G20 measures to reduce bank misconduct risk via banking remuneration and culture
12/09/2016
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At the recent G20 meeting, the Financial Stability Board (FSB) described the progress made since the previous progress report (in November 2015) across the various streams of work, focusing on recent work relating to incentives. The report, published on 1 September 2016, provides an indication of how the continued focus on bank remuneration and culture may further play out.

The FSB made some interesting observations relevant to how bank remuneration and culture should be regulated.

In particular, given recent political wrangling pre and post the recent Australian federal election, the FSB noted that the division of labour between financial institutions and regulators is clearer – financial institutions need to own conduct/culture and if authorities owned this, then it would fail as it would become a compliance exercise. Financial institutions are wary of prescriptive details on culture/conduct that would hinder the ability of financial institutions to take their own approach. The implication is that ASIC and APRA need not regulate more. The observation is more in keeping with APRA’s supervisory focus than ASIC’s compliance focus.

The FSB also noted that driving culture change needs a rounded view of compensation and performance management; it is not just about compensation but also promotion, prestige and validation. It is important to put these non-compensation mechanisms into practice. While some individual Australian banks are doing this, it would be safe to say that implementation across the industry appears uneven.

On enforcement, participants thought that ex post enforcement actions against financial institutions were important but enforcement actions against individuals could be a more effective deterrent; a rogue trader would be impacted by the fear of jail.

Based on responses to the FSB survey of global participants, the ex post compensation tools that are most actively used in cases of misconduct include:

  • In-year bonus adjustments – Bonus reductions (or risk-adjusting annual pay based on performance against ex ante risk and performance objectives) appears to be the most frequently applied tool particularly when less serious misconduct occurs. In-year adjustments are considered to be much easier to apply, and may adjust compensation for events that originated in a previous time period.
  • Malus – The use of malus is not infrequent in a number of jurisdictions, although some banks noted that malus is used only when in-year adjustments do not suffice. The decision to implement malus may be influenced by the seriousness of the misconduct. Malus generally operates on all compensation considered to be “at risk”. Some of the institutions surveyed tie use of malus to compensation from specific periods of time in which inappropriate risk-taking or conduct occurred, but the majority consider any deferred compensation to be potentially at risk of malus, regardless of whether it is linked to the year in which misconduct occurred. Typically dismissal is accompanied by malus (loss of any unvested remuneration).
  • Clawback – Some of the institutions surveyed reported including contractual clawback provisions that are generally meant to be invoked for the most egregious cases.

Looking ahead, the FSB indicated that a change in tack might be in the offing. In Australia it would be helpful if the heat goes out of the “culture regulation” rhetoric first.

Financial institutions and supervisors have signalled the importance of shifting the supervisory focus to positive measures aimed at building a culture of good conduct. For the link between compensation and conduct to be meaningful, the focus must. therefore, be on the full career cycle, from hiring to promotion to potential dismissal. The institutions surveyed emphasised the importance of setting conditions for and motivating good conduct as part of the employee’s longer-term relationship with the employer, where professional development and reward should reflect a shared commitment to long-term values. This is particularly the case where there is a risk that other drivers, such as short-term profitability goals, may pull away from conduct goals.

The changes in culture – attitudes, policies, processes – that are underway will take time to embed. Changes triggered by regulatory requirements and supervisory guidance related to compensation and conduct over the last few years have been significant. Indeed, many participants at the industry roundtable said that compensation reforms needed time to be fully embedded and that additional regulation would not be desirable before existing reforms have been fully implemented. They noted the need for a number of performance cycles over which to incorporate and judge the effectiveness of recently implemented reforms. Both institutions and regulators are of the view that it may be too early to obtain a meaningful measure of the effectiveness of compensation policies and practices in managing conduct risk. They note, however, that there is an ongoing dialogue among jurisdictions as well as among supervisors and regulated institutions on these issues, and further enhancements to this dialogue could benefit from increased sharing of better practice. An enhanced dialogue may also facilitate consistency in approaches, a goal particularly important for global institutions.

The FSB report can be found HERE.

© Guerdon Associates 2021
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