commercial bank examination manual, section 4000 · commercial lending company in the united...

Section 4000.1

[Reserved]

Commercial Bank Examination Manual March 1994Page 1

Sound Incentive Compensation PoliciesEffective date October 2010 Section 4008.1

Incentive compensation practices in the finan-cial industry were one of many factors thatcontributed to the financial crisis that began inmid-2007. Banking organizations too oftenrewarded employees for increasing theorganization’s revenue or short-term profitwithout adequate recognition of the risks theemployees’ activities posed to the organiza-tion.1 These practices exacerbated the risks andlosses at a number of banking organizations andresulted in the misalignment of the interests ofemployees with the long-term well-being andsafety and soundness of their organizations.This section provides guidance on sound incen-tive compensation practices to bankingorganizations supervised by the Federal Reserve(also the Office of the Comptroller of the Cur-rency, the Federal Deposit Insurance Corpora-tion, and the Office of Thrift Supervision (col-lectively, the ‘‘Agencies’’)).2 This guidance isintended to assist banking organizations indesigning and implementing incentivecompensation arrangements and related poli-cies and procedures that effectively considerpotential risks and risk outcomes.3

Alignment of incentives provided to employ-ees with the interests of shareholders of theorganization often also benefits safety and sound-ness. However, aligning employee incentiveswith the interests of shareholders is not alwayssufficient to address safety-and-soundness con-cerns. Because of the presence of the federalsafety net (including the ability of insured deposi-tory institutions to raise insured deposits andaccess the discount window and payment ser-

vices of the Federal Reserve), shareholders of abanking organization in some cases may bewilling to tolerate a degree of risk that isinconsistent with the organization’s safety andsoundness. Accordingly, the Federal Reserveexpects banking organizations to maintain incen-tive compensation practices that are consistentwith safety and soundness, even when thesepractices go beyond those needed to align share-holder and employee interests.

To be consistent with safety and soundness,incentive compensation arrangements4 at a bank-ing organization should:

1. Provide employees incentives that appropri-ately balance risk and reward;

2. Be compatible with effective controls andrisk-management; and

3. Be supported by strong corporate gover-nance, including active and effective over-sight by the organization’s board of directors.

These principles, and the types of policies,procedures, and systems that banking organiza-tions should have to help ensure compliance withthem, are discussed later in this guidance.

The Federal Reserve expects banking organi-zations to regularly review their incentive com-pensation arrangements for all executive andnon-executive employees who, either individu-ally or as part of a group, have the ability toexpose the organization to material amounts ofrisk, as well as to regularly review the risk-management, control, and corporate governanceprocesses related to these arrangements. Bank-ing organizations should immediately addressany identified deficiencies in these arrangementsor processes that are inconsistent with safety andsoundness. Banking organizations are respon-sible for ensuring that their incentive compen-sation arrangements are consistent with the prin-

1. Examples of risks that may present a threat to theorganization’s safety and soundness include credit, market,liquidity, operational, legal, compliance, and reputationalrisks.

2. As used in this guidance, the term ‘‘banking organiza-tion’’ includes national banks, state member banks, statenonmember banks, savings associations, U.S. bank holdingcompanies, savings and loan holding companies, Edge andagreement corporations, and the U.S. operations of foreignbanking organizations (FBOs) with a branch, agency, orcommercial lending company in the United States. If theFederal Reserve is referenced, the reference is intended to alsoinclude the other supervisory Agencies.

3. This guidance (see 75 Fed. Reg. 36395, June 25, 2010,for the entire text) and the principles reflected herein areconsistent with the Principles for Sound Compensation Prac-tices issued by the Financial Stability Board (FSB) in April2009, and with the FSB’s Implementation Standards for thoseprinciples, issued in September 2009.

4. In this guidance, the term ‘‘incentive compensation’’refers to that portion of an employee’s current or potentialcompensation that is tied to achievement of one or morespecific metrics (e.g., a level of sales, revenue, or income).Incentive compensation does not include compensation that isawarded solely for, and the payment of which is solely tied to,continued employment (e.g., salary). In addition, the termdoes not include compensation arrangements that are deter-mined based solely on the employee’s level of compensationand does not vary based on one or more performance metrics(e.g., a 401(k) plan under which the organization contributesa set percentage of an employee’s salary).

Commercial Bank Examination Manual October 2010Page 1

ciples described in this guidance and that theydo not encourage employees to expose theorganization to imprudent risks that may posea threat to the safety and soundness ofthe organization.

The Federal Reserve recognizes that incentivecompensation arrangements often seek to serveseveral important and worthy objectives. Forexample, incentive compensation arrangementsmay be used to help attract skilled staff, inducebetter organization-wide and employee perfor-mance, promote employee retention, provideretirement security to employees, or allow com-pensation expenses to vary with revenue on anorganization-wide basis. Moreover, the analysisand methods for ensuring that incentive com-pensation arrangements take appropriate accountof risk should be tailored to the size, complexity,business strategy, and risk tolerance of eachorganization. The resources required will dependupon the complexity of the firm and its use ofincentive compensation arrangements. For some,the task of designing and implementing compen-sation arrangements that properly offer incen-tives for executive and non-executive employ-ees to pursue the organization’s long-term well-being and that do not encourage imprudentrisk-taking is a complex task that will requirethe commitment of adequate resources.

While issues related to designing and imple-menting incentive compensation arrangementsare complex, the Federal Reserve is committedto ensuring that banking organizations moveforward in incorporating the principles describedin this guidance into their incentive compensa-tion practices.5

As discussed further below, because of thesize and complexity of their operations, largecomplex banking organizations (LCBOs)6 should

have and adhere to systematic and formalizedpolicies, procedures, and processes. These areconsidered important in ensuring that incentivecompensation arrangements for all coveredemployees are identified and reviewed by appro-priate levels of management (including the boardof directors where appropriate and control units),and that they appropriately balance risks andrewards. In several places, this guidance specifi-cally highlights the types of policies, proce-dures, and systems that LCBOs should have andmaintain but that generally are not expected ofsmaller, less complex organizations. LCBOswarrant the most intensive supervisory attentionbecause they are significant users of incentivecompensation arrangements and because flawedapproaches at these organizations are more likelyto have adverse effects on the broader financialsystem. The Federal Reserve will work withLCBOs as necessary through the supervisoryprocess to ensure that they promptly correct anydeficiencies that may be inconsistent with thesafety and soundness of the organization.

The policies, procedures, and systems ofsmaller banking organizations that use incentivecompensation arrangements7 are expected to beless extensive, formalized, and detailed thanthose of LCBOs. Supervisory reviews of incen-tive compensation arrangements at smaller, less-complex banking organizations will be con-ducted by the Federal Reserve as part of theevaluation of those organizations’ risk-management, internal controls, and corporategovernance during the regular, risk-focusedexamination process. These reviews will betailored to reflect the scope and complexity of anorganization’s activities, as well as the preva-lence and scope of its incentive compensationarrangements. Little, if any, additional examina-tion work is expected for smaller banking orga-nizations that do not use, to a significant extent,incentive compensation arrangements.8

5. In December 2009, the Federal Reserve, working withthe other Agencies, initiated a special horizontal review ofincentive compensation arrangements and related risk-management, control, and corporate governance practices oflarge banking organizations (LBOs). This initiative wasdesigned to spur and monitor the industry’s progress towardsthe implementation of safe and sound incentive compensationarrangements, identify emerging best practices, and advancethe state of practice more generally in the industry.

6. For supervisory purposes, the Federal Reserve (as wellas the other federal bank regulatory agencies) segments theorganizations it supervises into different supervisory port-folios based on, among other things, size, complexity, and riskprofile. For purposes of this guidance, the LBOs referred to inthe guidance are identified in this section as large complexbanking organizations to be consistent with the FederalReserve’s other supervisory policies. LBOs are designated by(1) the OCC as the largest and most complex national banks

as defined in the Large Bank Supervision booklet of theComptroller’s Handbook; (2) the FDIC, large, complex insureddepository institutions (IDIs); and (3) the OTS, the largest andmost complex savings associations and savings and loanholding companies.

7. This guidance does not apply to banking organizationsthat do not use incentive compensation.

8. To facilitate these reviews, where appropriate, a smallerbanking organization should review its compensation arrange-ments to determine whether it uses incentive compensationarrangements to a significant extent in its business operations.A smaller banking organization will not be considered asignificant user of incentive compensation arrangements sim-ply because the organization has a firm-wide profit-sharing or

4008.1 Sound Incentive Compensation Policies

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For all banking organizations, supervisoryfindings related to incentive compensation willbe communicated to the organization andincluded in the relevant report of examination orinspection. In addition, these findings will beincorporated, as appropriate, into the organiza-tion’s rating component(s) and subcomponent(s)relating to risk-management, internal controls,and corporate governance under the relevantsupervisory rating system, as well as the orga-nization’s overall supervisory rating.

The Federal Reserve (or the organization’sappropriate federal supervisor) may take enforce-ment action against a banking organization if itsincentive compensation arrangements or relatedrisk-management, control, or governance pro-cesses pose a risk to the safety and soundness ofthe organization, particularly when the organi-zation is not taking prompt and effective mea-sures to correct the deficiencies. For example,the appropriate federal supervisor may take anenforcement action if material deficiencies arefound to exist in the organization’s incentivecompensation arrangements or related risk-management, control, or governance processes,or the organization fails to promptly develop,submit, or adhere to an effective plan designedto ensure that its incentive compensation arrange-ments do not encourage imprudent risk-takingand are consistent with principles of safety andsoundness. As provided under section 8 of theFederal Deposit Insurance Act (12 U.S.C. 1818),an enforcement action may, among other things,require an organization to take affirmative action,such as developing a corrective action plan thatis acceptable to the appropriate federal supervi-sor to rectify safety-and-soundness deficienciesin its incentive compensation arrangements orrelated processes. Where warranted, the appro-priate federal supervisor may require the orga-nization to take additional affirmative action tocorrect or remedy deficiencies related to theorganization’s incentive compensation practices.

Effective and balanced incentive compensa-tion practices are likely to evolve significantly inthe coming years, spurred by the efforts ofbanking organizations, supervisors, and otherstakeholders. The Federal Reserve will reviewand update this guidance as appropriate to incor-porate best practices that emerge from theseefforts.

SCOPE OF APPLICATION

The incentive compensation arrangements andrelated policies and procedures of banking orga-nizations should be consistent with principles ofsafety and soundness.9 Incentive compensationarrangements for executive officers as well asfor non-executive personnel who have the abil-ity to expose a banking organization to materialamounts of risk may, if not properly structured,pose a threat to the organization’s safety andsoundness. Accordingly, this guidance applies toincentive compensation arrangements for:

1. Senior executives and others who are respon-sible for oversight of the organization’s firm-wide activities or material business lines;10

2. Individual employees, including non-executive employees, whose activities mayexpose the organization to material amountsof risk (e.g., traders with large position limitsrelative to the organization’s overall risktolerance); and

3. Groups of employees who are subject to thesame or similar incentive compensationarrangements and who, in the aggregate, mayexpose the organization to material amountsof risk, even if no individual employee islikely to expose the organization to materialrisk (e.g., loan officers who, as a group,originate loans that account for a materialamount of the organization’s credit risk).

For ease of reference, these executive andnon-executive employees are collectively re-ferred to hereafter as ‘‘covered employees’’ or‘‘employees.’’ Depending on the facts and cir-cumstances of the individual organization, the

bonus plan that is based on the bank’s profitability, even if theplan covers all or most of the organization’s employees.

9. In the case of the U.S. operations of FBOs, the organi-zation’s policies, including management, review, and approvalrequirements for its U.S. operations, should be coordinatedwith the FBO’s group-wide policies developed in accordancewith the rules of the FBO’s home country supervisor. Thepolicies of the FBO’s U.S. operations should also be consis-tent with the FBO’s overall corporate and managementstructure, as well as its framework for risk-management andinternal controls. In addition, the policies for the U.S. opera-tions of FBOs should be consistent with this guidance.

10. Senior executives include, at a minimum, ‘‘executiveofficers’’ within the meaning of the Federal Reserve’s Regu-lation O (see 12 CFR 215.2(e)(1)) and, for publicly tradedcompanies, ‘‘named officers’’ within the meaning of theSecurities and Exchange Commission’s rules on disclosure ofexecutive compensation (see 17 CFR 229.402(a)(3)). Savingsassociations should also refer to the OTS’s rule on loans bysavings associations to their executive officers, directors, andprincipal shareholders. (12 CFR 563.43).

Sound Incentive Compensation Policies 4008.1


types of employees or categories of employeesthat are outside the scope of this guidancebecause they do not have the ability to exposethe organization to material risks would likelyinclude, for example, tellers, bookkeepers, cou-riers, or data processing personnel.

In determining whether an employee, or groupof employees, may expose a banking organiza-tion to material risk, the organization shouldconsider the full range of inherent risks arisingfrom, or generated by, the employee’s activities,even if the organization uses risk-managementprocesses or controls to limit the risks suchactivities ultimately may pose to the organiza-tion. Moreover, risks should be considered to bematerial for purposes of this guidance if they arematerial to the organization, or are material to abusiness line or operating unit that is itselfmaterial to the organization.11

For purposes of illustration, assume that abanking organization has a structured-financeunit that is material to the organization. A groupof employees within that unit who originatestructured-finance transactions that may exposethe unit to material risks should be considered‘‘covered employees’’ for purposes of this guid-ance even if those transactions must be approvedby an independent risk function prior to con-summation, or the organization uses other pro-cesses or methods to limit the risk that suchtransactions may present to the organization.

Strong and effective risk-management andinternal control functions are critical to thesafety and soundness of banking organizations.However, irrespective of the quality of thesefunctions, poorly designed or managed incen-tive compensation arrangements can themselvesbe a source of risk to a banking organization.For example, incentive compensation arrange-ments that provide employees strong incentivesto increase the organization’s short-term rev-enues or profits, without regard to the short- orlong-term risk associated with such business,can place substantial strain on the risk-management and internal control functions ofeven well-managed organizations.

Moreover, poorly balanced incentive compen-sation arrangements can encourage employeesto take affirmative actions to weaken or circum-vent the organization’s risk-management or inter-nal control functions, such as by providing

inaccurate or incomplete information to thesefunctions, to boost the employee’s personalcompensation. Accordingly, sound compensa-tion practices are an integral part of strongrisk-management and internal control functions.A key goal of this guidance is to encouragebanking organizations to incorporate the risksrelated to incentive compensation into theirbroader risk-management framework. Risk-management procedures and risk controls thatordinarily limit risk-taking do not obviate theneed for incentive compensation arrangementsto properly balance risk-taking incentives.

PRINCIPLES OF A SOUNDINCENTIVE COMPENSATIONSYSTEM

Principle 1: Balanced Risk-TakingIncentives

Incentive compensation arrangements shouldbalance risk and financial results in a mannerthat does not encourage employees to exposetheir organizations to imprudent risks.

Incentive compensation arrangements typicallyattempt to encourage actions that result in greaterrevenue or profit for the organization. However,short-run revenue or profit can often divergesharply from actual long-run profit because riskoutcomes may become clear only over time.Activities that carry higher risk typically yieldhigher short-term revenue, and an employeewho is given incentives to increase short-termrevenue or profit, without regard to risk, willnaturally be attracted to opportunities to exposethe organization to more risk.

An incentive compensation arrangement isbalanced when the amounts paid to an employeeappropriately take into account the risks (includ-ing compliance risks), as well as the financialbenefits, from the employee’s activities and theimpact of those activities on the organization’ssafety and soundness. As an example, under abalanced incentive compensation arrangement,two employees who generate the same amountof short-term revenue or profit for an organiza-tion should not receive the same amount ofincentive compensation if the risks taken by theemployees in generating that revenue or profitdiffer materially. The employee whose activitiescreate materially larger risks for the organiza-

11. Thus, risks may be material to an organization even ifthey are not large enough themselves to threaten the solvencyof the organization.



tion should receive less than the other employee,all else being equal.

The performance measures used in an incen-tive compensation arrangement have an impor-tant effect on the incentives provided employeesand, thus, the potential for the arrangement toencourage imprudent risk-taking. For example,if an employee’s incentive compensation pay-ments are closely tied to short-term revenue orprofit of business generated by the employee,without any adjustments for the risks associatedwith the business generated, the potential for thearrangement to encourage imprudent risk-takingmay be quite strong. Similarly, traders whowork with positions that close at year-end couldhave an incentive to take large risks toward theend of a year if there is no mechanism forfactoring how such positions perform over alonger period of time. The same result couldensue if the performance measures themselveslack integrity or can be manipulated inappropri-ately by the employees receiving incentivecompensation.

On the other hand, if an employee’s incentivecompensation payments are determined basedon performance measures that are only distantlylinked to the employee’s activities (e.g., formost employees, organization-wide profit), thepotential for the arrangement to encourage theemployee to take imprudent risks on behalf ofthe organization may be weak. For this reason,plans that provide for awards based solely onoverall organization-wide performance are un-likely to provide employees, other than seniorexecutives and individuals who have the abilityto materially affect the organization’s overallrisk profile, with unbalanced risk-takingincentives.

Incentive compensation arrangements shouldnot only be balanced in design, they also shouldbe implemented so that actual payments varybased on risks or risk outcomes. If, for example,employees are paid substantially all of theirpotential incentive compensation even whenrisk or risk outcomes are materially worse thanexpected, employees have less incentive to avoidactivities with substantial risk.

• Banking organizations should consider thefull range of risks associated with an employ-ee’s activities, as well as the time horizon overwhich those risks may be realized, in assess-ing whether incentive compensation arrange-ments are balanced.

The activities of employees may create a widerange of risks for a banking organization, suchas credit, market, liquidity, operational, legal,compliance, and reputational risks, as well asother risks to the viability or operation of theorganization. Some of these risks may be real-ized in the short term, while others may becomeapparent only over the long term. For example,future revenues that are booked as currentincome may not materialize, and short-termprofit-and-loss measures may not appropriatelyreflect differences in the risks associated withthe revenue derived from different activities(e.g., the higher credit or compliance risk asso-ciated with subprime loans versus prime loans).12In addition, some risks (or combinations of riskystrategies and positions) may have a low prob-ability of being realized, but would have highlyadverse effects on the organization if they wereto be realized (‘‘bad tail risks’’). While share-holders may have less incentive to guard againstbad tail risks because of the infrequency of theirrealization and the existence of the federalsafety net, these risks warrant special attentionfor safety-and-soundness reasons given the threatthey pose to the organization’s solvency and thefederal safety net.

Banking organizations should consider thefull range of current and potential risks associ-ated with the activities of covered employees,including the cost and amount of capital andliquidity needed to support those risks, in devel-oping balanced incentive compensation arrange-ments. Reliable quantitative measures of riskand risk outcomes (‘‘quantitative measures’’),where available, may be particularly useful indeveloping balanced compensation arrange-ments and in assessing the extent to whicharrangements are properly balanced. However,reliable quantitative measures may not be avail-able for all types of risk or for all activities, andtheir utility for use in compensation arrange-ments varies across business lines and employ-ees. The absence of reliable quantitative mea-sures for certain types of risks or outcomes doesnot mean that banking organizations shouldignore such risks or outcomes for purposes ofassessing whether an incentive compensation

12. Importantly, the time horizon over which a risk out-come may be realized is not necessarily the same as the statedmaturity of an exposure. For example, the ongoing reinvest-ment of funds by a cash management unit in commercial paperwith a one-day maturity not only exposes the organization toone-day credit risk, but also exposes the organization toliquidity risk that may be realized only infrequently.



arrangement achieves balance. For example,while reliable quantitative measures may notexist for many bad-tail risks, it is important thatsuch risks be considered given their potentialeffect on safety and soundness. As in otherrisk-management areas, banking organizationsshould rely on informed judgments, supportedby available data, to estimate risks and riskoutcomes in the absence of reliable quantitativerisk measures.

Large complex banking organizations. Indesigning and modifying incentive compensa-tion arrangements, LCBOs should assess inadvance of implementation whether such ar-rangements are likely to provide balanced risk-taking incentives. Simulation analysis of incen-tive compensation arrangements is one way ofdoing so. Such analysis uses forward-lookingprojections of incentive compensation awardsand payments based on a range of performancelevels, risk outcomes, and levels of risks taken.This type of analysis, or other analysis thatresults in assessments of likely effectiveness,can help an LCBO assess whether incentivecompensation awards and payments to anemployee are likely to be reduced appropriatelyas the risks to the organization from the employ-ee’s activities increase.

• An unbalanced arrangement can be movedtoward balance by adding or modifying fea-tures that cause the amounts ultimatelyreceived by employees to appropriately reflectrisk and risk outcomes.

If an incentive compensation arrangementmay encourage employees to expose their bank-ing organization to imprudent risks, the organi-zation should modify the arrangement as neededto ensure that it is consistent with safety andsoundness. Four methods are often used to makecompensation more sensitive to risk. Thesemethods are:

1. Risk Adjustment of Awards: The amount ofan incentive compensation award for anemployee is adjusted based on measures thattake into account the risk the employee’sactivities may pose to the organization. Suchmeasures may be quantitative, or the size ofa risk adjustment may be set judgmentally,subject to appropriate oversight.

2. Deferral of Payment: The actual payout of an

award to an employee is delayed signifi-cantly beyond the end of the performanceperiod, and the amounts paid are adjusted foractual losses or other aspects of performancethat are realized or become better knownonly during the deferral period.13 Deferredpayouts may be altered according to riskoutcomes either formulaically or judgmen-tally, subject to appropriate oversight. To bemost effective, the deferral period should besufficiently long to allow for the realizationof a substantial portion of the risks fromemployee activities, and the measures of lossshould be clearly explained to employees andclosely tied to their activities during therelevant performance period.

3. Longer Performance Periods: The timeperiod covered by the performance measuresused in determining an employee’s award isextended (for example, from one year to twoor more years). Longer performance periodsand deferral of payment are related in thatboth methods allow awards or payments tobe made after some or all risk outcomes arerealized or better known.

4. Reduced Sensitivity to Short-Term Perfor-mance: The banking organization reducesthe rate at which awards increase as anemployee achieves higher levels of the rel-evant performance measure(s). Rather thanoffsetting risk-taking incentives associatedwith the use of short-term performance mea-sures, this method reduces the magnitude ofsuch incentives. This method also can includeimproving the quality and reliability of per-formance measures in taking into accountboth short-term and long-term risks, for exam-ple improving the reliability and accuracy ofestimates of revenues and long-term profitsupon which performance measures depend.14

13. The deferral-of-payment method is sometimes referredto in the industry as a ‘‘clawback.’’ The term ‘‘clawback’’ alsomay refer specifically to an arrangement under which anemployee must return incentive compensation payments pre-viously received by the employee (and not just deferred) ifcertain risk outcomes occur. Section 304 of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7243), which applies to chiefexecutive officers and chief financial officers of public bank-ing organizations, is an example of this more specific type of‘‘clawback’’ requirement.

14. Performance targets may have a material effect onrisk-taking incentives. Such targets may offer employeesgreater rewards for increments of performance that are abovethe target or may provide that awards will be granted only if



These methods for achieving balance are notexclusive, and additional methods or variationsmay exist or be developed. Moreover, eachmethod has its own advantages and disadvan-tages. For example, where reliable risk measuresexist, risk adjustment of awards may be moreeffective than deferral of payment in reducingincentives for imprudent risk-taking. This isbecause risk adjustment potentially can takeaccount of the full range and time horizon ofrisks, rather than just those risk outcomes thatoccur or become more evident during the defer-ral period. On the other hand, deferral of pay-ment may be more effective than risk adjustmentin mitigating incentives to take hard-to-measurerisks (such as the risks of new activities orproducts, or certain risks such as reputational oroperational risk that may be difficult to measurewith respect to particular activities), especially ifsuch risks are likely to be realized during thedeferral period. Accordingly, in some cases twoor more methods may be needed in combinationfor an incentive compensation arrangement tobe balanced.

The greater the potential incentives an arrange-ment creates for an employee to increase therisks associated with the employee’s activities,the stronger the effect should be of the methodsapplied to achieve balance. Thus, for example,risk adjustments used to counteract a materiallyunbalanced compensation arrangement shouldhave a similarly material impact on the incentivecompensation paid under the arrangement. Fur-ther, improvements in the quality and reliabilityof performance measures themselves, for exam-ple, improving the reliability and accuracy ofestimates of revenues and profits upon whichperformance measures depend, can significantlyimprove the degree of balance in risk-takingincentives.

Where judgment plays a significant role in thedesign or operation of an incentive compensa-tion arrangement, strong policies and proce-dures, internal controls, and ex post monitoringof incentive compensation payments relative toactual risk outcomes are particularly importantto help ensure that the arrangements as imple-mented are balanced and do not encourageimprudent risk-taking. For example, if a bankingorganization relies to a significant degree on thejudgment of one or more managers to ensure

that the incentive compensation awards toemployees are appropriately risk-adjusted, theorganization should have policies and proce-dures that describe how managers are expectedto exercise that judgment to achieve balance andthat provide for the manager(s) to receive appro-priate available information about the employ-ee’s risk-taking activities to make informedjudgments.

Large complex banking organizations. Meth-ods and practices for making compensationsensitive to risk are likely to evolve rapidlyduring the next few years, driven in part by theefforts of supervisors and other stakeholders.LCBOs should actively monitor developmentsin the field and should incorporate into theirincentive compensation systems new or emerg-ing methods or practices that are likely toimprove the organization’s long-term financialwell-being and safety and soundness.

• The manner in which a banking organizationseeks to achieve balanced incentive compen-sation arrangements should be tailored toaccount for the differences betweenemployees—including the substantial differ-ences between senior executives and otheremployees—as well as between bankingorganizations.

Activities and risks may vary significantlyboth across banking organizations and acrossemployees within a particular banking organiza-tion. For example, activities, risks, and incentivecompensation practices may differ materiallyamong banking organizations based on, amongother things, the scope or complexity of activi-ties conducted and the business strategies pur-sued by the organizations. These differencesmean that methods for achieving balanced com-pensation arrangements at one organization maynot be effective in restraining incentives toengage in imprudent risk-taking at another orga-nization. Each organization is responsible forensuring that its incentive compensation arrange-ments are consistent with the safety and sound-ness of the organization.

Moreover, the risks associated with the activi-ties of one group of non-executive employees(e.g., loan originators) within a banking organi-zation may differ significantly from those ofanother group of non-executive employees (e.g.,spot foreign exchange traders) within the orga-nization. In addition, reliable quantitative mea-

a target is met or exceeded. Employees may be particularlymotivated to take imprudent risk in order to reach perfor-mance targets that are aggressive but potentially achievable.



sures of risk and risk outcomes are unlikely tobe available for a banking organization as awhole, particularly a large, complex organiza-tion. This factor can make it difficult for bankingorganizations to achieve balanced compensationarrangements for senior executives who haveresponsibility for managing risks on anorganization-wide basis solely through use ofthe risk-adjustment-of-award method.

Furthermore, the payment of deferred incen-tive compensation in equity (such as restrictedstock of the organization) or equity-based instru-ments (such as options to acquire the organiza-tion’s stock) may be helpful in restraining therisk-taking incentives of senior executives andother covered employees whose activities mayhave a material effect on the overall financialperformance of the organization. However,equity-related deferred compensation may notbe as effective in restraining the incentives oflower-level covered employees (particularly atlarge organizations) to take risks because suchemployees are unlikely to believe that theiractions will materially affect the organization’sstock price.

Banking organizations should take account ofthese differences when constructing balancedcompensation arrangements. For most bankingorganizations, the use of a single, formulaicapproach to making employee incentive com-pensation arrangements appropriately risk-sensitive is likely to result in arrangements thatare unbalanced at least with respect to someemployees.15

Large complex banking organizations. Incen-tive compensation arrangements for seniorexecutives at LCBOs are likely to be betterbalanced if they involve deferral of a substantialportion of the executives’ incentive compensa-tion over a multi-year period in a way thatreduces the amount received in the event of poorperformance, substantial use of multi-year per-formance periods, or both. Similarly, the com-pensation arrangements for senior executives atLCBOs are likely to be better balanced if asignificant portion of the incentive compensa-tion of these executives is paid in the form of

equity-based instruments that vest over multipleyears, with the number of instruments ultimatelyreceived dependent on the performance of theorganization during the deferral period.

The portion of the incentive compensation ofother covered employees that is deferred or paidin the form of equity-based instruments shouldappropriately take into account the level, nature,and duration of the risks that the employees’activities create for the organization and theextent to which those activities may materiallyaffect the overall performance of the organiza-tion and its stock price. Deferral of a substantialportion of an employee’s incentive compensa-tion may not be workable for employees atlower pay scales because of their more limitedfinancial resources. This may require increasedreliance on other measures in the incentivecompensation arrangements for these employeesto achieve balance.

• Banking organizations should carefully con-sider the potential for ‘‘golden parachutes’’and the vesting arrangements for deferredcompensation to affect the risk-taking behav-ior of employees while at the organizations.

Arrangements that provide for an employee(typically a senior executive), upon departurefrom the organization or a change in control ofthe organization, to receive large additionalpayments or the accelerated payment of deferredamounts without regard to risk or risk outcomescan provide the employee significant incentivesto expose the organization to undue risk. Forexample, an arrangement that provides anemployee with a guaranteed payout upon depar-ture from an organization, regardless of perfor-mance, may neutralize the effect of any balanc-ing features included in the arrangement to helpprevent imprudent risk-taking.

Banking organizations should carefully reviewany such existing or proposed arrangements(sometimes called ‘‘golden parachutes’’) and thepotential impact of such arrangements on theorganization’s safety and soundness. In appro-priate circumstances an organization should con-sider including balancing features—such as riskadjustment or deferral requirements that extendpast the employee’s departure—in the arrange-ments to mitigate the potential for the arrange-ments to encourage imprudent risk-taking. In allcases, a banking organization should ensure thatthe structure and terms of any golden parachutearrangement entered into by the organization do

15. For example, spreading payouts of incentive compen-sation awards over a standard three-year period may notappropriately reflect the differences in the type and timehorizon of risk associated with the activities of differentgroups of employees, and may not be sufficient by itself tobalance the compensation arrangements of employees whomay expose the organization to substantial longer-term risks.



not encourage imprudent risk-taking in light ofthe other features of the employee’s incentivecompensation arrangements.

Large complex banking organizations. Provi-sions that require a departing employee to forfeitdeferred incentive compensation payments mayweaken the effectiveness of the deferral arrange-ment if the departing employee is able to nego-tiate a ‘‘golden handshake’’ arrangement withthe new employer.16 This weakening effect canbe particularly significant for senior executivesor other skilled employees at LCBOs whoseservices are in high demand within the market.

Golden handshake arrangements present spe-cial issues for LCBOs and supervisors. Forexample, while a banking organization couldadjust its deferral arrangements so that departingemployees will continue to receive any accrueddeferred compensation after departure (subjectto any clawback or malus17), these changescould (1) reduce the employee’s incentive toremain at the organization and, thus, weaken anorganization’s ability to retain qualified talent,which is an important goal of compensation, and(2) create conflicts of interest. Moreover, actionsof the hiring organization (which may or maynot be a supervised banking organization) ulti-mately may defeat these or other risk-balancingaspects of a banking organization’s deferralarrangements. LCBOs should monitor whethergolden handshake arrangements are materiallyweakening the organization’s efforts to con-strain the risk-taking incentives of employees.The Federal Reserve will continue to work withbanking organizations and others to developappropriate methods for addressing any effectthat such arrangements may have on the safetyand soundness of banking organizations.

• Banking organizations should effectively com-municate to employees the ways in whichincentive compensation awards and payments

will be reduced as risks increase.

In order for the risk-sensitive provisions ofincentive compensation arrangements to affectemployee risk-taking behavior, the organiza-tion’s employees need to understand that theamount of incentive compensation that they mayreceive will vary based on the risk associatedwith their activities. Accordingly, banking orga-nizations should ensure that employees coveredby an incentive compensation arrangement areinformed about the key ways in which risks aretaken into account in determining the amount ofincentive compensation paid. Where feasible, anorganization’s communications with employeesshould include examples of how incentive com-pensation payments may be adjusted to reflectprojected or actual risk outcomes. An organiza-tion’s communications should be tailored appro-priately to reflect the sophistication of the rel-evant audience(s).

Principle 2: Compatibility withEffective Controls andRisk-Management

A banking organization’s risk-management pro-cesses and internal controls should reinforceand support the development and maintenanceof balanced incentive compensationarrangements.

In order to increase their own compensation,employees may seek to evade the processesestablished by a banking organization to achievebalanced compensation arrangements. Simi-larly, an employee covered by an incentivecompensation arrangement may seek to influ-ence, in ways designed to increase the employ-ee’s pay, the risk measures or other informationor judgments that are used to make the employ-ee’s pay sensitive to risk.

Such actions may significantly weaken theeffectiveness of an organization’s incentive com-pensation arrangements in restricting imprudentrisk-taking. These actions can have a particu-larly damaging effect on the safety and sound-ness of the organization if they result in theweakening of risk measures, information, orjudgments that the organization uses for otherrisk-management, internal control, or financialpurposes. In such cases, the employee’s actionsmay weaken not only the balance of the orga-

16. Golden handshakes are arrangements that compensatean employee for some or all of the estimated, non-adjustedvalue of deferred incentive compensation that would havebeen forfeited upon departure from the employee’s previousemployment.

17. A malus arrangement permits the employer to preventvesting of all or part of the amount of a deferred remunerationaward. Malus provisions are invoked when risk outcomes areworse than expected or when the information upon which theaward was based turns out to have been incorrect. Loss ofunvested compensation due to the employee voluntarily leav-ing the firm is not an example of malus as the term is used inthis guidance.



nization’s incentive compensation arrangements,but also the risk-management, internal controls,and other functions that are supposed to act as aseparate check on risk-taking. For this reason,traditional risk-management controls alone donot eliminate the need to identify employeeswho may expose the organization to materialrisk, nor do they obviate the need for theincentive compensation arrangements for theseemployees to be balanced. Rather, a bankingorganization’s risk-management processes andinternal controls should reinforce and supportthe development and maintenance of balancedincentive compensation arrangements.

• Banking organizations should have appropri-ate controls to ensure that their processes forachieving balanced compensation arrange-ments are followed and to maintain the integ-rity of their risk-management and otherfunctions.

To help prevent damage from occurring, abanking organization should have strong con-trols governing its process for designing, imple-menting, and monitoring incentive compensa-tion arrangements. Banking organizations shouldcreate and maintain sufficient documentation topermit an audit of the effectiveness of theorganization’s processes for establishing, modi-fying, and monitoring incentive compensationarrangements. Smaller banking organizationsshould incorporate reviews of these processesinto their overall framework for compliancemonitoring (including internal audit).

Large complex banking organizations. LCBOsshould have and maintain policies and proce-dures that (1) identify and describe the role(s) ofthe personnel, business units, and control unitsauthorized to be involved in the design, imple-mentation, and monitoring of incentive compen-sation arrangements; (2) identify the source ofsignificant risk-related inputs into these pro-cesses and establish appropriate controls gov-erning the development and approval of theseinputs to help ensure their integrity; and (3) iden-tify the individual(s) and control unit(s) whoseapproval is necessary for the establishment ofnew incentive compensation arrangements ormodification of existing arrangements.

An LCBO also should conduct regularinternal reviews to ensure that its processes forachieving and maintaining balanced incentivecompensation arrangements are consistently fol-

lowed. Such reviews should be conducted byaudit, compliance, or other personnel in a man-ner consistent with the organization’s overallframework for compliance monitoring. AnLCBO’s internal audit department also shouldseparately conduct regular audits of theorganization’s compliance with its establishedpolicies and controls relating to incentivecompensation arrangements. The results shouldbe reported to appropriate levels of manage-ment and, where appropriate, the organization’sboard of directors.

• Appropriate personnel, including risk-management personnel, should have inputinto the organization’s processes for design-ing incentive compensation arrangements andassessing their effectiveness in restrainingimprudent risk-taking.

Developing incentive compensation arrange-ments that provide balanced risk-taking incen-tives and monitoring arrangements to ensurethey achieve balance over time requires anunderstanding of the risks (including compli-ance risks) and potential risk outcomes associ-ated with the activities of the relevant employ-ees. Accordingly, banking organizations shouldhave policies and procedures that ensure thatrisk-management personnel have an appropriaterole in the organization’s processes for design-ing incentive compensation arrangements andfor assessing their effectiveness in restrainingimprudent risk-taking.18 Ways that risk manag-ers might assist in achieving balanced compen-sation arrangements include, but are not limitedto

1. reviewing the types of risks associated withthe activities of covered employees;

2. approving the risk measures used in riskadjustments and performance measures, aswell as measures of risk outcomes used indeferred-payout arrangements; and

3. analyzing risk-taking and risk outcomes rela-tive to incentive compensation payments.

Other functions within an organization, suchas its control, human resources, or finance func-tions, also play an important role in helping

18. Involvement of risk-management personnel in thedesign and monitoring of these arrangements also should helpensure that the organization’s risk-management functions canproperly understand and address the full range of risks facingthe organization.



ensure that incentive compensation arrange-ments are balanced. For example, these func-tions may contribute to the design and review ofperformance measures used in compensationarrangements or may supply data used as part ofthese measures.

• Compensation for employees in risk-management and control functions should besufficient to attract and retain qualifiedpersonnel and should avoid conflicts ofinterest.

The risk-management and control personnelinvolved in the design, oversight, and operationof incentive compensation arrangements shouldhave appropriate skills and experience needed toeffectively fulfill their roles. These skills andexperiences should be sufficient to equip thepersonnel to remain effective in the face ofchallenges by covered employees seeking toincrease their incentive compensation in waysthat are inconsistent with sound risk-managementor internal controls. The compensation arrange-ments for employees in risk-management andcontrol functions thus should be sufficient toattract and retain qualified personnel with expe-rience and expertise in these fields that is appro-priate in light of the size, activities, and com-plexity of the organization.

In addition, to help preserve the independenceof their perspectives, the incentive compensa-tion received by risk-management and controlpersonnel staff should not be based substantiallyon the financial performance of the businessunits that they review. Rather, the performancemeasures used in the incentive compensationarrangements for these personnel should bebased primarily on the achievement of the objec-tives of their functions (e.g., adherence to inter-nal controls).

• Banking organizations should monitor theperformance of their incentive compensationarrangements and should revise the arrange-ments as needed if payments do not appropri-ately reflect risk.

Banking organizations should monitor incen-tive compensation awards and payments, riskstaken, and actual risk outcomes to determinewhether incentive compensation payments toemployees are reduced to reflect adverse riskoutcomes or high levels of risk taken. Resultsshould be reported to appropriate levels of

management, including the board of directorswhere warranted and consistent with Principle3 below. The monitoring methods and pro-cesses used by a banking organization shouldbe commensurate with the size and complexityof the organization, as well as its use of incen-tive compensation. Thus, for example, a small,noncomplex organization that uses incentivecompensation only to a limited extent may findthat it can appropriately monitor its arrange-ments through normal management processes.

A banking organization should take the resultsof such monitoring into account in establishingor modifying incentive compensation arrange-ments and in overseeing associated controls. If,over time, incentive compensation paid by abanking organization does not appropriatelyreflect risk outcomes, the organization shouldreview and revise its incentive compensationarrangements and related controls to ensure thatthe arrangements, as designed and implemented,are balanced and do not provide employeesincentives to take imprudent risks.

Principle 3: Strong CorporateGovernance

Banking organizations should have strong andeffective corporate governance to help ensuresound compensation practices, including activeand effective oversight by the board ofdirectors.

Given the key role of senior executives inmanaging the overall risk-taking activities of anorganization, the board of directors of a bankingorganization should directly approve the incen-tive compensation arrangements for seniorexecutives.19 The board also should approve anddocument any material exceptions or adjust-ments to the incentive compensation arrange-ments established for senior executives andshould carefully consider and monitor the effects

19. As used in this guidance, the term ‘‘board of directors’’is used to refer to the members of the board of directors whohave primary responsibility for overseeing the incentivecompensation system. Depending on the manner in which theboard is organized, the term may refer to the entire board ofdirectors, a compensation committee of the board, or anothercommittee of the board that has primary responsibility foroverseeing the incentive compensation system. In the case ofFBOs, the term refers to the relevant oversight body for thefirm’s U.S. operations, consistent with the FBO’s overallcorporate and management structure.



of any approved exceptions or adjustments onthe balance of the arrangement, the risk-takingincentives of the senior executive, and the safetyand soundness of the organization.

The board of directors of an organizationalso is ultimately responsible for ensuring thatthe organization’s incentive compensationarrangements for all covered employees areappropriately balanced and do not jeopardizethe safety and soundness of the organization.The involvement of the board of directors inoversight of the organization’s overall incen-tive compensation program should be scaledappropriately to the scope and prevalence ofthe organization’s incentive compensationarrangements.

Large complex banking organizations andorganizations that are significant users ofincentive compensation. The board of directorsof an LCBO or other banking organization thatuses incentive compensation to a significantextent should actively oversee the developmentand operation of the organization’s incentivecompensation policies, systems, and relatedcontrol processes. The board of directors ofsuch an organization should review andapprove the overall goals and purposes of theorganization’s incentive compensation system.In addition, the board should provide cleardirection to management to ensure that thegoals and policies it establishes are carried outin a manner that achieves balance and is con-sistent with safety and soundness.

The board of directors of such an organizationalso should ensure that steps are taken so that theincentive compensation system—including per-formance measures and targets—is designed andoperated in a manner that will achieve balance.

• The board of directors should monitor theperformance, and regularly review the designand function, of incentive compensationarrangements.

To allow for informed reviews, the boardshould receive data and analysis from manage-ment or other sources that are sufficient to allowthe board to assess whether the overall designand performance of the organization’s incentivecompensation arrangements are consistent withthe organization’s safety and soundness. Thesereviews and reports should be appropriatelyscoped to reflect the size and complexity of thebanking organization’s activities and the preva-

lence and scope of its incentive compensationarrangements.

The board of directors of a banking organiza-tion should closely monitor incentive compen-sation payments to senior executives and thesensitivity of those payments to risk outcomes.In addition, if the compensation arrangement fora senior executive includes a clawback provi-sion, then the review should include sufficientinformation to determine if the provision hasbeen triggered and executed as planned.

The board of directors of a banking organiza-tion should seek to stay abreast of significantemerging changes in compensation plan mecha-nisms and incentives in the marketplace as wellas developments in academic research and regu-latory advice regarding incentive compensationpolicies. However, the board should recognizethat organizations, activities, and practices withinthe industry are not identical. Incentive compen-sation arrangements at one organization may notbe suitable for use at another organizationbecause of differences in the risks, controls,structure, and management among organiza-tions. The board of directors of each organiza-tion is responsible for ensuring that the incentivecompensation arrangements for its organizationdo not encourage employees to take risks thatare beyond the organization’s ability to manageeffectively, regardless of the practices employedby other organizations.

Large complex banking organizations andorganizations that are significant users of incen-tive compensation. The board of an LCBO orother organization that uses incentive compen-sation to a significant extent should receive andreview, on an annual or more frequent basis, anassessment by management, with appropriateinput from risk-management personnel, of theeffectiveness of the design and operation of theorganization’s incentive compensation systemin providing risk-taking incentives that are con-sistent with the organization’s safety and sound-ness. These reports should include an evaluationof whether or how incentive compensation prac-tices may increase the potential for imprudentrisk-taking.

The board of such an organization also shouldreceive periodic reports that review incentivecompensation awards and payments relative torisk outcomes on a backward-looking basis todetermine whether the organization’s incentivecompensation arrangements may be promotingimprudent risk-taking. Boards of directors of



these organizations also should consider periodi-cally obtaining and reviewing simulation analy-sis of compensation on a forward-looking basisbased on a range of performance levels, riskoutcomes, and the amount of risks taken.

• The organization, composition, and resourcesof the board of directors should permit effec-tive oversight of incentive compensation.

The board of directors of a banking organiza-tion should have, or have access to, a level ofexpertise and experience in risk-managementand compensation practices in the financial ser-vices industry that is appropriate for the nature,scope, and complexity of the organization’sactivities. This level of expertise may be presentcollectively among the members of the board,may come from formal training or from experi-ence in addressing these issues, including as adirector, or may be obtained through advicereceived from outside counsel, consultants, orother experts with expertise in incentive com-pensation and risk-management. The board ofdirectors of an organization with less complexand extensive incentive compensation arrange-ments may not find it necessary or appropriate torequire special board expertise or to retain anduse outside experts in this area.

In selecting and using outside parties, theboard of directors should give due attention topotential conflicts of interest arising from otherdealings of the parties with the organization orfor other reasons. The board also should exer-cise caution to avoid allowing outside parties toobtain undue levels of influence. While theretention and use of outside parties may behelpful, the board retains ultimate responsibilityfor ensuring that the organization’s incentivecompensation arrangements are consistent withsafety and soundness.

Large complex banking organizations andorganizations that are significant users of incen-tive compensation. If a separate compensationcommittee is not already in place or required byother authorities,20 the board of directors of anLCBO or other banking organization that usesincentive compensation to a significant extentshould consider establishing such a committee—reporting to the full board—that has primary

responsibility for overseeing the organization’sincentive compensation systems. A compensa-tion committee should be composed solely orpredominantly of non-executive directors. If theboard does not have such a compensation com-mittee, the board should take other steps toensure that non-executive directors of the boardare actively involved in the oversight of incen-tive compensation systems. The compensationcommittee should work closely with any board-level risk and audit committees where the sub-stance of their actions overlap.

• A banking organization’s disclosure practicesshould support safe and sound incentive com-pensation arrangements.

If a banking organization’s incentive compen-sation arrangements provide employees incen-tives to take risks that are beyond the toleranceof the organization’s shareholders, these risksare likely to also present a risk to the safety andsoundness of the organization.21 To help pro-mote safety and soundness, a banking organiza-tion should provide an appropriate amount ofinformation concerning its incentive compensa-tion arrangements for executive and non-executive employees and related risk-management, control, and governance processesto shareholders to allow them to monitor and,where appropriate, take actions to restrain thepotential for such arrangements and processesthat encourage employees to take imprudentrisks. Such disclosures should include informa-tion relevant to employees other than seniorexecutives. The scope and level of the informa-tion disclosed by the organization should betailored to the nature and complexity of theorganization and its incentive compensationarrangements.22

• Large complex banking organizations shouldfollow a systematic approach to developing acompensation system that has balanced incen-tive compensation arrangements.

20. See New York Stock Exchange Listed Company ManualSection 303A.05(a); Nasdaq Listing Rule 5605(d); InternalRevenue Code section 162(m) (26 U.S.C. 162(m)).

21. On the other hand, as noted previously, compensationarrangements that are in the interests of the shareholders of abanking organization are not necessarily consistent withsafety and soundness.

22. A banking organization also should comply with theincentive compensation disclosure requirements of the federalsecurities law and other laws as applicable. See, for example,Proxy Disclosure Enhancements, SEC Release Nos. 33-9089,34-61175, 74 F.R. 68334 (Dec. 23, 2009) (to be codified at 17C.F.R. 229 and 249).



At banking organizations with large numbersof risk-taking employees engaged in diverseactivities, an ad hoc approach to developingbalanced arrangements is unlikely to be reliable.Thus, an LCBO should use a systematicapproach—supported by robust and formalizedpolicies, procedures, and systems—to ensurethat those arrangements are appropriately bal-anced and consistent with safety and soundness.Such an approach should provide for the orga-nization effectively to:

1. Identify employees who are eligible to receiveincentive compensation and whose activitiesmay expose the organization to materialrisks. These employees should includea. senior executives and others who are

responsible for oversight of the organiza-tion’s firm-wide activities or material busi-ness lines;

b. individual employees, including non-executive employees, whose activities mayexpose the organization to materialamounts of risk; and

c. groups of employees who are subject tothe same or similar incentive compensa-tion arrangements and who, in the aggre-gate, may expose the organization to mate-rial amounts of risk;

2. Identify the types and time horizons of risksto the organization from the activities ofthese employees;

3. Assess the potential for the performancemeasures included in the incentive compen-sation arrangements for these employees,those that encourage employees to takeimprudent risks;

4. Include balancing elements (such as riskadjustments or deferral periods) within theincentive compensation arrangements forthese employees, that are reasonably designed

to ensure that the arrangement will be bal-anced in light of the size, type, and timehorizon of the inherent risks of the employ-ees’ activities;

5. Communicate to the employees the ways inwhich their incentive compensation awardsor payments will be adjusted to reflect therisks of their activities to the organization;and

6. Monitor incentive compensation awards, pay-ments, risks taken, and risk outcomes forthese employees and modify the relevantarrangements if payments made are not appro-priately sensitive to risk and risk outcomes.

CONCLUSION ON SOUNDINCENTIVE COMPENSATION

Banking organizations are responsible for ensur-ing that their incentive compensation arrange-ments do not encourage imprudent risk-takingbehavior and are consistent with the safety andsoundness of the organization. The FederalReserve expects banking organizations to takeprompt action to address deficiencies in theirincentive compensation arrangements or relatedrisk-management, control, and governanceprocesses.

The Federal Reserve intends to actively moni-tor the actions taken by banking organizations inthis area and will promote further advances indesigning and implementing balanced incentivecompensation arrangements. Where appropriate,the Federal Reserve will take supervisory orenforcement action to ensure that material defi-ciencies that pose a threat to the safety andsoundness of the organization are promptlyaddressed. The Federal Reserve also will updatethis guidance as appropriate to incorporate bestpractices as they develop over time.



Earnings—Analytical Review of Income and ExpenseEffective date October 2018 Section 4010.1

INTRODUCTION

From a regulator’s standpoint, the essentialpurpose of bank earnings, both current andaccumulated, is to absorb losses and augmentcapital. Earnings is the initial safeguard againstthe risks that a bank incurs in the course ofdoing business, and represents a bank’s first lineof defense against capital depletion resultingfrom a decline in the value of its assets. Thissection is designed to provide a high-leveloverview for examiners in assessing a bank’searning through the use of analytical reviewtechniques. Examiners need to remain cognizantof the inextricable links among capital, assetquality, earnings, liquidity, and market risk sen-sitivity.

GENERAL EXAMINATIONAPPROACH

As part of the off-site preparation for an on-siteexamination, examiners review and analyze abank’s financial condition. (See the manualsections entitled, “Examination Strategy andRisk-Focused Examinations” and “FederalReserve System Bank Surveillance Program.”)This analysis is meant to identify potentialproblem areas and to develop the examinationscope so that proper staff levels and appropriateexamination procedures can be used.

The analysis of earnings includes all bankoperations and activities. When evaluating earn-ings, examiners should develop an understand-ing of the bank’s core business activities. Coreactivities are those operations that are part of abank’s normal or continuing business. Examin-ers should understand a bank’s composition ofearnings and sustainability of the various earn-ings components. This would include balance-sheet composition, particularly the volume andtype of earning assets and off-balance-sheetitems, if applicable.

ANALYTICAL REVIEW

In performing the analytical review of a bank,examiners should use the most recent UniformBank Performance Report (UBPR) as well asthe most recent financial statements and other

related financial information that supports thesource and trend in the bank’s earnings. Awell-performed analytical review provides exam-iners with an understanding of the bank’s opera-tions. An analytical review of bank earningshighlights matters of interest and potential prob-lem situations which, examiners will need toaddress with the bank. In reviewing and assess-ing a bank’s earning, examiners perform leveland trend analysis of financial report data andratios as well as reviewing other metrics. Ana-lytical review is based on the assumption thatperiod-to-period balances and ratios are freefrom significant error considering the proce-dures relating to income and expenses, andregulatory reports conducted by internal or exter-nal auditors. (See the manual section entitled,“Internal Control and Audit Function, Over-sight, and Outsourcing,” for a discussion offactors to consider in reviewing the audit workof others.)

Analytical Tools

The UBPR and the bank’s financial statementsare key sources of analysis for examinationstaff. Bank-prepared statements and supplemen-tal schedules, if available, facilitate an in-depthanalytical review. The information from thoseschedules may give examiners considerableinsight into the interpretation of the bank’s basicfinancial statements. To properly understand andinterpret a particular bank’s financial and statis-tical data, examiners should be familiar withcurrent economic and industry conditions, includ-ing any idiosyncratic cyclical or seasonal factorsin the nation, region, and local area that mayhave an affect on the bank’s earnings. Economicand industry information, reports, and journalsare useful informational sources of industryconditions and trends. Finally, examiners shouldbe knowledgeable about new banking laws andnew accounting standards or methodologies thatcould have a material effect on financial institu-tions’ business and earnings.

UBPR

The information used to prepare UBPRs arelargely based on the Consolidated Reports of


Condition and Income (Call Report). Each UBPRalso contains corresponding average data for thebank’s peer group (a group of banks of similarasset size and reporting characteristics) andpercentile rankings for most ratios. The UBPRfacilitates the evaluation of a bank’s currentcondition, trends in its financial performance,and comparisons with the performance of itspeer group.

The user’s guide for the UBPR explains howa structured approach to financial analysis shouldbe followed.1 This approach breaks down abank’s income stream into its major componentsof interest margin performance, overhead, non-interest income, loan-loss provisions, tax fac-tors, and extraordinary items. These major com-ponents can then be broken down into varioussubcomponents. Also, examiners should analyzethe balance-sheet composition along with eco-nomic conditions to understand the source andfuture variability of a bank’s income stream.

The dollar amounts displayed for most incomeand expense items in the UBPR are shown forthe year-to-date period. However, to allow com-parison of ratios between quarters, income andexpense and related data used in certain ratiosare annualized for interim reporting periods.Thus, the income or expense item is multipliedby the indicated factor listed below beforedividing it by the corresponding asset or liabil-ity. The UBPR annualization factors are

• March 4.0,• June 2.0, and• September 1.3333.

Income and expense information reported onthe December 31 Call Report is not annualized.Since the year-end UBPR represents a full fiscalyear.

Frequently, examiners need a more detailedand current review of a bank’s financial condi-tion than that provided by the UBPR. Undercertain circumstances, UBPR procedures mayneed to be supplemented because—

• asset-quality information must be linked to theincome stream;

• more detailed information is necessary onasset-liability maturities and matching;

• more detailed information is necessary on

other liquidity aspects, as they may affectearnings;

• yield or cost information, which may bedifficult to interpret from the report, is needed;

• certain income or expense items may needclarification, as well as normal examinationvalidation;

• volume information, such as the number ofdemand deposits, certificates of deposit, andother accounts, is not reported, and vulnerabil-ity in a bank subject to concentrations nor-mally should be considered;

• components of interest and fees on loans arenot reported separately by category of loan;thus, adverse trends in the loan portfolio maynot be detected (for example, the yield of aparticular bank’s loan portfolio may be similarto those of its peer group, but examiners maydetect an upward trend in yields for a specificcategory of loans. That upward trend might bepartially or wholly offset by a downward trendof yields in another category of loans, andexaminers should consider further investigat-ing the circumstances applicable to each ofthose loan categories. A change in yieldscould be a result of a change in the bank’sbusiness model or risk “appetite” for certaintypes of loans or may indicate a change inloan underwriting standards.); or

• income or expense resulting from a change inthe bank’s operations, such as the opening ofa new branch or starting of a mortgage bank-ing activity or trust department, may skewperformance ratios. (When there has been asignificant change in a bank’s operations,examiners should analyze the potential impactof the change on future bank earnings.)

Review of Management’s Budget andFinancial Statements

In addition to UBPR analysis, examiners shouldincorporate a review of management’s budgetand/or financial projections. In reviewing abank’s projections and individual variances fromits operating budget, examiners should be ableto identify the sources and trends in the bank’sprior and future earnings. Examiners should alsoverify the reasonableness of the budgetedamounts, frequency of budget review by bankmanagement and the board of directors, andlevel of involvement of key bank personnel inthe budget process.

In reviewing a bank’s financial statements,

1. The Federal Financial Institutions Examination Council(FFIEC) provides additional information on the UBPR, includ-ing the UBPR User’s Guide at www.ffiec.gov/ubpr.htm.

4010.1 Earnings—Analytical Review of Income and Expense


examiners should be cognizant of new account-ing standards or changes in accounting method-ologies. In addition, alternative accounting treat-ments for similar transactions among peer banksalso should be considered because they mayproduce significantly different results. The ana-lytical review must be based on figures derivedunder valid accounting practices consistentlyapplied, particularly in the accrual areas. Accord-ingly, during the analytical review, examinersshould work with Reserve Bank accountingspecialists to determine any material inconsis-tencies in the application of accounting prin-ciples.

Review of Nonrecurring andExtraordinary Items

When assessing earnings, examiners should beaware of nonrecurring events or actions thathave affected a bank’s earnings performance,positively or negatively, and should adjust earn-ings on a tax equivalent (TE) basis for compari-son purposes. Although the analysis shouldreflect adjustments for non-recurring events,examiners should also include within their analy-sis the impact that these items had on overallearnings performance. Examples of events thatmay affect earnings include adoption of newaccounting standards, extraordinary items, orother actions taken by management that are notconsidered part of a bank’s normal operationssuch as sales of securities for tax purposes or forsome other reason unrelated to active manage-ment of the securities portfolio.

The exclusion of nonrecurring events fromthe analysis allows examiners to analyze theprofitability of a bank’s core operations withoutthe distortions caused by non-recurring items.By adjusting for these distortions, examiners arebetter able to compare a bank’s current earningsperformance against the bank’s past perfor-mance and industry norms (for example, peergroup data).

Compliance with Laws andRegulations Relating to Earnings andDividends

Examiners should consider the interrelation-ships that exist among the dividend-payout ratio,the rate of growth of retained earnings, and the

bank’s ability to cover losses and maintainadequate capital. A bank’s earnings should alsobe more than sufficiently adequate in relation toits current dividend rate. In particular, examinersshould consider whether a bank’s dividend rateis prudent relative to its financial position andnot based on overly optimistic earnings sce-narios. See SR-09-4, “Applying SupervisoryGuidance and Regulations on the Payment ofDividends, Stock Redemptions, and Stock Re-purchases at Bank Holding Companies.”2 Pru-dent management dictates that a bank shouldconsider the curtailment of the dividend rate ifcapital is inadequate and greater earnings reten-tion is required. If it appears that a bank’sdividend payout isexcessive or that there is arecord of recent operating losses, examinersshould refer to sections 5199(b) and 5204 of theUnited States Revised Statutes and section208.19 of Regulation H which restrict statemember bank dividends. See also this manual’ssection entitled, “Dividends.”

ASSIGNING THE EARNINGSRATING

After performing the appropriate examinationprocedures and documenting the supervisoryassessment of a bank, examiners assign a com-ponent Uniform Financial Institution RatingsSystem rating based on an evaluation of a banksearnings. Examiners assign a rating that ad-dresses the quantity and trend of a bank’searnings, as well as factors that may affect thesustainability or quality of earnings. The quan-tity as well as the quality of a bank’s earningscan be affected by excessive or inadequatelymanaged credit risk that may result in loanlosses and require additions to the allowance forloan and lease losses, or by high levels of marketrisk that may unduly expose an institution’searnings to volatility in interest rates.3 Thequality of earnings may also be diminished byundue reliance on extraordinary gains, nonrecur-ring events, or favorable tax effects. Futureearnings may be adversely affected by an inabil-ity to forecast or control funding and operating

2. See also the Bank Holding Company Supervision Manualfor a discussion of the Board’s “Policy Statement on thePayment of Cash Dividends by State Member Banks and BankHolding Companies.”

3. See this manual’s section entitled, “Allowance for Loanand Lease Losses,” for more information.

Earnings—Analytical Review of Income and Expense 4010.1


expenses, improperly executed or ill-advisedbusiness strategies, or poorly managed or uncon-trolled exposure to other risks.

Examiners base their rating of a bank’s earn-ings based upon, but not limited to, an assess-ment of the following evaluation factors:

• the level of earnings, including trends andstability

• the bank’s ability to provide for adequatecapital through retained earnings

• the quality and sources of earnings• the level of expenses in relation to the bank’s

operations• the adequacy of the bank’s budgeting systems,

forecasting processes, and management infor-mation systems in general

• the adequacy of the bank’s provisions for theallowance for loan and lease losses and othervaluation allowance accounts

• the earnings exposure to market risk such asinterest rate, foreign exchange, and price risks

4010.1 Earnings—Analytical Review of Income and Expense


Earnings—Analytical Review of Income and ExpenseExamination ObjectivesEffective date October 2018 Section 4010.2

1. To determine whether profit planning andbudgeting practices are adequate.

2. To determine whether internal controls areadequate.

3. To assess whether the audit or independentreview functions adequate.

4. To determine whether information and com-munication systems are adequate and accu-rate.

5. To determine whether earnings are sufficientto support operations, provide for funding ofthe allowance for loan and lease losses andaugment capital.

6. To assess whether earnings are sustainable.

7. To determine whether board and senior man-agement effectively supervise this area.


Earnings—Analytical Review of Income and ExpenseExamination ProceduresEffective date October 2018 Section 4010.3

1. Review previous reports of examination,prior examination work papers, and filecorrespondence for an overview of anypreviously identified earnings concerns,strengths, or other considerations.

2. Review recent audits and independentreviews to identify deficiencies concerningthe reliability of management informationsystems (MIS) that may affect the qualityand reliability of reported earnings.

3. Review management’s remedial actions tocorrect examination and audit deficiencies.

4. Discuss with management any recent orplanned changes in strategic objectives andtheir implications for profit plans.

5. Review board and committee minutes andmanagement reports to determine theadequacy/quality of MIS systems and re-ports.

6. Review recent Uniform Bank PerformanceReports (UBPR) to develop an initial assess-ment of overall earnings performance. Con-sider the impact of Chapter S tax filingstatus when selecting performance ratios toreview.

7. Compare financial statements, UBPRs, andConsolidated Reports of Condition andIncome (Call Reports) to determine if therehave been any significant changes that couldmaterially affect earnings performance.

PROFIT PLANNING ANDBUDGETING PRACTICES

8. Review strategic plans, profit plans, andbudgets to determine if the underlyingassumptions are realistic. Determine thesources of input for profit plans and bud-gets. Profit plans and budgets should con-sider the following areas with detail appro-priate for the size, complexity, and riskprofile of the bank:

• anticipated funding of the allowance forloan and lease losses

• anticipated level and volatility of interestrates

• interest rate and maturity mismatches• local and national economic conditions• funding strategies

• new products and business lines

• asset and liability mix and pricing

• growth objectives

• capital requirements

9. Assess the timeliness of preparing andapproving the profit plans and budgets.

10. Compare earnings performance to budgetforecasts. Determine whether managementcompares budgeted performance to actualperformance on a periodic basis, modifiesprojections when interim circumstanceschange significantly, and evaluates budgetforecasts under multiple stress scenarios.

INTERNAL CONTROLS

11. Review management’s procedures to pre-vent, detect, and correct errors with respectto MIS.

12. Determine whether the income and expenseposting, reconcilement, and review func-tions are independent of each other. Con-sider testing selected income, expense, andbalance sheet items to observe the opera-tional flow of transactions and to assessthe potential for fraud from internal con-trol weaknesses. Areas commonly selectedfor review are

• large volumes of other income (miscella-neous, service fees, or any other unusualaccounts);

• proper amortization of loan originationfees;

• insider expense accounts;

• management fees or other payments toaffiliates;

• significant legal fees;

• prepaid accounts;

• stale items; and

• expenses accrued and unpaid.

13. Determine whether significant or nonrecur-ring income, expenses, and capital chargesare reviewed and appropriately authorized.


14. Determine whether insider or affiliate-related income and expense items are rou-tinely reviewed for authorization, appropri-ateness, and compliance with laws andregulations.

AUDIT OR INDEPENDENTREVIEW

15. Determine whether the audit or independentreview program provides sufficient cover-age of earnings activities relative to thebank’s size, complexity, and risk profile.Consider the following:

• adherence with profit planning objectives,accounting standards, and ConsolidatedReport of Income Instructions

• transaction testing completed to assureincome and expenses are accurately re-corded

• separation of duties and internal controls• adequacy, accuracy, and timeliness of

reports to senior management and theboard

• recommended corrective action when war-ranted

• verification of implementation and effec-tiveness of corrective action

INFORMATION ANDCOMMUNICATION SYSTEMS

16. Determine whether managerial reports pro-vide sufficient information relative to thesize and risk profile of the institution.

17. Evaluate the accuracy and timeliness ofreports produced for the board and seniormanagement. Reports may include

• periodic earnings results;• budget variance analyses;• income and expense projections;• non-recurring or cyclical items;• exposure to interest rate/market risk;• large item reviews;• insider related transaction disclosures; and• tax planning analyses.

18. Validate the accuracy of Call Reports asappropriate. Use bank work papers, thegeneral ledger, downloaded exception re-ports, and interviews with bank personnel to

verify the accuracy of the appropriate CallReport schedules.

RATIO AND TREND ANALYSIS

20. Assess the level, trend, and sustainability ofthe return on average assets relative tohistorical performance, peer comparisons,the organization’s risk profile, balance sheetstructure/composition, and local and nationaleconomic conditions. Consideration shouldalso be given to the amount and volatility ofincome from high-risk assets, asset concen-trations, non-recurring items, and account-ing practices subject to management discre-tion (which could manipulate earnings).Identify and assess any areas needing fur-ther investigation.

21. Evaluate the level, trend, and stability of thebank’s net interest margin. Discuss withexaminers reviewing credit, market, andliquidity risks the impact to present andfuture earnings performance from potentialchanges in asset quality, market fluctua-tions, and interest rates.

22. Evaluate the level and trend of overheadexpenses. Consider the impact of presentand future strategic initiatives (for example,branch openings/closings, increases/decreases in operating staff or executiveofficers).

23. Evaluate the level, trend, and sources ofnon-interest income. Discuss with manage-ment any projections for changes in feestructures. Consider the impact of changesin interest rates and market conditions onmortgage banking income, securities gains,or other non-interest revenue sources.

24. Review the level and trend of provisions forloan and lease losses and the relationship toactual loan losses to

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