The good news is that banking supervisors around the world have vastly increased their knowledge and understanding of risk and remuneration practices.  The bad news is… banking supervisors around the world have vastly increased their knowledge and understanding of risk and remuneration practices.

 

This is evident in a report by the Basel Committee on Banking Supervision that lays bare current practices, and the challenges faced by supervisors in deciding on action to control banking practices.  Australia’s APRA had a hand in the report’s development. 

 

You can find the Basel Committee on Banking Supervision‘s recently published report “Range of Methodologies for Risk and Performance Alignment of Remuneration” HERE.

 

Australia’s banks (and insurers) seeking an insight into what APRA may want to see going forward are well advised to read this report. 

 

The objectives of the report are to present (i) the remuneration practices and methodologies that support sound incentives and (ii) the challenges or elements influencing the effectiveness of risk alignment that should be considered by banks, when developing their methodologies, and supervisors, when reviewing and assessing banks’ practices.

 

In this regard, some Australian banks may have to review their current practices.  The Committee’s report suggested that:

 

“Measures of financial performance, such as targets based on revenue, profit or income, cash flow or return on equity, are still frequently used for performance measurement.  Measures used are often accounting-based and retrospective.  Virtually all companies employ a “management accounting” framework which maps company-wide financial measures to internal organisational units.  Many companies also rely on market based performance measures such as share price, particularly in the case of senior management.  Such measures rarely capture the full range (or any) of risks that employees’ activities pose for the company.”  (Guerdon Associates’ emphasis).

 

The Committee specifically notes that external measures, like share prices, may be adequately linked with the company’s objectives and strategies but may be influenced by various factors like market sentiment or general economic conditions, not specifically related to companies’ or employees’ actions.  In addition, they say that relative performance measures may increase incentives to take more risk or may, under certain circumstances, reward failure by decoupling remuneration from absolute value generation.

 

The idea that Australian banks should consider incentive plan measures other than those related to total shareholder return, including various risk adjusted approaches, has long been supported by Guerdon Associates.  The Committee supports this approach, suggesting:

 

“[risk-adjusted return on capital (RAROC), economic profit, risk-adjusted cost of funding (where the risks of a specific activity are directly priced into the cost of capital) or pure accounting adjustments (such as provisioning for future expense)] might be used directly to assess risk-adjusted performance or as drivers to apply risk adjustment in the award process.”

 

Banks that have instituted a bonus deferral plan that is uniformly applicable across disparate levels and types of staff may be in for a bit of work reviewing, unwinding, and then more discriminatingly re-applying it.  The Committee acknowledged that most large international banks continued to feature a deferral period and vesting schedule that is the same for all or almost all employees of the company who receive deferred remuneration, especially for employees below the senior executive level.  That is, the duration of deferral periods and details of vesting schedules vary somewhat between companies, but not much within companies.  Moreover, the fraction of bonuses that is deferred tends to depend formulaically on the employee’s total pay. 

 

The Committee suggests that this is not good:

 

“Though deferred remuneration is often described as helping to align risk-taking incentives, standardising the features in ways that do not depend on risk calls into question whether companies are really paying attention to risk incentive alignment.”

 

Deferral is now practiced by virtually all large Australian-based, APRA-regulated companies, as well as the majority of OECD banks.  Bonus deferral was a relatively easy and transparent process to implement in the wake of the GFC.  Perhaps as a result, deferral also comes in for more attention from the supervisors, who want to make it clear that they do not regard it as a panacea for better risk management. 

 

In that regard, a major concern for the supervisors is very long tail risk.  Deferral (for ex post risk adjustment) may not be fully effective in constraining the incentives of employees who have the ability to expose the company to extremely long-term risks, as these risks are unlikely to be realised during a reasonable deferral period.  In such cases, ex ante risk adjustments become more important.  The Committee is therefore indicating it would like to see more up front risk adjustment in the measures used (e.g. RAROC, EVA etc).

 

A website article like this does not allow us to do more than select a few highlights from the Basel Committee on Banking Supervision paper, which is a rich source of examples of remuneration plans that cover the gamut of institution size, product, geographic scope, employee accountability and risk adjustment methods.  For those in banking (and insurance) it is well worth the read not only to anticipate what APRA may require of you next (and in that regard, consider how you may rate by referencing the scorecard in Annex 3 of the paper), but to refine your own approaches to complex remuneration and risk management issues.

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