Remuneration policy – do what I say or lose some pay…

The current crisis has turned the spotlight of public opinion on the way in which systemically important financial institutions remunerate their senior management and their front office staff, with a particular focus on rewards for failure – with Sir Fred Goodwin acting as the movement’s poster child due to his apparently upwardly mobile pension arrangements.

Lord Turner, in the thoughtful FSA review of the causes of the crisis and the necessary remediation thereof, has played to the gallery of public opinion – not doing so was never an option – whilst giving a clear view of how remuneration policy was a contributor, rather than a fundamental cause.

There is an unambiguous acceptance that, whilst the remediation proposals include detailed provisions on oversight of remuneration, it is more likely that the other policy proposals – principally around making higher risk business strategies exponentially more expensive to run – will have a greater impact on the levels of variable remuneration paid to structurers, traders, and bank directors.

Despite the lesser importance of remuneration within the Turner review package, there is a truly momentous potential impact for compliance and risk management functions arising from the proposals accompanying the review, which we cover below.

There is also the fundamental acknowledgement that national action in this area is almost an irrelevance if there is no concerted global action and standard: sensibly, the 10 principles on which FSA bases its future regulation of remuneration policy have been developed with the Financial Stability Forum, which has now published its own paper (FSF Principles for Sound Compensation Practices) containing broadly similar proposals to FSA’s, for international agreement.

The FSF paper is naturally written at a much higher level than FSA’s proposals, allowing for a global governmental and regulatory audience. Whilst clearly focused on the same outcome, the key difference is that the FSA paper is more prescriptive – in keeping with the demise of ‘light-touch regulation’.

The core element, from a UK compliance and risk management perspective, is not in the Turner review itself, but is contained within the accompanying Consultation Paper. The FSF does provide a hint of what is to come in guidance to the Principles that, “Poor business unit results for internal audit, compliance, or risk management, for example, should reduce payments to the staff and managers of that business unit.”

FSA Proposals
The Turner review proposals on remuneration are covered in more detail in FSA Consultation Paper 09/10, published on the same day.

In summary, FSA proposes a simple, over-arching requirement to be incorporated into the Handbook as a Rule: “A firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management.”

FSA then proposes ten Principles to be incorporated in the Handbook as evidential provisions supporting the very generic requirement, each with its own detailed guidance.

Practical impacts of underlying Principles
In our view there are two fundamental Principles amongst these ten which signal, strengthen and underline major cultural changes for firms’ most senior management and for their risk and compliance functions, demanding a major change in approach and engagement.

Principle 1
Part (c) of Principle 1 requires that a remuneration committee should have the skills and experience to reach an independent judgment on the suitability of the policy, including its implications for risk and risk management.

This implies three things:

• Non-executive directors are going to have to receive training on risks attached to the underlying products and business models, unless they can demonstrate sufficient knowledge to avoid it,
• Therefore there is likely to be a preference for non-execs with wide financial services, rather than industry, experience, and
• There will need to be a formal advisory relationship between the CRO/CCO and the Remuneration Committee, with attendance at key meetings.

The implication of the third point is absolutely fundamental, as the CRO/CCO may have the responsibility of telling the Remuneration Committee that the proposed remuneration package for executive Board directors is far too generous, based on an assessment of the underlying risks. Will you be comfortable telling the non-execs that they should reduce your CEO’s bonus?

It is, however, noteworthy that (from their own website) the least damaged of the major UK global banking groups already has a Remuneration Committee comprised solely of non-executives, who have enormous experience in managing major multi-national groups but no apparent personal experience in banking.

Has Lord Turner got it wrong on this point, then? I think he may have: what is over-ridingly important is the culture of the institution: the detailed governance structure is a support to that, and not a guarantee.

Principle 2
The second part of Principle 2 has even greater implications for compliance and risk functions:

“A firm’s risk management and compliance functions should have significant input into setting remuneration for other business areas.”

Sit back and think about that one for a moment. This proposal, if delivered, is an enormous swing in the banking balance of power away from the front office and towards control staff.

This is generally a good thing – many of us will say ‘about time, too’. It does also contain significant dangers, as potentially it allows risk and compliance managers to introduce the subject into any difficult conversation with the business as a substitute for coherent and well thought-out argument.

It also further reiterates the requirement for risk management staff to advise and attend the Remuneration Committee, specifically in this instance on risk adjustment for performance-based P&L measures.

Conclusion
This under-regarded element of the Turner review represents an absolutely fundamental change in the nature of the relationship between risk and compliance management functions and the institutions they serve. It will be interesting to see whether the FSA proposals remain intact (any industry opposition is likely to be disregarded as arising from self-interest) and to what extent other national regulators take a similar line in interpreting the FSF Principles – this fundamental change in role may become globally mandated, rather than purely domestic.

All is not, however, days of wine and roses for risk and compliance staff, and those based in the UK may choose actively to make a response to the FSA Consultation Paper on at least one point (particularly bearing in mind the FSA/FSF alignment on this paper).

The most unhelpful element of CP 09/10 is undoubtedly the FSA’s statement as Guidance to Principle 3 that:

“We would generally expect the ratio of the potential variable component of
remuneration to the fixed component of remuneration to be significantly lower for employees in risk management and compliance functions than for employees in other business areas…”