The Committee of European Banking Supervisors (CEBS) published its draft principles on remuneration policy on Friday 6 March 2009.

This is the latest in regulator reports that converge on applying the same remuneration principles globally. And to make sure they do this, it has already been agreed by the 26 members of the Financial Stability Forum in March that the Basel Committee on Banking Supervision will be the global enforcer, according to Lord Turner, chairman of the UK’s FSA (see the FSA chairman’ s report HERE).

However, it is important in reviewing these responses to keep in mind that the impact of remuneration on the crisis and the role of remuneration regulation is anything but clear cut. This has been admitted by investigators and the regulators themselves, particularly the excellent IIF report back in October (see HERE) and Lord Turner recently.

Lord Turner admitted it is difficult to gauge the extent of the role of incentivisation in the crisis, but said it is reasonable to suggest that “while inappropriate remuneration structures played a role, they were considerably less important than other factors – inadequate approaches to capital, accounting and liquidity“.

He added: “It is indeed likely that the regulatory responses which will have greatest influence on future remuneration levels will not be the specific remuneration-related policies. The major increases in capital required against trading book activity are likely to play a much more significant role in reducing the aggregate scale of trading activity, and so the aggregate remuneration of people involved in those activities, than any policies designed directly to influence remuneration.”

He noted the need to be “realistic” about the ability of remuneration policies to ensure “sensible” employee behaviour and to compare the importance of remuneration policies with other regulatory tools. “Excessive risk taking, at least at the top management level, may be driven more by broad behavioural and cultural factors than by a rational consideration of the precise incentives inherent within remuneration contracts: dominant executive personalities have a strong tendency to believe in their own strategies. And the reality of excessive risk can often only be spotted at a systemic level.”

These principles address key aspects of a well functioning remuneration policy and thus support the sound operations of banking institutions. The wording is less precise than that of the FSA Code (see HERE), so could be taken as less prescriptive. However, in some ways CEBS, the FSA, probably APRA and other country-specific regulatory agencies may drift from the clarity of the principles initially developed by the International Institute of Finance (IIF) in July 2008 (see HERE).

These were that “firms should:

• Base compensation on risk-adjusted performance, and align incentives with shareholder interests and long-term, firm-wide profitability;
• Ensure that compensation incentives do not induce risk-taking in excess of the firm’s risk appetite;
• Align payout with the timing of related risk-adjusted profit;
• Take into account realized performance for shareholders over time in determining severance pay; and
• Make the approach, principles, and objectives of each firm’s compensation policies transparent to stakeholders.”

The IIF noted that their “Principles of Conduct for Compensation Policies” set broad guidelines but that it was neither possible nor desirable to state specific recommendations as in other parts of their report. Compensation — and especially “incentive” compensation — is a differentiating factor for firms and each firm must make its own decisions on how to apply the principles of conduct.

Well, it seems that the regulatory agencies are becoming more specific, with the consequence that compensation may become a less differentiating factor across the sector.

The scope of the CEBS’ principles covers remuneration policies applying throughout an organisation rather than focusing exclusively on executive pay or severance pay. It focuses on key aspects of the remuneration policy, and in particular:

• Alignment of company and individual objectives;
• Transparency towards internal and external stakeholders;
• Governance with respect to oversight and decision-making;
• Performance measurement;
• Form of remuneration

In drafting these principles, CEBS coordinated its work with other relevant international forums working on the topic of remuneration, in particular the FSF.

The implementation of these guidelines by the banks is expected by the end of Q3 ’09 in order for supervisors to make a first assessment of the institutions’ progress in transposing the principles.

The principles recognise that the requirements and appetites for risk will differ between financial institutions.

For example, while it notes that remuneration should not encourage “excessive” risk taking, they encourage remuneration policies in line with each firm’s “business strategy and risk tolerance”.

Interestingly, the principles single out the “control functions” (i.e. risk, compliance, internal audit and human resources) for “adequate” reward. We take that as code for the control functions not to be the poorly paid cousins of their risk-taking line area risk jockeys, and to be paid a fair whack more than they are being paid now.

However, as with the FSA Code, the principles also note that these functions should not have their pay contingent on the same outcomes as line areas, and that their performance pay be based on achievement of their own separate and unique objectives.

Also, in accord with the FSA Code and statements from agencies around the world, they note that performance pay should not be the outcome of a mechanical formula tied to financials, but there should also be an overlay involving assessment of non-financial aspects.

The principles explicitly require that poor performance in non-financials (such as unethical or non-compliant behaviour) override otherwise good profit performance.

As with other agencies in this space, the principles require that performance measures used be adjusted for risk and the cost of capital. Unfortunately, as with all other regulators, there is no recognition that the market’s (low) valuation of capital costs encouraged overleveraging that got the world into this mess in the first place.

Also in line with others’, the principles require that employees not be dependent on their bonuses. As we have noted before (see HERE), this will result in a significant increase in pay “without performance”, which should please shareholders no end!

In addition, there is no recognition that significant variable pay is a safety valve (if managed properly) that allows the cost base of companies to vary with profit levels, keeping margins intact, companies solvent and employees in their jobs perhaps long enough to see out the downturn.

Blink and you will miss the CEBS consultation period, which ended on Friday, the 3rd April 2009. The shortened consultation period is caused by external deadlines (i.e. we expect this is the need to have the code ready for European companies to develop plans in their 3rd quarter for implementation in 2010).

The CEBS principles have been removed from their site since the close of submissions on Friday 3 April 2009.  We will provide a link when they are republished.

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