposed” a new version of the compensation rules, which are more prescriptive than the principles-based rules proposed in 2011. These changes reflect the experience and insights gained by regulators over the last five years of working with financial institutions. Once finalized, the new rules would be effective 18 months after publication.

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Which institutions will have to comply?

There are, in effect, two lists of covered institutions, although both groups will be subject to the same requirements and asset thresholds. The first comes directly from Section 956 of the Dodd-Frank Act. The second list includes institutions the regulatory agencies have jointly proposed to treat as subject to the rules.

Institution types mandatorily covered by legislation:

• National banks, state member banks, and federal savings associations
• Bank holding companies (BHCs) and savings and loan holding companies (SLHCs)
• SEC-registered broker-dealers
• Credit unions
• Investment advisers (registered and unregistered)
• Fannie Mae
• Freddie Mac

Additional institution types covered by agencies’ proposed rule:

• US operations of foreign banking organizations (FBOs) that are treated as BHCs
• Edge and Agreement corporations
• State-licensed and uninsured branches and agencies of FBOs
• State-chartered non-depository trust companies that are members of the Federal Reserve System (FRB)
• Federal home loan banks

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How should institutions respond?

Deloitte’s analysis suggests covered institutions should address the requirements in three phases:

1. Short-term actions:

• Identify covered employees
• Review and assess incentive plan design and deferral requirements
• Revise existing clawback policy
• Review and update governance documentation procedures
• Review compensation committee oversight and independence

2. Medium-term actions:

• Solidify scrutiny of the rewards program
• Review performance management
• Review control function employees

3. Long-term actions:

• Build in ongoing review and governance

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Culture as the root of compliance

The most significant determinant of behavior in organizations isn’t rules, but culture—the value, beliefs, attitudes, and actions that the people in an organization share. Compensation both reflects and drives these attributes.

One reason culture is vital is that it can inform subjective decisions in ways that rules can’t. Financial institutions should take measured risks and reward people for taking risks effectively. But they should also avoid undue levels of risk and make certain they don’t compensate people in ways that tempt such behavior. This doesn’t mean that incentive compensation has become imprecise or “squishy” with the injection of culture—quite the reverse. Culture, applied to a regulated environment, emerges as something distinct and measurable. And like any input into business outcomes, it must be measured to be controlled.

How can an enterprise exert control over its culture? Some sources say the impetus must come from the top down. Other voices emphasize the role of the middle—because front-line managers can lead by direct example in ways senior leaders may not. This is a false choice. Culture is the responsibility of everyone, at every level, to define it, spread it, or live it. But the effort should be deliberate. Every organization should have a team leading the charge of culture, and programs such as training, while an internal communication strategy should be developed to spread the message.

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What happens next?

There are many process, technology, and cultural steps that can’t be defined until the rules become final. But that doesn’t mean the intervening period should be given over entirely to watchful waiting.

In particular, it’s advisable for each institution to verify:

• Which set of rules apply
• Which personnel under the proposed rules would qualify as “covered individuals”
• What adjustments need to be made to existing incentive programs

The new rules on incentive compensation are the long-delayed, operative culmination of a legislative and regulatory impulse that has its roots in a years-old debate. Their arrival is a surprise to no one—but the details of their implementation still require careful scrutiny.

To learn more, read the full report, Pay check: New proposed regulations for incentive pay at financial institutions, and visit our Regulatory & Compliance services page.

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