Navigating Incentive Compensation Programs- Managing the Risks of Incentive Compensation Programs

Posted on September 05, 2023

by Christopher Price, CAMS, AMLP, Senior Consultant, Regulatory Advisory Services

Incentive Compensation Programs (ICPs) can play a crucial role in driving the success of financial institutions. According to the Supplementary Information section of the Interagency Guidance on Sound Incentive Compensation Policies, ICPs can attract skilled staff, enhance organization-wide and employee performance, encourage employee retention, provide retirement security, and align personnel costs with revenues.

Given these benefits, it's no wonder financial institutions use them. However, compensation arrangements come with inherent risks. Inadequate risk management in ICPs has led to imprudent risks taken by both C-Level management and employees, risking possible reputation and consumer harm, as well as civil and criminal penalties. Over the last seven years, two large banks faced significant enforcement actions due to abusive practices towards consumers, largely driven by unsound incentive compensation practices.

Our blog examines these practices and offers insights into how financial institutions can mitigate the associated risks. By adopting prudent risk management strategies, institutions can strike a balance between incentivizing their workforce and ensuring a secure and compliant operational environment.


Unsound Compensation Policies

Several incentive compensation policy failures historically contributed to financial crises and major compliance failures.  Among these are:

  • Compensation arrangements that fail to balance risk and reward can and have encouraged short-term profits at the expense of long-term risks.
  • Failure to involve risk management personnel in designing ICPs and thus failing to integrate ICPs into risk-management and internal control frameworks to effectively monitor and control ICPs.
  • Failure of bank board of directors to play an informed and active role in ensuring a proper balance between risk and profit initially and on an ongoing basis.


Types of Incentives & Their Corresponding Risks

Incentives can be broadly categorized as:

1. Cash-based – Include commissions and bonuses.

  • Example: providing tellers a bonus for cross-selling a certain number of credit cards to customers each month.
  • Risk: Tellers might aggressively sell credit cards to customers who don’t need them, potentially causing customers to take on unnecessary debt.

2. Non-Cash – trips, additional time off, vacations, gift cards etc.

  • Example: Offering mortgage officers stock options that vest over time based on the number of mortgages originated.
  • Risk: Advisors might prioritize quantity over quality, leading to the origination of risky mortgages to meet stock option price targets, but may ultimately lead to defaults and subsequent losses for the bank.

3. Profit Sharing – sharing of the financial institution’s annual profits

  • Example: Distributing a portion of the financial institution’s annual profits among all employees.
  • Risk: If profit-sharing becomes a significant portion of compensation, employees might focus on short-term profits at the expense of long-term strategic planning.

4. Career Development – promotions, special projects etc.

  • Example: Offering promotions and advancement opportunities based on achieving specific skill and performance milestones.
  • Risk: Employees might rush through skill acquisition to meet promotion criteria, potentially compromising the depth and quality of their expertise.


Core Principles to Manage ICP Risks

The 2010 Interagency Guidance on Sound Incentive Compensation Policies addresses the unsound policies covered above.  The converse of those unsound policies are three core principals:

1. Provide employees incentives that appropriately balance risk and reward;

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

3. Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.


By basing ICPs on these core principals, compensation arrangements become tailored to the size and complexity of the institution and its risk tolerance, rather than forcing a cookie-cutter approach that could result in a “square peg in a round hole” internal control structure, which will ultimately be ineffective and costly.


Reducing ICP Risk in Mortgage Products

Various regulations restrict or prohibit certain compensation. Much of the potential abuse consumers can face from improper incentive-risk balance involve mortgage products which generate a lot of revenue. Regulation Z’s Loan Originator Compensation Rules in 12 CFR 1026.36 define loan originators and place meticulous restrictions on how they can be compensated in closed-end dwelling-secured consumer transactions. Likewise for Sections 8A and 8B of RESPA which prohibit kickbacks and unearned fees. Compliance with these rules should include policy statements; documented procedures for both business line personnel and compliance personnel; and documented internal controls and reporting mechanisms to help manage day-to-day compliance.  Internal audit should have specific work programs for testing compliance of the ICP.


Best Practices to Mitigate ICP Risks

Not all products and services are governed by incentive compensation-specific provisions. Rather, regulatory guidance sets forth principals from which policies, procedures, processes and practices should flow.  Capco recommends financial institutions consider these, and fine-tune them to the size and complexity of the respective institution:


1. Risk Assessments – ICPs should be assessed for several risk areas, including exposure for credit risk, liquidity risk, legal risk and compliance risk. The Compliance Risk Assessment should measure the ICP against consumer protection risks and the various respective consumer protection rules (TILA, RESPA, TISA, FCRA, SCRA etc), fair lending risks (ECOA, FHA, HMDA, SCRA) UDAAP risks, and be considered within the Compliance Management System.

2. Sales Practice Evaluations/Referral Fees – Management should evaluate sales practices, particularly concerning products that generate higher sales commissions, as these can provide incentive for personnel to engage in inappropriate sales practices.

  • Institutions that employ dual employees, who work for both the bank and say, a broker-dealer, should carefully monitor their activities for steering of customers away from bank products toward investments (or vice versa) based on commissions or other incentive compensation.
  • Periodically review sales trends by product to identify any escalation in sales beyond the norm. Review those products against other product liquidations or other early termination for signs of possible steering from lower-commission products to the products with heightened sales statistics.

3. Training – Appropriate, mandatory training, with acknowledgment,  for all covered employees on Code of Ethics and Interagency Guidance. Further, case studies and recent enforcement actions to raise awareness at Board level.

4. Compliance Validations - While periodic audits of the ICP are a must, it may be prudent for the compliance function to conduct periodic compliance validations of the ICP, similar to an audit with respect to sample testing, but differing in that reporting is to Risk Management rather than the Board.


How Capco Can Help

Do you need additional support to ensure your ICP is compliant? Capco Regulatory Advisory Services can help! Our Big Orange Book Compliance Manual is a comprehensive guide to federal compliance regulations. User-friendly and easy to read, our clients find it to be the first place they look when confronted with a regulatory issue. Included in our services is direct access to run any compliance questions by our staff of compliance experts via our live chat and ticketing system. We also have an informative compliance Quick Reference Guide available on RESPA Section 8 – Prohibition Against Kickbacks and Unearned Fees.

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