Six US Agencies Propose Rule to Curb Excessive Risk for Firms with Over $1b

An invitation for the public to comment has been offered by six federal agencies in the United States that have come together to propose a new rule that would prohibit incentive-based compensation arrangements that encourage inappropriate risk at certain financial institutions, according to an official press release from the Securities and Exchange Commission (SEC) today.

The SEC was joined in the press release with the Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), the Federal Reserve Board of Governors (FED), National Credit Union Administration (NCUA), and Office of the Comptroller of the Currency (OCC), and the public comment period has a deadline of July 22, 2016, for feedback to be received.

The proposed rule was submitted for publication in the Federal Register and cites its basis under section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act which states that such rules and regulations are required, and aims to make relevant revisions to related sections.

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Dodd-Frank and fintech spotlight

In addition, the press release noted that there is evidence of flawed incentive-based compensation packages in the financial industry and how they contributed to the financial crisis that started in 2007.

As a convergence between new fintech solutions and traditional banking continues, a recent article by CNBC highlighted that some companies will likely need to deal with potential conflicts of interest, following the abrupt departure of LendingClub’s founder Renaud Laplanche over such concerns.

That news highlighted how the enthusiasm behind new technologies can sometimes mask the underlying potential conflicts that had already existed in traditional approaches – yet may have been camouflaged in fintech clothing, or as in LendingClub’s case, between the clients taking loans and the underlying investors buying the debt assets from LendingClub.

It's not clear if such developments prompted the coordinated action from the agencies or if the timing was coincidental, yet both are nonetheless reflective of the larger challenge at hand. In addition, the tail-end of the JOBS Act kicks in this month with regard to Regulation Regulation Like any other industry with a high net worth, the financial services industry is tightly regulated to help curb illicit behavior and manipulation. Each asset class has its own set of protocols put in place to combat their respective forms of abuse.In the foreign exchange space, regulation is assumed by authorities in multiple jurisdictions, though ultimately lacking a binding international order. Who are the Industry’s Leading Regulators?Regulators such as the UK’s Financial Conduct Authority ( Like any other industry with a high net worth, the financial services industry is tightly regulated to help curb illicit behavior and manipulation. Each asset class has its own set of protocols put in place to combat their respective forms of abuse.In the foreign exchange space, regulation is assumed by authorities in multiple jurisdictions, though ultimately lacking a binding international order. Who are the Industry’s Leading Regulators?Regulators such as the UK’s Financial Conduct Authority ( Read this Term A+, adding to the timeliness of the proposed rule.

Capital markets and lending

A section of the proposed rule letter used examples in fee arrangements used at mortgage lender and banking institution Washington Mutual (WaMu) which had basically gone bankrupt during the crisis before getting picked-up by Chase later in the same day after its stock price crashed.

An excerpt of the jointly proposed rules states: 'Some compensation arrangements rewarded employees – including nonexecutive personnel like traders with large position limits, underwriters, and loan officers – for increasing an institution’s revenue or short-term profit without sufficient recognition of the risks the employees’ activities posed to the institutions, and therefore potentially to the broader financial system. Traders with large position limits, underwriters, and loan officers are three examples of non-executive personnel who had the ability to expose an institution to material amounts of risk.'

Firms with over $1 billion AuM

The proposed rules are aimed at large institutions, with three levels prescribed, including level 1 for firms with $250 billion or more in assets, level 2 for firms with anywhere from $50 billion to $250 billion, and level 3 for institutions with assets of $1 billion to $50 billion in assets.

Companies that would fall into any of these categories would be required to document their incentive-based compensation arrangements annually, and keep those records for a period of seven years, according to the update.

The aforementioned compensation packages would also require that a company's board of directors be required to carry out proper oversight of the arrangements to make sure that inappropriate risk-taking is avoided. As excessive compensation could otherwise incentivize a material financial loss at the expense of investor/company assets.

Taming incentive-fueled risk

On a smaller scale, such commission-related activity that can lead to excessive risk, known as churning, in the asset management world, when a manager trades excessively for the sake of generating commission without regard for the effect of trading on client’s equity – including the resulting trading costs. For companies in the lending industry and the investors behind debt securities and related assets, similar examples can be applied, as noted in the proposed rule.

For companies with more than $1 billion in Assets under Management (AUM), such a new role as proposed in the joint press release earlier today could help bring more transparency while reducing the potential conflict of interest that the regulators seem concerned with, along with potential systemic risk in order to avert future crises. It will be interesting to see how respondents answer to the proposed rule during the comment period over the nearly 60 day allotted to them.