Stephen Bartholomeusz
A policy that will pay dividends
The good thing about the Australian Prudential Regulation Authority’s final version of its remuneration policies for banks and other financial institutions is that, apart from some minor tidying up of its detail, it has stuck to the core policies it set out in its original consultation paper in May.
The policies remain principle-based and retain their focus on stronger governance structures and process in relation to remuneration and encourage rather than dictate prudent practices in relation to the detail of incentive schemes.
The approach isn’t prescriptive, although the regulated would be very aware that APRA has the regulatory authority to take action against any institution it felt wasn’t pursuing sound remuneration policies.
The requirements do echo the consensus on remuneration policies that has emerged globally among international regulatory agencies in the aftermath of a financial crisis that was seen to have arisen, either partly or largely, because of remuneration structures that actively encouraged excessive risk-taking.
The principles-based approach allows individual institutions the freedom to devise their own approach to remuneration and incentive structures – provided they have the proper governance framework in place to consider and evaluate the implications of their practices for risk.
That is preferable to doing what Kenneth Feinberg, the US pay ‘tsar’ did to those institutions still receiving taxpayer assistance earlier this year. He halved their executive compensation by decree. That will have unintended consequences, given that those banks and other institutions that have repaid their assistance are now back taking risks, paying out big bonuses and recruiting again.
APRA has also resisted lobbying to confine its regulation to banks. Sensibly, while banks may have been the epicentre of this particular crisis (although AIG, of course, was decimated by its risk-taking) APRA will extend the requirements to all the institutions it regulates, including general and life insurers.
The new regime places a special responsibility on an institution’s remuneration committee to both manage and monitor the compensation of senior individuals and report to their main board on the remuneration packages of executives whose roles and responsibilities might impact on the financial stability of the institution as well as more general risk-evaluation of remuneration practices for other employees.
The policies the committee develops must cover, not just employees, but third parties contracted to perform functions on the institutions’ behalf that could expose the organisation to risk.
Despite submissions to the contrary, APRA says there is sufficient evidence that the activities of third-party distribution channels created losses for regulated institutions (a reference to Storm Financial and the like, perhaps) to support its position.
Originally APRA wanted the remuneration of risk and financial control staff de-linked from the performance of the businesses they oversee but it has softened that stance slightly to provide some latitude to link the incentives for the chief risk officer and chief financial officer to the group performance "in certain circumstances". That’s a concession to the continuing war for talent.
The significance of APRA’s approach isn’t that the board of a bank or other regulated institution delegates remuneration policy to a committee and then washes its hands of the issue, but rather that each institution has a group of independent directors with expertise, or access to expertise, develop remuneration policies and monitor their implementation with a particular focus on their impact on risk-taking.
All financial institutions take risk and all financial institutions routinely experience losses as a consequence, even in the best of times. Even after the experience of the crisis regulators don’t want to discourage that.
However, boards do need to ensure they understand the risks being taken and that remuneration structures don’t promote excessive risk-taking – which fundamentally means creating symmetry in their incentive schemes between risk-adjusted performance and rewards over reasonable timeframes. A contributing factor to the crisis was the prevalence of short-term incentives for risk-taking that had no regard to longer term outcomes.
APRA does, of course, have the ability to balance schemes it considers encourages excessive risk taking by imposing capital surcharges on individual institutions. It has that authority today.
One would expect that once the new requirements are implemented and the remuneration and incentive policies and structures are developed, it will fine-tune its capital requirements to reflect the level of risk-taking encouraged by particular institutions’ remuneration strategies.