Federal Reserve Incentive Compensation Initiative Mark Carey Federal Reserve Board January 2012 This presentation and my remarks represent my own opinions, not those of the Board of Governors or the Federal Reserve System. 1

Fed’s Compensation Initiative Change banks’ employee compensation practices – Limit incentives to take imprudent risks – All employees who take or influence risk, not just senior executives (typically 1000s at large banks) Not level of pay, but pay practices related to risk- taking incentives Via supervisory reviews, using safety-and- soundness authority Principles-based, not fomulaic All banking organizations, but so far mainly large 2

Suggested Takeaways Risk works differently at financial firms, so incentives should too Almost everything the Fed is doing appears compatible with traditional shareholder views – No-upside LTIPs might be an exception Shareholders must still be attentive – Prudential regulator Evidence of change mostly down in the weeds 3

Timeline Commenced late summer 2009 Supervisory guidance Oct 2009 (for comment) – Written description of sound practices Major supervisory exercise commenced Nov 2009 – Iterative process still ongoing…banks submit plans, supervisors review and react, new plan submitted, etc. – Migrating to normal supervisory process 4

Which Banks So Far? 16 domestic, 9 foreign with major ops in US JPMC Citi BAC GS MS StateStreet BNYM Wells USB PNC Suntrust NorthernTrust Ally/GMAC, CapOne, Amex, Discover RBC; RBS Barclays HSBC; UBS CS; DB; Socgen BNPP Now rolling out to next tier of domestic banks 5

Financial Firms Are Different Take as given that higher earnings tend to be rewarded with higher bonuses Simplified nonfinancial firm: – Risk-taking via investment that takes time to fruition – Reduces earnings in short run, increases later – Must incentivize risk-taking, esp. by senior execs Financial firm – More risk now means more revenue now, losses later – Higher cash bonus, without regard to risks-taken, may incentivize imprudent risk-taking – At large firms, risk-taking decisions are delegated and diffuse, and control systems are imperfect and subject to distortion 6

Pre-crisis The archetype: An individual: – With a bonus driven by short-run profit-and-loss (P&L) – the P&L may not reflect all risk outcomes, even in short run – Who puts on significant long-term risk, esp. tail risk – Who puts pressure on controls and risk management – Containment only by controls, limits, etc. is like driving with both the gas and brake pedals down 7

Three Principles Balanced risk-taking incentives: Provide employees with incentives that do not encourage imprudent risk-taking. Be compatible with effective controls and risk management Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors for lots of employees, not just NEOs 8

What is the Fed not doing? Not the level of pay. Not a backdoor way of dictating risk appetite. Not reviewing or approving individual pay packages. Focus is on the pay system. Not dictating the structure of pay. Diversity is essential. – Firms, and employees within firms, differ in the types and extent of risks taken, and in other ways. – Firms should fix it. Not backward-looking. Fix it going forward. 9

What was wrong with pre-crisis methods? Risk-taking largely ignored in the pay process Mechanically, no targeted way to cut pay in response to poor risk outcomes Bonus awards must incentivize performance-year activity, and retention is an issue. So awards not reduced for legacy loss realizations…awards stay high after the crash. Vesting of deferred pay was conditional only on employment. Exposure was only via the stock price. But most employees don’t think their decisions impact the stock price And stock ownership offers both upside and downside Limited shareholder attention below the NEOs Mistake. Controls are never perfect, incentives matter 10

How to do it: Main “balancing” methods Upfront risk adjustment Performance based deferral (Pay structure is not the only thing that drives the relationship between risks-taken and pay- delivered) 11

Upfront risk adjustments to bonuses Formulaic way – Measure the risks taken during the performance year and subtract a risk charge from P&L Example: $10 economic capital allocated to $100 loan, 15% required cost of capital…subtract 150bps from spread – Pro: Predictable, consistent – Con: Caveat capture all risk taking Judgmental way – Assess risks taken and judgmentally adjust P&L or bonus – Pro: Flexible, inclusive – Con: Hard to get consistency Do both 12

Deferral If employees get paid whole bonus in cash upfront, risk-taking incentives are strong due to limited future exposure Deferring a fraction helps, but by itself is not enough – In cash: exposed only to failure – In stock: yes downside exposure, but upside exposure works to offset 13

Vesting Should Depend on Performance “Malus” versus “clawback” Forfeit unvested for very bad outcomes, not ordinary P&L blips NOT the same as a typical LTIP – Most incentivize high financial performance – Typically offers upside as well as downside based on ROE or another measure – Relative measures: Lake Woebegone effect – LTIP structure OK, but Fed actively discouraging setups with upside and relative measures alone 14

Fraction deferred Material, but high fraction is not a panacea Example of EU formula – 60% deferred Half in stock (with what malus? Just failure?) Half in cash (with what malus? Just failure? Not really much exposure in most setups) – 40% upfront Half in stock with 6-12 month retention – Not much time for news to arrive Half in cash…that must be used to pay taxes? – Overall: delay, but only 30% really exposed 15

Vesting Triggers Formulaic way Trigger + Judgmental process way Triggers should be customized to the employee’s business – Not just for senior executives 16

Six-step program 1)Which employees take material risk? 2)What risks does each take (not forgetting tail), with what time horizons? 3)Do performance measures capture risk and risk outcomes? How much of a gap? 4)Design and implement risk adjustments, deferral arrangements, etc. if needed. 5)Tell the employees how it works. 6)Track awards, payments, risk, and risk outcomes, analyze them, and improve over time. 17

Some Parts Are Unfamiliar to Compensation Community Not used to systematic, holistic thinking about risk…involvement of risk professionals essential Financial firms are fundamentally different from nonfinancial firms Deferred compensation, LTIPs, some other structures are not enough, or even may harm Much of what the Fed is doing appears to be in the shareholders interest…but we are focused on the public interest Good news: It’s doable, with patience and dialog 18

Challenges Get the idea across…new, different Get the right people to work together and pay attention Getting past fears it’s politically motivated – It’s not. Technical. Complement risk management. International differences – Some European initiatives have a different focus 19

Fed’s Next Steps Mainly, keep it up – Changing systems takes time. Keep the pressure on – Roll out to next tiers of banks Dodd Frank 956 Rule – Core is similar to the supervisory guidance…a non- event for big banks – Gives SEC authority for investment managers, broker dealers 20