Bank board members are required to provide effective oversight on risks related to compensation at all levels of the organization. While most banks have implemented rigorous risk management processes and believe their incentive structures mitigate risk, the Wells Fargo & Co. scandal puts incentive practices under a new microscope.
Since 2010, all banks are subject to the Interagency Guidance on Sound Incentive Compensation Practices that require banks to review their incentive compensation arrangements to ensure no individual or group of individuals has the ability to expose the institution to material risk. This spring, regulators issued an updated proposal of Section 956 of the Dodd-Frank Act specifying more prescriptive rules on incentive compensation practices. Once finalized, these rules will require specific changes to bank incentive structures and result in increased time and responsibilities for compensation committees. Many fear the Wells Fargo scandal might hasten regulators push to finalize the rules.
Questions to Ask
In light of the regulatory expectations and potential pressure resulting from the Wells Fargo situation, boards and compensation committees should ask the following:
- Do we have a complete inventory of all our incentive plans?
- Have potential risks been fully identified?
- What actions are we taking when potential risks are identified?
- Do we have adequate information and opportunity to discuss the risk assessment findings?
- How are we creating a culture that values risk management?
- Do we have proper controls to ensure the incentive payouts are legitimate?
- Are independent control functions approving the payouts?
- How do we hold management accountable for ensuring sound risk management?
- Is the board receiving reports on any concerns raised through our ethics and fraud hotline?
Tools for Mitigating Risk in Incentive Plans
There are several plan features that can help mitigate risk in incentive plans, including the use of multiple performance measures, capped payouts, deferrals of a portion of payouts and ensuring an appropriate balance of fixed and variable pay opportunities. It is also important to be prepared to adjust payouts based on risk outcomes. There are three primary methods to adjust payouts:
- Downward adjustments: Reduces amount of incentive before the award is finalized, if it is determined that there were risk or compliance deficiencies in generating the results under the incentive plan.
- Forfeitures: Occur after incentive amounts are determined but before they are paid, during a deferral or vesting period. Wells Fargo is an example of the use of forfeitures, as all of the CEO’s unvested equity awards were forfeited as a result of the scandal.
- Clawbacks: Occur after the incentives have already been paid. While they are an expected governance feature, clawbacks are not sufficient on their own and should be viewed as a last result. They can be difficult to execute, as they may require asking individuals to repay amounts they have already received.
The Wells Fargo situation provides a reminder for all banks to step back and take a fresh look at their risk management practices, incentive compensation programs and governance structure. There is no one- size-fits-all approach, and all banks should establish programs and policies appropriate to their organization. Boards and their committees should ask if they are receiving appropriate information about the risks posed by incentive programs across the organization, not just at the senior levels. They should also look deeper at the underlying behaviors incentive plans are potentially motivating. As we learned with Wells Fargo, even lower level employees can take actions that are detrimental to the bank. The key is to create a culture of sound risk management practices with accountability for its oversight at all levels. Your bank’s reputation and future depend on it.