APRA regulation need not prescribe remuneration – there is an alternative
09/09/2019
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The APRA Act requires APRA to balance the objectives of financial safety and efficiency, competition, contestability and competitive neutrality, and, in balancing these objectives, promote financial system stability in Australia. In effect, outcomes from APRA regulation and supervision are for thriving (aka profitable), healthy, and safe banking, insurance and superannuation industries.

The framework prescribed in the draft CPS 511 arguably does not achieve these outcomes.

The situation facing an APRA-regulated entity at any point in time varies with each entity. Prescribing a universal pay framework does not allow entities to respond effectively to each specific situation. For example, an entity in dire financial straits has to attend to financial performance to survive[1]. An APRA-regulated entity under threat from non-regulated entities has to respond competitively, whether this is in terms of service pricing, customer experience, and/or technology investment. Remuneration frameworks complement strategies to achieve these various ends. Flexibility is needed to be suitably agile and responsive, and cater to the situation. Prescribing remuneration frameworks is suboptimal in terms of financial safety and efficiency, competition, contestability and competitive neutrality.

Other countries have achieved change in remuneration frameworks without the level of prescription proposed by APRA.

This is not to say that several entities have failed in remuneration framework design, or in monitoring to ensure the design operates as intended. In addition, it is not denied that regulatory supervision has been found wanting, and that the shareholders in listed entities have been remarkably short-sighted. In fact, the latter, with prescriptive guidelines on how remuneration should be structured provide ready examples why a prescriptive approach has been suboptimal. For example, a significant proportion of these shareholders require the use of total shareholder return (TSR) measures, contrary to APRA guidelines (PPG 511).

While it is understandable that APRA wants a “counter-prescription” to the prescriptions of others, there are other, more effective, ways to change remuneration frameworks and practices, yet permit a degree of flexibility to be responsive, agile and competitive.

Guerdon Associates suggests this can be achieved with better transparency and the application of current APRA powers.

Better transparency can be achieved by

  • APRA stating remuneration design principles; and
  • Requiring entities to submit, annually, a remuneration report.

The remuneration report would not be dissimilar to ASX-listed company remuneration reports, but better.  APRA regulation would require the report to demonstrate how the remuneration framework and its implementation:

  • Is aligned with the entity’s business cycle
  • Promotes growth, sustainability and resilience[2]
  • Encourages today’s occupants of “responsible role categories” to develop and maintain a sound legacy for their successors
  • Adequately measures and rewards risk-adjusted financial outcomes (i.e. ex ante measures), and risk management behaviours (i.e. conduct)
  • Applies “consequence management” for less desirable performance, conduct and risk outcomes

If an entity does not provide sufficient or adequate evidence, APRA could use its power to remove the chair of the remuneration committee, and members, for failing to meet the “fit and proper” requirements under CPS 520 (see HERE) and as it is empowered to do by various legislation (e.g. Section 23 of the Banking Act 1959, see HERE) .

The UK, which does not prescribe remuneration frameworks to the extent proposed by APRA, has nevertheless achieved the same desirable outcomes partly by transparency (requiring the publication of a Remuneration Policy Statement), and the threat of removal of the director considered most accountable , the chair of the remuneration committee . See, for example, the latest UK FCA missive to remuneration committee chairs HERE .

In practice, it would probably be sufficient for APRA to provide notice that disclosures or evidence were inadequate and it would consider exercising its power if no improvements were made.

As we have observed under the “two-strikes” law, the threat of director removal, and subsequent reputational damage, has been sufficient for boards to respond to shareholders’ remuneration concerns. The APRA threat would have more substance, given that few “two strikes” have resulted in a board spill and re-election, whereas APRA can direct removal by law. Therefore, APRA’s power should be more than enough to counter the prescriptions of shareholders in listed entities.

In addition, the transparency of disclosures, and evidence provided, should find support among listed-entity shareholders as well.

Transparency by the entity, and the transparency of APRA’s response, will enhance accountability for both.

If APRA was to go down this path, we would expect there may be objections from bodies representing directors and other stakeholders. But this is already an APRA power, so in effect, such objections would be without foundation.

The requirement would leverage other aspects of the draft CPS 511, including:

  • The annual remuneration compliance review under para 33
  • The triennial remuneration effectiveness review under para 34
  • The board competence requirements under para 23(b)

While the approach suggested above is considered more than adequate, some may want it to go further. If more oomph is required, the reporting requirements could be further increased by referring to the draft CPS 511 framework (e.g. deferral, extent of financial and non-financial measures) and require companies to report on an “if not, why not” basis on the extent to which the requirements have been applied.

This type of reporting is not preferred, as the temptation would be for boards to defer to a formulaic remuneration framework without adequate attention and critical assessment. As has been observed in the responses of listed companies to the two strikes law and shareholder and proxy adviser prescriptions . It has often been easier for boards to adopt prescriptions rather than work through and implement what is fit for purpose. In contrast, the requirement for boards to produce evidence that their remuneration framework meets APRA principles may avoid what was observed by APRA’s CBA Prudential Inquiry (see HERE) and its more recent review of 36 entities’ self assessments (see HERE).

An underlying assumption is that APRA would, in its supervisory capacity, make a judgement based on the evidence reported. Critics may say that APRA has not exhibited any significant leverage on remuneration frameworks in the past, even though all the listed banks, for example, did not follow PPG 511 guidelines. They continued a heavy reliance on relative TSR, and little reliance on ex-ante measures of risk-adjusted performance. This lack of action probably reflected the lack of expertise within APRA on remuneration and culture, which APRA has indicated it is seeking to address. This will be enhanced if the government accepts recommendations in the APRA capability review, that would make it easier for APRA to attract and retain suitably qualified personnel, among other things.

If APRA’s capability is not improved then a prescriptive approach, as advocated by draft CPS 511, could be implemented. However, while a prescriptive approach could be administered without an APRA capability improvement, it would fail in meeting APRA’s mandate. As a consequence, the nation will suffer from banking, insurance and superannuation industries that will be less competitive, and less healthy, than they otherwise would be.

[1] This includes profitability. Despite various comments in the Hayne Royal Commission report inferring an excessive focus on profitability was a reason for misconduct, it is an essential requirement for sustainability.

[2] It is interesting that APRA, despite prescribing an even split between financial and non-financial measures in CPS 511, gives pre-eminence to financial measures in its discussion paper (p.30):“APRA’s view is that these issues can be managed through sound remuneration design, such as by limiting the weighting of non-financial measures in scenarios with adverse financial outcomes.”

© Guerdon Associates 2019
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