Notice of Proposed Rulemaking on Incentive-Based Compensation Arrangements

Introduction

The FDIC Board has approved a Notice of Proposed Rulemaking to implement Section 956 of the Dodd Frank Act1, which addresses an important lesson from the Global Financial Crisis of 2008: poorly designed financial institution compensation programs can provide incentives for short-term risk taking that can jeopardize the safety and soundness of the institution.  This is a re-proposal of an NPR that was issued by the FDIC in 2016.

Material Loss Reviews of failed institutions issued by the Inspectors General for the three federal banking agencies between 2007-2010 found that, in a number of instances, poor compensation practices were a contributing factor to the institution’s failure.2 In addition, reports concerning the 2023 bank failures of Silicon Valley Bank, Signature Bank of New York, and First Republic Bank in Spring 2023 identified common weaknesses that included an excessive focus on growth and short-term profitability, and a lack of risk metrics in compensation policies and practices that may have encouraged excessive risk taking.3 When poor compensation practices involve the largest financial institutions, the negative impacts of inappropriate risk-taking can have broader consequences for the financial system. 

The Dodd-Frank Act requires six agencies -- the FDIC, OCC, Federal Reserve Board, FHFA, NCUA, and SEC -- to issue jointly regulations or guidelines that prohibit incentive-based compensation arrangements that encourage inappropriate risks by covered financial institutions with assets of $1 billion or more: 

• by providing an executive officer, employee, director, or principal shareholder with excessive compensation, fees, or benefits; or 
• that could lead to material financial loss at the institution. 

Covered financial institutions are also required to disclose to the appropriate Federal regulator the structure of incentive-based compensation arrangements.

Overview of the Proposed Rule 

Two prior efforts preceded the current proposal. In April 2011, the FDIC, FRB, OCC, NCUA, FHFA, and SEC jointly published a notice of proposed rulemaking to implement Section 956.4  In June 2016, those Agencies published a second NPR to implement section 956 and received over 100 comments, which the agencies have reviewed and continue to consider.5

Given the passage of time, additional supervisory experience, changes in industry practices, and other developments, the FDIC Board is re-proposing the rule text previously proposed in June 2016 to implement section 956.  The proposal, along with proposed alternatives and questions in the preamble, seeks to align employee incentives with the long-term interests and safety and soundness of covered financial institutions.  Since issuing the June 2016 proposal, the FDIC and other agencies have continued to address incentive-based compensation practices at supervised institutions.  Despite these supervisory efforts and other regulatory developments, however, the mandate under section 956 to prohibit any types or features of incentive-based compensation arrangements that encourage inappropriate risks to re-enforce those efforts is clear.  The Agencies are proposing to meet that mandate under this proposal by applying a consistent set of enforceable standards to covered institutions.

The proposal uses a tiered approach with three size categories of covered institutions: Level 1, with $250 billion or more in total assets; Level 2, with $50 to $250 billion; and Level 3, with $1 to $50 billion.  This approach would tailor the applicability of the proposed rule to the size and complexity of covered institutions.

All covered institutions would be subject to a general set of requirements and prohibitions, and more stringent provisions would apply to the two categories of larger institutions.  For all covered institutions, the proposal would prohibit incentive-based compensation that encourages inappropriate risks by providing compensation that is excessive or could lead to material financial loss. Incentive-based compensation would be required to meet three key principles, which are to appropriately balance risk and financial rewards, be compatible with effective risk management and controls, and be supported by strong corporate governance.  The proposed rule would require recordkeeping and disclosure to the institution’s primary federal regulator.

In regard to the larger institutions, this proposal would require minimum deferral amounts and time periods for incentive-based compensation arrangements for senior executive officers and other employees who can expose the institution to material levels of risk, known as significant risk-takers. Deferral provides an important mechanism to discourage inappropriate risk-taking by allowing time to pass to evaluate the outcomes of risk-taking behavior and to adjust incentive-based compensation accordingly. Level 1 and Level 2 institutions would be required to defer between 40 to 60 percent of incentive-based compensation for periods ranging from one to four years, depending on the type of incentive-based compensation arrangement, the size of the covered institution, and whether the covered person is a senior executive officer or a significant risk-taker.

The proposal also requires those deferred amounts to be considered for forfeiture and downward adjustment and clawback, in the event of undue risk taking as defined in the firm’s program and other factors as described in the proposal. 

Additionally, based on experiences in reviewing and supervising incentive-based compensation at some institutions, the proposal seeks public comment on potential alternative regulatory provisions to the proposed rule text discussed in the preamble.  Included among these alternative provisions are (i) establishing a two-tiered asset threshold structure rather than a three-tiered structure; (ii) simplifying the definition of significant risk-taker; and (iii) limiting the discretion of a larger covered institution to seek to recover incentive-based compensation by requiring, rather than mandating consideration of, forfeiture, downward adjustment, and clawback of incentive-based compensation when misconduct results in significant financial or reputational harm to the covered institution.

Conclusion

This proposal includes the FDIC, OCC, FHFA, and NCUA. However, all six agencies will continue to coordinate on implementing section 956.  This is perhaps the most important Dodd-Frank rulemaking remaining to be implemented, and I strongly support the proposed rule. 

The FDIC seeks comment on all aspects of the rule, including the potential alternative provisions discussed in the preamble. The FDIC is making this proposal available on the FDIC’s website, will accept comments at IncentiveCompProposal2024@fdic.gov, and will post comments on the “Public Comments to the FDIC” webpage. Once the proposal is adopted by all six agencies, it will be published in the Federal Register with a comment period of 60 days following publication.

In conclusion, I would like to thank FDIC staff, as well as the staff at the other agencies, for their dedication and commitment to completing this proposed rulemaking.

• 1

  Pub. L. 111-203, 124 Stat. 1376 (2010), codified at 12 USC 5641.

• 2

  Material Loss Reviews relating to the failure of an FDIC-supervised institution issued by the FDIC Office of Inspector General may be found at https://www.fdicoig.gov. MLRs relating to the failure of a FRB-supervised institution issued by the Federal Reserve Board Office of Inspector General may be found at https://oig.federalreserve.gov. MLRs relating to the failure of an OCC-supervised institution issued by the Treasury Department Office of Inspector General may be found at https://oig.treasury.gov.

• 3

  Id.

• 4

  76 FR 211 70 (April 14, 2011).

• 5

  81 FR 37673 (June 10, 2016).