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FDIC's comp proposal raises questions and concerns E-mail

Plan would link compensation to deposit insurance assessments


January 28, 2010

By Steve Cocheo, executive editor, This e-mail address is being protected from spam bots, you need JavaScript enabled to view it

Update: ABA filed its comment letter on this proposal on Feb. 17. To read the letter after reading this article, click here.
ABA Resource: On March 11, ABA will present a two-hour telephone briefing related to this FDIC proposal, the Federal Reserve's  pending compensation proposal, and related matters. For further information, click here.
Washington has been focusing hard on pay in the current crisis atmosphere, but the Jan. 12 proposal by FDIC has kicked the issue up many notches. The controversial proposal makes the combination of potential restrictions on and costs of administering compensation an issue of universal industry concern, affecting banks of all sizes.
Up till now, compensation scrutiny has been focused principally on executive bonuses in very large banks and investment banks. There are pay issues in the pending financial reform legislation; special compensation issues for TARP institutions; new compensation disclosure rules for larger companies from the Securities and Exchange Commission; and the Federal Reserve’s pending compensation proposal.
Now FDIC has added a new wrinkle: linking compensation issues and deposit insurance assessments.
In a divided vote, FDIC’s board approved for 30 days comment an “advance notice of proposed rulemaking” that could result in a system in which a bank’s compensation program could affect how much it pays for deposit insurance.

Experts’ reaction to FDIC’s concept
In the days following the proposal, experts in compensation questioned, during interviews, the methodology, timing, and applicability of FDIC’s concept.
ABA believes that it is “entirely appropriate for examiners to review compensation for safety and soundness purposes,” said Sarah Miller, the association’s senior vice-president, Center for Securities, Trust, and Investments. However, linking compensation directly to deposit insurance assessments would be a bad policy, said Miller, who has handled many of the compensation issues facing banks in the current period.
“If the goal is to focus on risk behavior, let’s go after the bad behavior, and not the plans that may or may not incent that behavior,” said Miller.
Miller also said ABA finds the FDIC’s timing for such a proposal “premature.”
“You’ve got Congress looking at compensation, as well,” in the financial reform debate, Miller said. H.R. 4173, the House-passed version of the reform legislation, requires the federal regulators to jointly issue rules addressing bank compensation plans.
Miller said that the association agreed with points made by Comptroller of the Currency John Dugan, and Acting OTS Director John Bowman, in their opposition to the proposal.
Dugan, beyond indicating his feeling that the action was premature, thought FDIC should hold back in favor of the Federal Reserve Board’s outstanding proposal. “We should wait until we have the results of the Board’s efforts before heading down a path that could be both unnecessary and inconsistent,” said Dugan.
Bowman stated that he believed that the Fed’s approach, once refined, might be turned into an interagency approach.
(As proposed, the Fed’s concept would cover bank holding companies and state member banks, among the community bank fraternity. While it would apply to bank holding companies and not to officers of subsidiary bank holding companies, unless they are employed by state member banks, many such officers are dual employees of holding company and bank, so they would be covered, in that sense. FDIC’s concept would cover all insured banks and thrifts. To read past online coverage of the Fed proposal, click here for Part 1 and here for Part 2. To read ABA’s Nov. 25, 2009, comment letter on the Fed proposal, click here. For a podcast concerning the Fed proposal, click here.)

Basics of FDIC’s concept
“Compensation has become a lightning rod for the financial crisis, but the financial crisis’ roots goes beyond compensation in my opinion,” said Susan O’Donnell, managing director at Pearl Meyer & Partners, a leading compensation consulting firm. (O’Donnell will be a featured speaker in the March 11 ABA telephone briefing about compensation issues mentioned above. For a program description, click here.)
“Most of my bank clients are either in a state of panic about this, or are trying to put processes in place without really knowing exactly what they have to do or what the regulators are going to ask for,” O’Donnell added, reflecting on the mass of concern over pending legislation, the Fed proposal, and the FDIC announcement. “Everybody is looking to at least get started on it so that they have some response if a regulator happens to be conducting their review, even though no regs are finalized.” Examiners have long been permitted to review compensation programs.
The FDIC’s notice includes a proposed compensation model, for discussion purposes. It consists of three main elements. The concept is that having compensation programs toe this line would be “voluntary,” but that insurance assessments would be adjusted based on meeting or not meeting the three factors. The three elements:
Pay in restricted stock. A significant portion of compensation for employees whose activities can present significant risk to the bank would be paid in restricted, non-discounted stock.
Clawbacks and vesting. Significant awards of company stock would only be vested over multi-year periods, subject to potential “clawback” to account for risks assumed in earlier periods.
Board oversight. The compensation program would be administered by independent directors with input from independent compensation experts.
FDIC noted that compensation programs were cited as a factor in 35% of the staff reports prepared last year in cases where failed banks caused losses to the Deposit Insurance Fund.
“FDIC does not seek to impose a ceiling on the level of compensation that institutions may pay their employees,” the proposal stated. “Rather, the criteria should focus on whether an employee compensation system is likely to be successful in aligning employee performance with the long-term interests of the firm and its stakeholders, including FDIC.” [Emphasis added.]
“As with many things, the government is throwing out a lot of ideas at once,” said Brian Dunn, president of McLagan, a subsidiary of AON Corp., and CEO of Global Compensation.

Compensation, governance experts assail concept
Experts find much to dislike about the FDIC notice and the framework it presents.
“I don’t think it’s appropriate for a third party to be setting compensation for a private organization,” said Prof. Charles Elson of the University of Delaware. He is director of the John L. Weinberg Center for Corporate Governance, there, and holder of the Edgar S. Woolard, Jr., Chair in Corporate Governance. A third-party, he continued, cannot know the internal workings of a company and thus can’t get it right.
“A bank is not a government agency,” said Elson.
“This would set a very bad precedent,” said ABA’s Sarah Miller (also a speaker in the ABA telephone briefing). She also challenges some of the claims FDIC made in its staff memorandum regarding research on incentive plans. (One point: “Studies almost universally find that poorly designed employee compensation programs provide incentives to take risks that can significantly and adversely affect a firm beyond a period when compensation is earned or awarded.”)
Compensation decisions and design belong in the private sector, and “it’s better done by a well-functioning board,” said Elson. What FDIC is proposing “is a pretty far-reaching move,” he added, without any parallel he knew of other than the actions of the federal “pay czar,” Kenneth Feinberg. Feinberg’s actions affected only a handful of very large institutions, while FDIC’s concept, as ventured, would be universal.
For Pearl Meyer’s Susan O’Donnell, the FDIC’s fixation on restricted stock as part of the “safe” structure is puzzling and problematic.
O’Donnell notes that a key element of the concept is compensation through restricted stock with multi-year vesting. The intent is to build in incentives to actions leading to long-term performance, rather than quick kills for short-term gain.
“A large portion of the banks covered by FDIC are not even stock banks and wouldn’t even have the capacity to provide a significant portion of compensation in stock,” said O’Donnell. “They could in the end decide to create some arrangements that otherwise focus on the long term. You can have cash long-term incentive plans. You can have phantom-stock plans. But again that’s putting a requirement on a compensation package that actually many smaller banks don’t have the capacity or even the cash to offer.”
Compensation programs are best when matched to corporate strategies, O’Donnell said, and many plans, in her experience, are not stock-based and yet don’t encourage excessive risk taking. Indeed, she said that balance among compensation forms and between short-term and long-term incentives marks a sound plan. As published, she said, the FDIC concept “is very, very TARPish.”
The flip side of not encouraging risky behavior in the short-term, added O’Donnell, is “sustainability of performance in the long-term. And you can get at that through many means.”

Stock is a limiting concept
ABA’s Sarah Miller points out that for some banking companies, a stock-based plan might be either awkward or impossible. Subchapter S banks, of which there are about 2,500, are restricted in several regards with their stock, for instance. And mutual savings banks don’t issue stock, although mutual holding companies do.
“This is one of those things where the devil is in the details,” said consultant Brian Dunn. FDIC’s suggested approach may cause some accounting headaches, he pointed out, because of the traditional methods used for accounting for shares.
Indeed, closer looks bring up more to deal with. Miller pointed out that banking companies covered by Sarbanes-Oxley have already had difficulties finding sufficient independent directors to meet that law’s requirements for Audit Committee service. Adding independence requirements to the Compensation Committee’s membership, as FDIC suggested, means yet further burden, according to Miller. BJ 
[This article was posted on January 28, 2010, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2010 by the American Bankers Association.] 
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