FINANCIAL SERVICES
FSA publishes consultation paper on remuneration
A review of banking regulation by the Financial Services Authority (FSA) has signalled a major shift in the FSA’s supervisory approach with much greater scrutiny than ever before of bankers’ remuneration policies.
A new set of guidelines aimed at cracking down on pay and bonus plans in financial institutions would cover 45 of the largest banks, building societies and broker dealers operating in the UK. The code of practice on remuneration, which has been published as a consultation paper, includes a general requirement that “a firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management”.
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The FSA is planning to incorporate the remuneration code into its Handbook rule as “evidential provisions” to help guide regulated firms on the evidence the watchdog will focus on when assessing compliance. Failure to meet the standard could, for example, result in the FSA charging more to regulate them and/or requiring them to hold higher levels of regulatory capital.
An FSA spokeswoman told People Management that it would be the "first time that remuneration policy was specifically included as one of the FSA’s 'high-level principles' – standards that all regulated firms must meet or else face disciplinary action".
Role of reward in credit crunch
In his review of the banking crisis, Lord Turner concluded that inappropriate incentive structures did indeed play a role in encouraging excessive risk taking which contributed to the financial crisis. However, his review suggests that other factors played a greater part. Lord Turner said: “A reasonable judgement is that while inappropriate remuneration structures played a role, they were considerably less important than other factors already discussed – inadequate approaches to capital, accounting, and liquidity.”
He added: “In the past neither the FSA nor bank regulators in other countries played significant attention to remuneration structures. And within firms, little attention was paid to the implications of incentive structures for risk taking, as against the implications for firm competitiveness in the labour market and for firm profitability. In retrospect this lack of focus, by both firms and regulators, was a mistake.”
The Turner review recommends: “National and international action to ensure that remuneration policies are designed to discourage excessive risk-taking.”
Lord Turner was asked by the Chancellor of the Exchequer to examine the events that led to the financial crisis and to recommend reforms. The review identifies the underlying causes and stresses the importance of regulation and supervision being based on a system-wide "macro-prudential" approach rather than focussing solely on specific firms. Lord Turner said: "The changes recommended are profound, and the banking system of the future will be different from that of the last decade. The world’s economy will be better served as a result."
Want to know more?
--> The Turner Review: A regulatory response to the global banking crisis, Financial Services Authority, March 2009.
The 126-page Turner Review can be downloaded from the FSA web site in PDF format at:
www.fsa.gov.uk/pages/Library/Corporate/turner/index.shtml
Published alongside the Turner Review is an FSA discussion paper (PDF format) which sets out more detail on specific policy proposals. Discussion paper 09/2 can be downloaded at: www.fsa.gov.uk/pages/Library/Policy/DP/2009/09_02.shtml
The FSA invites comments on this discussion paper. You can send your response by electronic submission using the following form: www.fsa.gov.uk/Pages/Library/Policy/DP/2009/dp09_02_response.shtml
--> Reforming Remuneration Practices in Financial Services, Consultation Paper 09/10, Financial Services Authority, March 2009.
The consulting period on implementation of the Code for larger banks and broker dealers will run for two months, until 18 May. The period for discussion and feedback on the idea of extending the Code to other firms regulated by the FSA will run until 18 June. You can send your response by electronic submission using the following form: www.fsa.gov.uk/pages/Library/Policy/CP/2009/cp09_10_response.shtml
To download the consultation paper visit: www.fsa.gov.uk/pages/Library/Policy/CP/2009/09_10.shtml
The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and fighting financial crime. For more details visit www.fsa.gov.uk.
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Title: The Turner Review: A regulatory response to the global banking crisis, pp.79-81, Financial Services Authority.
2.5 (ii) Remuneration: requiring a risk-based approach
High levels of remuneration in banks, and in particular high bonuses paid both to top executives and to traders involved in trading activities which subsequently generated large losses, have been the subject of intense public focus as the financial crisis has developed. It is important to distinguish two distinct issues:
The first and short-term issue concerns the total level of remuneration paid to executives in banks which have received taxpayer support. This is a legitimate issue of public concern, and one where governments as significant shareholders have crucial roles to play. But it is not an issue for the long-term nor for bank regulators.
The long-term issue concerns the way in which the structure of remuneration can create incentives for inappropriate risk taking. It is on this issue that the FSA and financial regulators across the world are now focused.
In the past neither the FSA nor bank regulators in other countries played significant attention to remuneration structures. And within firms, little attention was paid to the implications of incentive structures for risk taking, as against the implications for firm competitiveness in the labour market and for firm profitability. In retrospect this lack of focus, by both firms and regulators, was a mistake. There is a strong prima facie case that inappropriate incentive structures played a role in encouraging behaviour which contributed to the financial crisis.
It is very difficult, however, to gauge precisely how important that contribution was. A reasonable judgement is that while inappropriate remuneration structures played a role, they were considerably less important than other factors already discussed – inadequate approaches to capital, accounting, and liquidity. And it is indeed likely that the regulatory responses which will have greatest influence on future remuneration levels, will not be the specific remuneration related policies described in this subsection. The major increases in capital required against trading book activity, described in Section 2.2 (ii), are likely to play a much more significant role in reducing the aggregate scale of trading activity, and so reduce the aggregate remuneration of people involved in those activities, than any policies designed directly to influence remuneration.
It is nevertheless likely that past remuneration policies, acting in combination with capital requirements and accounting rules, have created incentives for some executives and traders to take excessive risks and have resulted in large payments in reward for activities which seemed profit making at the time but subsequently proved harmful to the institution, and in some cases to the entire system.
In future the FSA will therefore include a strong focus on the risk consequences of remuneration policies within its overall risk assessment of firms, and will enforce a set of principles which will better align remuneration policies with appropriate risk management. An initial draft of the Code which sets out these principles has already been published, and an FSA Consultation Paper will be issued within the next week setting out a refined version of the Code, a description of the mechanisms by which the FSA will ensure its application, and an assessment of how existing industry practices compare with the Code principles.
Key principles within the Code include:
Firms must ensure that their remuneration policies are consistent with effective risk management.
Remuneration committees (or equivalent bodies with responsibility for remuneration policies) should reach independent judgements on the implications of remuneration for risk and risk management. Remuneration should reflect an individual’s record of compliance with risk management procedures, rules and appropriate culture, as well as financial measures of performance.
Financial measures used in remuneration policies should entail the adjustment of profit measures to reflect the relative riskiness of different activities.
The predominant share (two thirds or more) of bonuses which exceed a significant level, should be paid in a deferred form (deferred cash or shares) with a deferral period which is appropriate to the nature of the business and its risks.
Payment of deferred bonuses should be linked to financial performance during the deferral period.
Adherence to the rules will be achieved by:
a proposal to make adherence to the first overarching principle of the Code an FSA rule, at least for systemically important firms;
integrating assessment of remuneration policies into the FSA standard risk-assessment process (ARROW) with required improvements included in Risk Mitigation Plans; and
if necessary, using increases in Pillar 2 capital requirements to compensate for incomplete adherence.
The effectiveness of this new approach in achieving real change will depend on our ability to gain widespread international agreement to publish and enforce similar principles in all major financial markets. Acting alone, the FSA cannot influence the policies of foreign firms operating in the London market, nor (without possible adverse effects) the practices followed in other financial centres where UK banks have activities. The FSA has therefore been closely involved in a Financial Stability Forum (FSF) working group seeking to forge that international agreement, and the FSF will shortly publish principles closely aligned with the FSA’s approach. Achieving international agreement on mechanisms to ensure application of the principles by all major supervisory authorities will be a crucial subsequent step.
The principles developed by the FSA and the FSF, which share the objective of integrating analysis of remuneration issues into overall risk assessment, mark a significant shift in regulatory approach.
It should be reflected in bank management actions to ensure that remuneration committees focus on the risk consequences of remuneration policies.
But it is important to be realistic about the extent to which remuneration policies can ensure sensible risk assessment and behaviour, and about the relative importance of remuneration policies compared to other regulatory levers. Many top managers of financial firms which suffered huge losses during the financial crisis (and, in the case of Lehmans, complete failure), were very large shareholders in their firms, and in several cases had voluntarily chosen to invest large proportions of cash bonuses in their firms’ equity. But these large stakes in the long-term profitability and stability of their firms did not seem to result in any greater awareness of or concerns about the risks the firms were running.
Excessive risk taking, at least at the top management level, may be driven more by broad behavioural and cultural factors than by a rational consideration of the precise incentives inherent within remuneration contracts: dominant executive personalities have a strong tendency to believe in their own strategies. And the reality of excessive risk can often only be spotted at a systemic level.
While remuneration-related policies can therefore play a useful role, other regulatory changes, in particular those relating to capital, accounting and liquidity, will have more profound effects.
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