WASHINGTON — A Federal Reserve Board review of executive compensation practices released Wednesday found significant improvements at the largest U.S. banks, but said more reforms are necessary.
"Every firm in the review has made progress … in developing practices and procedures that will internalize the principles in the interagency guidance into the management system in each firm," the Fed's report stated. "Yet, every firm also needs to do more."
Risk-taking incentives had been a contributing factor to the most recent financial crisis, prompting the Fed to undertake a "horizontal review" of the 25 largest, most complex firms like American Express Co., Bank of America Corp., Capital One Financial Corp., and JPMorgan Chase & Co. It issued interagency guidance two year ago which was adopted by all federal banking agencies in 2010.
"Before the crisis, large banking organizations did not pay adequate attention to risk when designing and operating their incentive compensation systems, and some employees were provided incentives to take imprudent risks," the Fed's report stated.
Separately, the Fed is working with other banking agencies to draft a rule on incentive compensation practices.
During the two-year review, each firm was asked to develop its own practices under the supervision of the Fed to ensure that higher compensation was not being driven by risk taking and to make necessary changes to individual compensation structures.
For example, unlike past practices, all firms have now put into place new compensation packages that do not provide incentives to employees to take unnecessary risks that would expose their firms.
According to the Fed, there are two ways firms can achieve this: by either creating a risk adjustment strategy or by deferring payout — two practices that were rarely done pre-crisis.
Until recently, no firms have developed a strong strategy to deal with risk adjustments. Even so, the Fed said, firms have more work to do when it comes to ensuring that a wide range of risks are properly balanced.
In the case of deferring payout, the Fed said, nearly all firms now use some mechanism to adjust downward the amount of deferred incentive compensation that is paid if losses are large. Still, most firms have more work to do in applying such practices to a larger set of employees, the Fed said.
Secondly, efforts have now been made to identify relevant employees, who could either individually or as a group, influence risk at an organization — a practice that had largely been focused on senior level executives.
The Fed said all the firms have made progress in identifying the employees, like traders and loan originators, whose incentive compensation packages could pose a threat to the safety and soundness of an organization.
"Though the decisions and incentives of senior executives are indeed very important, the combined risk taking by a group of similarly compensated employees can also be material to the firm's risk profile," the Fed wrote in its report. "Identifying the set of employees, who may individually or collectively expose the firm to material amounts of risk, is a key element of practice."
Thirdly, firms were asked to revise their risk-management processes and internal controls to enforce that incentive compensation was balanced and risk was being properly considered.
"Because firms did not consider risk in the design of incentive compensation arrangements before the crisis, firms rarely involved risk-management and control personnel when considering and carrying out incentive compensation arrangements," the Fed's report said. Some firms, the Fed said, have further work to do in this area.
Lastly, all firms have taken steps to alter their corporate governance frameworks to include all employees, not just a firm's most senior-level executives.
Despite initial progress, the Fed said it would continue to monitor compensation practices as businesses evolved.
"Incentive compensation practices at banking organizations are continuing to evolve and develop," the Fed's report stated. "The Federal Reserve will continue to work with these firms through the supervisory process to ensure improvement and progress are sustained."
Additionally, the Fed made clear its guidance did not take a one-size-fits-all approach.
"Methods for achieving balanced incentive compensation arrangements at one organization may not be effective at another organization," the Fed wrote.
