On 4 April APRA released its review of remuneration practices in Australia’s largest banks, insurers and superannuation licensees. In a nutshell, APRA found that bank executives pay outcomes did not reflect their individual accountability for risk, and that poor risk outcomes were not reflected in executive variable pay.
APRA’s disappointment in its findings were highlighted in Chairman Wayne Byres’ speech at the AFR Banking & Wealth Summit 2018 in Sydney titled “The Incentive to Fly Safely”.
Mr Byres’ comments included:
- “Prudential supervisors need to take a much greater interest in the attitudes towards risk-taking – the risk culture – within the institutions they oversee. What has become clear from this work is that a key driver of risk culture are the formal and informal incentives that individuals face within their organisations, and the accountability (or lack thereof) shown when outcomes are not what they should be.”
- “If incentives are the carrot used by companies to boost staff performance, accountability mechanisms are the stick. … However, the perception in the community is that in the financial sector, particularly at senior executive level, the carrots are large and the sticks are brittle. Not only are rewards generous, but there are seemingly few repercussions for poor outcomes. It’s in the industry’s interests that this perception changes.”
- The goal of APRA’s review of remuneration practices “was to assess how well the objective of the prudential framework – that remuneration should be aligned to sound risk management and the long-term financial health of the institution – was being met in practice … The headline message is that the institutions we reviewed by and large had the required frameworks, policies and processes that could provide the basis for a sound system of remuneration. But in many cases their practical application left something to be desired.”
- “If variable remuneration is rewarded based primarily on ‘how much’, without sufficient regard to the ‘how’, it creates incentives for short-term risk taking, and a disregard for risk and control frameworks. Fine words and aspirations about the importance of risk and compliance – the tone from the top – will be undermined if it seems that senior leaders are operating in accordance with a different set of rules.”
- “When done well, appropriately structured incentives and accountability mechanisms are a critical component of sustained commercial success. So we are keen for industry participants to take up the challenge of improving themselves, as some are already doing, rather than waiting to be told what to do.”
See his speech HERE.
The review found that remuneration frameworks and practices across the sample of 12 Authorised Deposit-Taking Institutions did not consistently and effectively encourage behaviour that supports risk management frameworks and the long-term financial soundness of the institutions.
While all institutions had remuneration structures that satisfied the minimum requirements of APRA’s prudential standards, the implemented practices often fell short of the sound practices set out in APRA’s prudential guidance. APRA concluded the institutions were, therefore, some way from best practice.
The review focused on three main themes:
- design of risk management performance measures
- remuneration outcomes, and
- Board Remuneration Committee oversight.
Among other things, APRA concluded there is room for improvement in:
- Adopting practices that are appropriate to the institution’s size, complexity and risk profile
- Assessment of, and weighting, risk outcomes within performance scorecards
- Enforcement by bank boards of accountability mechanisms in response to poor risk outcomes, and
- Ensuring there is evidence of the rationale for remuneration decisions.
APRA maintains that, on the basis of these findings, there is considerable room for improvement in both the design and implementation of executive remuneration structures within the Australian financial system.
As a result (and be warned), APRA also intends to strengthen its prudential requirements on remuneration to better support this outcome.
Some specific findings that APRA is likely to focus are summarised below.
- STI Scorecards could be more effective
APRA’s review found that many institutions used performance scorecards with a large number of core drivers (up to 20 metrics in some cases). A high number of measures can reduce the impact of any one metric, and this is of particular concern if risk management is one of the metrics with diminished impact.
For the majority of the sample, risk management was given an average weighting of 14% of the total performance scorecard, with an overall range between 5% and 25%. As a result of the low weighting, the review identified cases where individuals with very poor risk management scores still receiving over 90% of their STI target. This indicates misalignment between effective risk management and remuneration outcomes.
- Individual performance measures and variability of outcomes minimised
For the majority of entities in the sample (7 out of the 12), the weighting of assessment metrics was more closely tied to the overall financial performance of the institution rather than to individual performance.
APRA’s concern is that an individual becomes less accountable for their particular responsibilities. This ‘averaging out’ effect potentially undermines effective risk management.
- Absence of significant downward adjustments at executive level
The review observed that downward remuneration adjustments to individual executives were rare. While there were many examples of employees at lower levels getting downward adjustments (either in-year adjustments or malus), these were not always matched by corresponding adjustments at an executive level to recognise overall line or functional accountability.
Limiting responsibility for poor risk outcomes to below the executive level suggests an inappropriate assignment of accountability.
- LTI vesting conditions focussed wholly on investor return measures such as total shareholder return (TSR) and return on equity (RoE).
No apparent links to measures of long-term financial soundness or risk-adjusted performance measures (such as metrics relating to risk-adjusted return on capital) were observed.
- Risk gates rarely used – so what is their use?
Some institutions in the sample used ‘risk gates’. These operate to make an executive ineligible for the variable component of their remuneration for a significant risk incident or a material breach of the institution’s risk management framework. While these risk gates provide a clear penalty for serious failures of risk management, APRA found they were rarely used.
APRA also considers that risk gates do not replace the need for more refined measures of risk-adjustment to the overall performance assessment.
- Very few had made provision for clawback.
Except in one case, there was no observed evidence that consideration had been given to events or issues that might reasonably give rise to the application of clawback. Clawback requires a repayment of what has already been received.
Although clawback is often considered to be difficult to execute, both from a legal and operational perspective, an institution will be better positioned to enforce clawback by having the appropriate provisions within remuneration policies, incentive plan terms, and individual employment contracts.
- Incentive pool amounts are largely based on short-term performance measures, with little evidence of explicit consideration of longer-term risk measures.
Furthermore, the majority of the sample had not developed mechanisms or processes for the adjustment of the incentive pool to respond to significant risk events.
- Most institutions in the sample underestimated the extent to which Material Risk Takers within their organisations needed to be covered by the remuneration policy.
- No superannuation trustee companies had any longer term remuneration.
Despite guidelines explicitly stating that sound practice involves boards structuring the components of executive remuneration in a way that aligns financial incentives with long-term successful stewardship of the RSE (see HERE), none of the RSEs did this.
What’s coming? APRA’s next steps
APRA was disappointed with the outcome of its review. Over the years since the global financial crisis, APRA has been a supporter of a principles-based approach to remuneration, unlike the more prescriptive approach increasingly adopted by the rest of the world. Its review have found Australian standards wanting.
So, it is not surprising that in the next phase of its work, APRA intends to review the prudential framework to support a more robust and credible implementation of its prudential requirements and guidance on remuneration.
APRA will also consider the expansion and strengthening of its prudential requirements to reflect evolving international standards and regulatory expectations related to remuneration. This will include the application of the most recent FSB Supplementary Guidance on Sound Compensation Practices (see HERE).
APRA intends that any proposals to address the areas identified in its review will be considered in conjunction with the implementation of other initiatives such as BEAR.
The proposed changes to be considered include, although may not be limited to:
- improved design of remuneration frameworks
- enhanced implementation and outcomes
- strengthened Board Remuneration Committee oversight, and
- enhanced reporting and disclosure.
APRA concluded by warning institutions not to wait for regulatory changes to address the scope for improvement that currently exist, nor simply make changes to meet the minimum regulatory requirements.
See APRA’s review HERE.© Guerdon Associates 2023 Back to all articles