As the limits of banker pay regulation are reached, the focus turns to culture…
29/05/2015
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As we have observed in Europe, there are practical limits to regulation of banker pay. The result is that culture is emerging as the new focus in regulators’ and supervisors’ attempts to ensure stability in the financial sector. This focus appears to have landed on top of each bank’s board of directors.

In the words of the governor of the Bank of England Mr Mark Carney, speaking as the Chair of the Financial Stability Board, “The succession of [bank] scandals means it is simply untenable now to argue that the problem is one of a few bad apples. The issue is with the barrels in which they are stored.” (see HERE for Mr Carney’s speech in Singapore in November 2014).

In the EU and European Economic Area (EEA), bonuses and other forms of variable pay for bankers are now limited to 100% of fixed remuneration, or 200% with shareholder agreement, and there are requirements for deferral and payment in financial instruments (refer to the fourth Capital Requirements Directive (CRD IV), which implemented the Basel III banking reforms). The 120 page European Banking Authority (EBA) guidelines to implementing these rules give some idea of the level of complexity (and bureaucracy) involved (the draft guidelines are open for consultation until 4 June). As you would expect, European banker fixed pay has started to soar to make up for the loss of incentives.

With London the biggest financial services centre in Europe, the UK has opposed bonus caps on the grounds that banker pay is an issue for shareholders rather than government regulation, and that it would inflate fixed pay, restrict the scope for using malus and clawback to penalise senior banker misconduct and discourage long-term performance based remuneration (especially as the EBA would apply the limits at vesting of long-term awards). In addition, as directors of Australian banks with European operations have noted to us, it increases bank vulnerability to have a variable cost converted to a higher fixed cost. 

One alternative approach, suggested by Mr Carney in his Singapore speech referred to above, would be to develop standards to put non-bonus or fixed pay at risk to ensure the burden of excessive risk taking is borne by those staff. While this interesting idea may call into question the “fixed pay” label, there is some research to support its validity (see HERE

The Managing Director of the International Monetary Fund, Ms Christine Lagarde, has also acknowledged that regulation alone cannot address the risks to financial stability caused by poor culture at some companies, and suggested that companies need more powers to claw back pay and bonuses in the event of misconduct, and that internal governance and risk management need further reform.

“Whether something is right or wrong cannot be simply reduced to whether or not it is permissible under the law,” she said. “What is needed is a culture that induces bankers to do the right thing, even if nobody is watching.”

“Ultimately, we need more individual accountability. Good corporate governance is forged by the ethics of its individuals … I want to see institutions themselves take up this matter – shareholders and bondholders too. There should be a drive in the private sector for better alignment of risks and incentives,” she said (see Ms Lagarde’s speech HERE).

In the UK, a significant move towards increased individual accountability has been taken by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA), which have published a set of near-final rules for a new accountability regime that is to come into force from 7 March 2016.  The ‘Senior Managers Regime’ will apply to senior managers in banks, building societies and designated investment companies and insurance sectors.  Contrary to notions of collective board accountability, it will also cover board chairs, senior independent risk directors and the chairs of the risk, audit, remuneration and nomination committees, as well as managers responsible for the day to day business operations. See the revised consultation paper published in March 2015; comments required by 16 June –HERE.

Senior bankers could also potentially be liable for prosecution, with the risk of a prison sentence in the most serious cases, for a new criminal offence of reckless misconduct that leads to bank failure, as established under s36 of the Banking Reform Act.

In Australia, both ASIC and APRA are now devoting more attention to improving the culture of organisations. 

As APRA’s Ian Laughlin put it in a speech on 13 March (see HERE

“Culture is … about what is truly important in an organization. It is about the way people actually behave (rather than what they should do, or even would like to do).

It is generally accepted that inappropriate culture was at the root of many of the problems that emerged in the GFC (such as the packaging of poor quality mortgages into AAA securities and the way they were sold). And in the problems that came to the surface since then (such as the LIBOR scandal and the attitudes that allowed it to evolve). And indeed in many of the problems that emerged before the GFC.

APRA is significantly increasing the attention it gives to risk … because it is so different to other aspects of prudential management and rather contrarily is actually quite hard to manage.

So what is needed for a sound risk culture? Here are a few thoughts:

The risk appetite must be clear and unambiguous; the espoused values must be clear and consistent with the risk appetite and the business strategy; those values must be embraced across the organisation; and decision-making must be consistent with the values, risk appetite and business strategy.

All of those nice words will be just that – nice words – if remuneration and incentives are not aligned with the desired behaviour and culture, or if senior management or the board are seen to act inconsistently with the words. I can’t stress this enough. Reward staff to behave as you would want them to. Act as you would want them to act.”

The APRA Chairman, Mr Wayne Byres, echoed these sentiments, and those of Ms Lagarde, in a speech on 28 May 2015, when he nominated the inter-related areas of governance, culture and remuneration as key areas still requiring serious improvement. In Mr Byres’ words,

“Much of the post-crisis reform agenda has been aimed at getting the organisational interests of financial firms more aligned with those of the wider community. Getting personal incentives correspondingly aligned with organisational interests needs to be seen as equally important.” 

Mr Byres’ speech can be seen HERE.

 

Given Australian (most) banks’ vertically integrated wealth management businesses and evidence of widespread financial advice abuses, the emphases of the regulators may see direct demands on boards to demonstrate how they actively oversee culture. Yet bank directors on a panel at the recent ACSI conference were observed to be at pains, it seems, to divert the debate away from such a focus. It appeared that monitoring a bank’s culture on top of compliance with regulation, transitioning to higher capital requirements, and managing other aspects of risk management is asking too much at this stage.

You cannot say that a bank director’s job does not throw up the odd challenges now and then.

© Guerdon Associates 2021
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