What you need to know about Dodd-Frank and incentive compensation

How you can mitigate your organization's risk

Portfolio Marketing Manager, IBM

We tend to think incentive compensation management (ICM) is just all about paying sales reps. But in an era of increasing regulation in many industries, it can become a key element in ensuring regulatory compliance.

This role for ICM became especially apparent recently when several federal agencies—consistent with their obligations under the Dodd-Frank Act—proposed a new joint rule on financial institution incentive compensation. Intended to prevent using incentive compensation to encourage unnecessary risk, this rule’s significance—as suggested in a comprehensive overview of it in The National Law Review—is the possibility it signals “the future of incentive compensation rules for other industries.”

The proposed rule and who it covers

The proposed rule bars covered financial institutions from creating or maintaining incentive compensation plans that encourage inappropriate risk by the institution. Right now, covered financial institutions are defined as those with over $1 billion in total consolidated assets. In general, broker-dealers, credit unions, depository institutions and investment advisors fall into this category, and based on asset size the requirements become increasingly stricter. While not all companies are covered by this proposal, keep in mind that although the proposed rule only applies to covered financial institutions today, it could be a sign of future rules for other industries and institutions later.

Two key determinants of whether incentive compensation is leading to inappropriate risk exist in the proposed rule: that an individual is provided excessive compensation, or that incentive compensation could lead to material losses for the covered institution. Many factors need to be considered when determining if an individual’s compensation is excessive, but you can ask yourself these questions as a starting point: 

  • When you look at the total amount of compensation paid to individuals, is the compensation aligned to their performance?
  • What is the financial condition of the institution?
  • When you look at compensation of comparable institutions and comparable individuals, how does the individual’s compensation compare?
  • What’s the projected total cost of post-employment benefits?
  • Does any connection exist between the individual and any insider abuse, act of fraud or breach of trust? 

And when it comes to the risk of material financial loss, organizations should also make several other considerations: 

  • Whether the incentive compensation will encourage risk that could result in significant financial loss to the institution
  • Whether the financial risk is balanced with the potential reward
  • Whether it is aligned with risk management and controls
  • Whether it is supported by effective governance

The possible extended reach of the joint rule

The proposed rule is intricate and detailed, and covers only specific institutions. However, as observers note, this rule may eventually extend into other industries given that the basic principles of a sound incentive compensation policy can apply to diverse industries and institutions. Obviously, the proposed rule is especially significant to complex financial organizations, but the concerns over excessive compensation and associated financial risk are worth considering when implementing incentive compensation programs—even in institutions that aren’t currently covered under this proposal.

Learn more about ICM in the flipbook, Transform Compensation Management to Boost Results and Mitigate Risk in Banking, and how it helps organizations mitigate risk and ensure regulatory compliance. Also see the video, How Zions Leverages Watson Analytics and Incentive Compensation Management, to learn how one bank is using ICM and cognitive analytics to manage risk.

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