Academic journal article AEI Paper & Studies

Incentive Compensation for Risk Managers When Effort Is Unobservable

Academic journal article AEI Paper & Studies

Incentive Compensation for Risk Managers When Effort Is Unobservable

Article excerpt

1. Introduction

The financial crisis focused attention on the management compensation practices of large financial institutions. Institutions that participated in the Troubled Asset Relief Program (TARP) faced limits on the compensation for their most highly paid executives. The Office of the Special Master for TARP Executive Compensation (Special Master) was created and assigned responsibility for setting compensation levels for top executives and highly paid employees at companies receiving TARP assistance. The Special Master did not restrict salaries, but instead limited the magnitude of incentive compensation (IC) awards, required extended vesting periods for IC payments, introduced "clawback" provisions, and prohibited "golden parachute payments" to the most senior executives of TARP institutions.

In June 2010 the federal banking regulators (2) jointly issued guidance on IC policies. This guidance applied to executive and non-executive bank employees who have the ability to control or influence the risk profile of a financial institution. Concurrently, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) which requires all federal financial regulators to issue formal rules to prevent covered financial institutions from writing IC agreements that expose an institution to inappropriate risks or material potential losses. In April 2011, the federal financial regulators issued a Notice of Proposed Rule Making (3) (NPR) on IC that is similar to the 2010 joint banking agency guidance.

Regulatory guidance on IC requires that compensation arrangements balance risk and financial results without encouraging employees to expose their organization to imprudent risks. The guidance and the April 2011 NPR recognize four methods to achieve this goal: (1) risk-adjusting IC awards based on quantitative or managerial judgment; (2) deferring IC significantly beyond the end of the performance period and adjusting it for interim losses; (3) basing IC on longer-horizon performance with perhaps a deferral component; and, (4) reducing IC's sensitivity to short term performance by structuring IC so that it is an increasing but strictly concave function of the performance measure.

The only specific guidance regarding IC for risk managers appears in the Federal Reserve Board's October 2011 horizontal review on incentive compensation practices. The report [19, p.22] argues that inappropriate risk manager IC can compromise risk management activities, and to ensure proper risk management, the institution should decouple the risk manager's IC performance target from the performance of the activities over which the risk manager exercises control:

"... a conflict of interest is created if the performance measures applied to them (risk managers), or the bonus pool from which awards are drawn, depend substantially on the financial results of the lines of business or business activities that such staff oversee. ... Thus, risk management and control personnel should be compensated in a way that makes their incentives independent of the lines of business whose risk taking and incentives compensation they monitor and control."

The purpose of IC is to create an incentive for the risk manager to expend effort or otherwise exercise risk control judgments that are in the best interest of stakeholders when the effort and judgments of risk managers cannot be directly observed or are otherwise not contractible. The regulatory guidance regarding risk manager IC is particularly unsettling because it requires that risk manager IC be independent of performance of the specific activities risk managers control.

When shareholder interests diverge from those of regulator and deposit insurer stakeholders, risk manager IC should be structured to account for the regulator's interests, but the IC must still be based on the ex post performance of the activities under the risk manager's control. …

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