APRA to take action for less TSR incentives, less formulaic pay outcomes, and longer incentive deferral
02/04/2019
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Wayne Byres recently addressed the AFR Banking & Wealth Summit providing a report card for the key elements of our financial stability and soundness.

Financial resilience: Pass – Internal stress testing outcomes being validated by IMF review – but never take your eye off the ball.

Operational resilience: OK but under continued focus given evolving technological vulnerabilities .

Organisational and cultural resilience: here is where it gets interesting.

Following the Royal Commission, the prudential enquiry into the CBA and the subsequent mandatory self-assessments by 36 large Australian companies, APRA has identified organisation and cultural resilience, especially in pay matters, as an area of weakness.

Self-assessments have apparently flushed out lengthy lists of action items for boards identifying weaknesses against most of the themes in the CBA report.

Board and executive performance was (self) assessed as being more positive.  APRA does not believe this. Specifically, Mr Byers said:

“This, of course, begs the obvious question: how can boards and management give themselves a pass mark when they have identified a wide range of weaknesses in a number of key areas? Do boards and management have a blind spot – that blind spot being themselves? It’s a difficult but important question to ask.”

Some boards appear to be suffering a dose of Lake Wobegon syndrome. Clearly, boards need to consider how they are assessing themselves, given that not everyone can be above average.

Armed with this background, APRA has crystallised the program of work to strengthen organisational and cultural resilience into four categories: assurance and compliance mechanisms; accountability and consequences; governance and risk oversight; and incentives.

The renewed focus on incentives is expected. A revised prudential standard to be ready for consultation in late June.

What is coming?  Mr Byers identified 3 priorities:

  • A move away from TSRs (and share-price) dominance and the use of financial metrics in general as vesting criteria for LTIs, the aspirational target being ‘something less than 25%’;
  • A desire to see more discretion exercised in Board judgements around allocation and vesting of rewards accompanied by more transparency about decision-making. Gone is the acceptance of formulaic outcomes; and
  • Clawback, or in its absence, longer vesting periods perhaps incorporating holding locks. Minimum BEAR deferral requirements are not enough, where Europe sees deferral and clawback provisions out to seven years.

Whatever APRA has in mind, it had better be framed in a way to entice listed company boards away from the prescriptions of investors and proxy advisers, who do not see pay the same way as APRA does (see this interesting Op Ed from Ownership Matters HERE).

We expect that the revised APRA standards would do well to borrow from the UK Prudential Regulatory Authority’s remuneration rules (see HERE) . The UK rules are more prescriptive than current standards used by APRA. Nevertheless, there is much to be commended about the PRA remuneration rules.

We like, for example, how the PRA rules avoid any reference to artificial demarcations between long term and short term remuneration. Instead, they recognise that remuneration should reflect the business cycle:

“A firm must ensure that the assessment of performance is set in a multi-year framework in order to ensure that the assessment process is based on longer-term performance and that the actual payment of performance-based components of remuneration is spread over a period which takes account of the underlying business cycle of the firm and its business risks.”

Translated to Australian ADIs, the business cycle is, arguably, 5 to 7 years. Certainly, that is the term of remuneration deferral prescribed for  bank senior managers by the UK’s PRA.

Malus and clawback are also prescribed. Interestingly, in the UK, they only need to be applied if misconduct occurred, and the misconduct resulted in significant losses to the bank, rather than the potential for losses, or other forms of misconduct that may not result in losses (such as hunting down whistleblowers, bullying, or harassment). On this basis, last year’s FY 18 bank incentives would have been paid, with prospective malus to come this year if PRA rules were to apply here.

The material costs of bank remediations for some banks are coming to light now. This should be reflected in bank malus this financial year for prior incentives paid but not vested. So, in effect, proxy advisers and investors may have jumped the gun relying on forward looking annual TSR, whereas banks rely (or should rely if PRA rules applied) on retrospective adjustment of financials due to misconduct. Outcomes would be just, either way, so if APRA adjusts is standards for pay adjustment for misconduct that has material financial outcomes, it may be just a question of timing differences. That is, expectations of APRA are on a look back on what financial would have been after a misconduct adjustment, while investors appear to expect an adjustment based on forward looking TSR. One lags the other, although some bank boards sold short may say TSR suffers from occasional bouts of insanity.

See Mr Byers full speech HERE .

© Guerdon Associates 2021
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