In stark contrast to some Australian and US institutional investors, the Financial Stability Board (FSB) has stepped up its requirements that bank boards must incorporate an assessment of “difficult to measure risks” when determining incentive pay outcomes.

On Friday 9 March, the FSB released “supplementary” guidance to its 2009 compensation guidance. This latest guidance does not establish additional principles or standards beyond those already set out in the FSB’s Principles and Standards for Sound Compensation Practices published in 2009 (see HERE). This supplementary guidance takes the form of recommendations on better practices for significant financial institutions.

Here is a summary of the supplementary guidance with Guerdon Associates’ comments (labelled with our initials).

1.  The board should oversee, and senior management should implement, a compensation system designed to promote ethical behaviour and compliance with laws, regulations, and internal conduct standards. Boards should actively engage with senior management, including challenging senior management’s compensation assessments and recommendations if warranted when serious or recurring misconduct occurs. Boards should ensure that on these occasions analysis of the root cause is undertaken, the lessons learned are promulgated throughout the firm and new rules and policies adopted to prevent it from happening again.

2.  Sound governance, robust risk management frameworks and adequate involvement by control functions, including human resources, in compensation design and decision-making are critical to the effectiveness of compensation incentives in addressing misconduct risk.

GA comment: In its explanation of this point, it is clear the FSB believes appropriate risk management should include the present value of career rewards. It is not just about current year fixed pay and incentives. Rather, a robust governance and risk management framework should have regard for performance assessments, development opportunities, promotion and career progression. We know this is something that APRA, too, is aware of, but has bypassed many boards.

3.  The ultimate responsibility for ensuring accountability for misconduct lies with the board of directors. Boards are accountable for overseeing compensation systems that promote prudent risk-taking behaviours and business practices. They should hold senior management accountable for implementing and participating in the design of a compensation system that effectively delineates how compensation tools address misconduct risk.

4.  Senior management should hold line of business management accountable for communicating, implementing and meeting expectations regarding ethical behaviour and business practices in compliance with laws, regulations, and internal conduct standards. Internal communications should ensure that the potential consequences of misconduct on compensation are clearly explained to all employees.

GA comment: while the board is ultimately responsible for the compensation system, participants should be able to clearly recognise how their compensation will be impacted in the event of misconduct, and conduct expectations clearly understood.

5. Compensation should be adjusted for all types of risk, including “difficult to measure” risks. These include risks associated with misconduct that can result in harm to companies, customers and other stakeholders. The processes for managing misconduct risk through compensation systems should include, at a minimum, ex ante processes that embed assessment criteria for non-financial matters such as the quality of risk management, degree of compliance with laws and regulations and the broader conduct objectives of the firm including fair treatment of customers. These non-financial matters should be reflected in individual performance management and compensation plans at all levels of the firm and as part of the broader governance and risk management framework. Such processes should be supported by ongoing programmes including formal training courses that reinforce appropriate standards of behaviour.

GA comment: Difficult to measure risk is included in the formal assessment process. Readers might recall that some shareholders and their advisers had trouble supporting incentive frameworks that rewarded, as well as punished, difficult to measure risks (see HERE).

6. To effectively accommodate the potentially longer-term nature of misconduct risk, compensation systems should provide for mechanisms to adjust variable compensation, including, for instance, through in-year adjustment, and malus or clawback arrangements that can reduce variable compensation after it is awarded or paid.

GA comment: this is now well-accepted among the ASX 50 and is certainly practised by all listed ADIs.

7. Compensation policies and procedures are an important control on misconduct. To ensure consistency, fairness and transparency in the application of compensation adjustment, it is important that effective policies and procedures are in place to decide cases that may result in reductions to variable compensation, based on clear specification of the misconduct triggers in those policies, or other mechanisms that may result in such reduction.

8. Supervisors should, within the scope of their authority, monitor and assess the effectiveness of firms’ compensation policies and procedures, including the application of compensation tools in addressing misconduct risk and related misconduct outcomes. National regulations and/or guidance should set out clear expectations, within the scope of applicable legislative and regulatory frameworks, on the use of compensation tools in addressing misconduct risk and related misconduct outcomes and the criteria for their application. GA – Although APRA’s guidance (See HERE) incorporated this, the BEAR legislation (See HERE) in effect mandates it.

See the new FSB guidance HERE.

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