Our Take: financial services regulatory update – May 10, 2024

Change remains a constant in financial services regulation. Read "our take" on the latest developments and what they mean.

Current topics – May 10, 2024

1. Regulators re-propose joint rule on incentive-based compensation

  • What happened? On May 6th, the FDIC, OCC, and FHFA re-proposed a rule on incentive-based compensation that was previously proposed in 2016 and 2011 to implement Section 956 of the Dodd-Frank Act (DFA), which requires federal financial regulators to issue regulations to prohibit incentive-based compensation that encourages inappropriate risks at any financial institution with consolidated assets of at least $1 billion.
  • What does the proposal say? The text of the new re-proposal is identical to the 2016 version, with questions on several potential changes:

 

Proposal details (identical to 2016)

Key questions on potential changes

Tiered approach

Covered institutions are categorized into three tiers based on average total consolidated assets with thresholds of $1 billion, $50 billion and $250 billion in assets (Level 3, Level 2 and Level 1 covered institutions, respectively). More stringent rules apply to incentive-based compensation paid to “senior executive officers” and “significant risk-takers” at Level 1 and Level 2 institutions.

The re-proposal asks about modifying this to a two-tier approach with $50 billion as the primary threshold to trigger enhanced requirements and requiring institutions to identify significant-risk takers with disclosure of their identification methodology to their primary regulator.

Limits

At Level 1 and Level 2 institutions, the maximum earned incentive for senior executive officers is limited to 125% of the target amount, and for significant risk-takers is limited to 150%. There are no fixed limits on the size of potential targets but there are prohibitions on basing performance measures solely on comparison to industry peer performance and basing incentive compensation solely on revenue or transaction volume.

The re-proposal asks whether the limits should be higher or lower as well as whether the relative performance restrictions should apply only to a more limited group of employees. It also asks about requiring performance measures and targets to be set before the beginning of the performance period.

Deferral

Includes incentive compensation deferral periods up to four years after the end of the performance period with minimum deferral amounts between 40-60% depending on whether the covered institution is Level 1 or Level 2 and whether the individual is a senior executive officer or significant risk-taker.

The re-proposal asks whether Level 1 and Level 2 employees should be treated more similarly with regard to deferrals as well as whether longer performance periods can provide risk balancing benefits similar to those provided by deferral.

Downward adjustment, forfeiture and clawback

Includes requirements to respond to various adverse outcomes by reducing incentive compensation that has not yet been awarded. It further requires a minimum seven year period from the end of vesting to clawback incentive compensation in the event of misconduct, fraud or intentional misrepresentation.

The re-proposal asks about requiring specific events to trigger forfeiture, downward adjustment and/or clawback rather than leaving it to the institution’s discretion.

Governance and reporting

Covered institutions would be required to have a compensation committee made up of members that are not senior executive officers and take input from the risk and audit committees, as well as annual assessments of the effectiveness of the institution’s executive compensation program. They would be subject to seven-year record retention requirements, with records disclosed to regulators on request.

The re-proposal asks whether assessments should be submitted more or less frequently to the committee.

  • What’s next? Section 956 of the DFA requires the Fed, FDIC, FHFA, NCUA, OCC and SEC to jointly propose and finalize an incentive-based compensation rule. Until all six agencies are in agreement, the proposal will not be published in the Federal Register. The SEC and NCUA are expected to issue their versions of the proposal soon, while Fed Chair Jerome Powell said in a recent hearing that he “would like to understand the problem we’re solving and then I would like to see a proposal that addresses that problem.”

Our Take

A false re-start? 13 years after it was first mandated by the DFA, this re-proposal comes after last year’s bank failures raised questions about senior executive compensation and consequences for significant risk management lapses. However, with even one holdout agency, it will not have an official comment period much less be on track for timely finalization - particularly with the looming election. Fed Vice Chair for Supervision Michael Barr will almost certainly be asked if the Board’s position has changed from Powell’s past skepticism when he appears before Congress next week.

Don’t write it off just yet. Unless Congress reverses or amends DFA Section 956, the requirement to implement incentive compensation rulemaking remains on the books and the 2016 proposal remains the most likely starting point for any future attempts. Accordingly, covered institutions should refresh their analyses of how their incentive compensation programs would need to change to comply with the re-proposal, including by determining their in-scope employee populations as well as the impact of any senior hiring or transitions. As part of this effort, they should broadly evaluate how their compensation programs account for risk management and compliance. Given the widespread public criticism of the failed banks’ executive compensation programs, institutions should consider reasons beyond regulatory requirements, such as potential reputational harm, to ensure that their compensation programs are effectively aligned with risk management outcomes.

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