Dodd-Frank Act Two-Year Anniversary
Seven takeaways on Dodd-Frank’s impact on compensation
As we approach the two-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), it’s worth pausing for a moment to take stock of how it has already influenced the financial services and banking industries, and what may lie ahead. Today, its full impact remains to be seen – financial services institutions are still grappling with the enormity and complexity of the 2,300-page law. And regulators from numerous federal agencies are still writing many of the rules that will affect different corners of the industry, which may contribute to uncertainty.
At the same time, after two years its impact has become clearer. For example, across the compensation landscape – from executives to producers, such as mortgage originators, commercial lenders, etc. – Dodd-Frank requires institutions to show that their incentive arrangements are consistently safe and sound and do not encourage employees to expose their firms to imprudent risk. The guidelines that have been issued are having a deep impact for many institutions, affecting such areas as overarching talent strategies and compensation practices to risk and auditing systems and more.
For banking executives working to understand where they should be focusing when it comes to compensation issues in the age of Dodd-Frank, here are seven important observations.
New incentive compensation guidelines may affect how you retain and attract talent
Financial institutions are being required to change how their employees receive incentive-based compensation, so that it reflects results over longer performance periods when unexpected risks or losses may surface. Previously, certain employees would receive incentive compensation – based on short-term results like revenue or growth – for decisions that could have placed their firms at imprudent risk down the road. Under the new landscape, significant components of incentive compensation are required to be risk adjusted, or deferred, and balanced based on inherent risks. Compensation could be clawed back if decisions that employees make today lead to big losses later on. Many of the institution’s employees are covered by these provisions, not just the executive level. With increased regulatory oversight of incentive compensation and employee incentive pay at risk for longer periods, banks may have a harder time attracting and retaining talent compared with other industries, such as technology or nonbank financial markets. These industries may offer more immediate incentive pay and less risk adjustment.
Clawbacks and forfeitures are new features
Financial institutions can use clawbacks and forfeitures during deferral periods to recover pay from employees who expose firms to imprudent risks. These policies and practices could also affect employee hiring and retention for many banks. It’s not just executives, traders, or commercial lenders who might be on the hook, but also many other employees. In fact, Section 956 of Dodd-Frank extends oversight to anyone paid an incentive for performance – and that is likely 25,000 or more people at large banks.1
Banks will likely need to balance risk versus reward when it comes to compensation
Financial institutions may have to identify and develop metrics that balance risks with sales or revenue goals – and then base incentive compensation programs on these metrics. Previously, many institutions paid compensation largely based on meeting revenue goals and may have paid little attention to associated risks. Regulators want firms to take a more balanced approach to prevent banking executives and other employees from taking imprudent risks. Regulators have also been given more leeway in using regulatory actions, consent orders, and tougher strategies to curb compensation practices that could encourage risk taking. Banks will likely need to spell out how compensation metrics will include penalties – such as forfeitures, clawbacks, or other deterrents – to demonstrate that such metrics do balance revenue generation with risk avoidance. Some risks to consider are credit, market, liquidity, operational, legal, compliance, and reputational.
Risk management processes and controls are needed
Governance should consider risk management processes and controls (internal audit) in the design and implementation of incentive compensation plans to assess that risk is properly considered and monitored. Previously, risk was rarely considered in the program design. In addition, boards of directors, armed with greater data about incentive compensation, are encouraged to take a more active role in overseeing compensation arrangements and related control processes.
The rules have yet to be finalized.
Over the years, federal banking agencies issued guidance to address incentive arrangements. Picking up where the guidance left off, Dodd-Frank included a provision that instructed agencies to issue rules or guidelines on incentive compensation. Although proposed more than a year ago,2 they have not been finalized. Federal regulators are still investigating the different compensation strategies and approaches that institutions are employing. Regulators are also evaluating compensation programs to find balanced approaches between risk mitigation and revenue generation. As a result, it may be difficult for institutions to navigate the uncertain regulatory environment.
Banks should consider upgrading IT systems to better manage compensation arrangements and concerns
Technology system upgrades can help financial institutions provide an integrated incentive compensation management platform across their organizations. This can help them meet regulatory reporting requirements, provide a platform to design compensation plans that support efforts around revenue growth, and also address problems, such as compensation overpayments and payment inaccuracies.
Regulatory risk programs continue to operate with significant uncertainty
Financial institutions are concerned about developing and implementing risk programs tied to compensation plans without knowing how federal regulators will view them and how it may affect their ability to attract and retain employees. For instance, many banks are developing lists of covered employees with risk profiles and establishing balanced metrics and risk adjustments at the macro, organizational level and moving down to specific compensation plans for specific positions (like mortgage originators) But regulators have yet to adopt a final rule to provide details at that specific level, which is causing some concern among banks that must comply by the end of 2012.
Because there’s a lot more to know about the Dodd-Frank Act, these takeaways are presented as part of a series of issue-focused insights into the impact of this legislation. In the coming days, Deloitte will release a more in-depth look at the law’s potential implications in other areas such as consumer protection, derivatives, the Volcker rule, and living wills. For more information, please visit us at Financial Regulatory Reform.
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1 Alberti, Merritt and Dicks, Robert, “Dodd-Frank Demands a Broader View of Compensation,” American Banker, May 22, 2012.
2 Federal Register, Vol. 76, No. 72, April 14, 2011, pp. 21170-21219.
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