Incentive-Pay Rules Draw Fresh Attention from Regulators - Analyst Blog

Financial institutions may face new rules relating to employee compensation and benefits. After the 2011 proposed rules, which never reached finalization, the US regulators are once again working on pay rules to cut back pay packages, which are likely to promote excessive risk taking, per a Wall Street Journal release.

Certain employees might be required to return their bonuses for fraud or heavy blunder. This clawback provision will be part of the incentive compensation rules outlined in the 2010 Dodd-Frank law. Under the clawback clause, when losses occur, employees return benefits or compensation, which was been already been paid before. Several banks have clawback policies; however, lack of disclosure by the banks keeps it concealed from the investors.

The compensation rules also require deferral of at least 50% of an executive's bonus for a certain period of time for firms with $50 billion or more in total consolidated assets. The incentive-compensation rules of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010 are aimed to commensurate firms' incentive packages in line with long term financial health of a company, and depending on the size and complexity.

While there is still uncertainty about the firms which are to come under the purview of the rules, the Dodd-Frank Act mentioned that the rules are applicable to depository institutions or depository institution holding companies, broker-dealers, credit unions, investment advisers, the Federal National Mortgage Association or Fannie Mae ( FNMA ), the Federal Home Loan Mortgage Corporation or Freddie Mac ( FMCC ) and any other financial institution that the Federal regulators considers to be necessary.

Inappropriate incentive packages induce employees to take undue risks, which affect the financial stability of the firm in the long run. Improper and flawed compensation structure in firms is believed to be one of the contributors to the 2008 financial crisis.

In order to prevent any future catastrophic situation, the regulatory bodies - Office of the Comptroller of the Currency (OCC), Treasury, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation (FDIC), Office of Thrift Supervision, Treasury (OTS), National Credit Union Administration (NCUA), U.S. Securities and Exchange Commission (SEC), and Federal Housing Finance Agency (FHFA) - had worked on the proposed rules drafted in 2011.

While such rules were not finalized, in 2014 Federal Reserve, OCC and FDIC forwarded a proposal to the SEC. The proposal gave rise to the need of several clarifications including the deferral period and the treatment of asset managers under the rule.

In a speech on Jan 20, 2015, Fed governor Jerome Powell said the Federal Reserve is in a process with other regulators to bring rules on compensation, which will include the "deferral of larger amounts of compensation over a longer period of time," forfeiture in case of risk-management errors. He also included the possibility of clawbacks, though "fairly extreme." He stated that regulators plan to issue a revised draft proposal for public comment later this year.

Banks' Moves

Following the crisis, several financial institutions have changed their compensation methods mainly through deferral of incentive compensation, with delayed vesting and the possibility of more vigorous forfeiture in an enlarged set of circumstances. Several banks award a bigger part of the bonuses in stock unlike cash payment practiced before the 2008 financial meltdown.

While regulatory pressure has broadened the clawback policies of Citigroup Inc. ( C ) and Wells Fargo & Co. ( WFC ) in recent times, JPMorgan Chase & Co. ( JPM ) took back total compensation of around two years from three traders involved in the 2012 trading fiasco. In January, The Goldman Sachs Group, Inc. ( GS ) revealed that, going forward, a part of the bonus amount of its top executives will be paid in restricted shares based on performance conditions.

However, a competitive environment has prompted several banks to tread in the opposite direction. Particularly for retaining skill in hedge funds and asset-management companies, institutions make more cash payments and defer a less amount of bonus payment. Notably at the end of 2014, Morgan Stanley ( MS ) revealed that about 50% of employee bonuses would be deferred for several years, significantly down from an average of around 80% few years back.

Road Ahead

Uncertainty persists around the finalization of the rules as several issues still demand clarity. Apart from the ambiguity over the period of deferred compensation, concern arises over application of incentive rules to financial institutions with different compensation practices than a conventional bank.

Further, it is not clear now that apart from fraud, which act will prompt clawback and whether conduct recognized by firm or regulators would require reclaiming of benefits.

Though it is a matter of time to witness any further related development, we believe regulators' efforts would definitely strengthen their initiatives to lower the risks associated with exorbitant pay packages of the employees and safeguard interests of the investors.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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