12/08/2019
APRA released a draft new pay regulation on 23 July, applicable to all APRA regulated entities (see HERE) .
The regulation is what we anticipated (for example see HERE and HERE) .
Also, as expected, business leaders and advisers are pushing back on the level of prescription. This is unlikely to have much traction with APRA, stung as they are from the capability review (see HERE ).
On Thursday, 8 August, APRA Chairman Mr Wayne Byers indicated that prescriptive regulation will proceed given the “failures in industry self-regulation” under current standards.
“All four levels of regulation have failed to some degree in the financial sector. You can argue the extent to which failings in formal regulation and self-regulation are to blame, but one thing is certain: the consequence of weak self-regulation has been an increase in formal regulation. The Government’s Banking Executive Accountability Regime (BEAR), APRA’s more prescriptive remuneration prudential standard, and ASIC’s product intervention power are recent examples. Undoubtedly, this additional regulation comes at a cost, and industry complaints about regulatory burden are increasingly being heard again. Thus far, however, not much has been offered as an alternative means of generating better outcomes.“ (see HERE) .
This article describes the new APRA pay regulation’s main elements, and implications for APRA regulated entities. Future articles will deal with deficiencies in the regulation itself in time for feedback submissions to be lodged.
Summary of main elements
1 . The board is now expected to oversee all remuneration. This includes some service provider remuneration arrangements.
2 . Prescribed remuneration deferral periods for significant financial institutions. Seven years for CEOs and 6 years for other Senior Managers and highly-paid Material Risk Takers (MRTs), plus requirements to apply clawback for up to a further 4 years post-vesting or payment.
3 . A limit on financial metrics of 50% being used to assess variable remuneration, applying across the entire organisation and across the total amount of variable remuneration, and capped individually at 25% .
Each of these is discussed briefly below.
Board and remuneration committee roles broadened
The board would be responsible for the remuneration policies that apply to all employees, not just senior “managers”, which will be a larger universe than “executives”. In addition, material risk takers will be a larger group to cover off, given that their definition will no longer be dependent on the extent of variable remuneration they receive.
The remuneration committee’s role would be significantly expanded, since it must recommend variable remuneration outcomes for material risk takers and senior executives, which the board must approve. The remuneration committee must also review the compliance of the remuneration framework with CPS 511 annually and commission and oversee an independent organisation wide, all employee (and contractor in some cases) remuneration effectiveness review every three years, to which the board must respond.
Implications
1 . The remuneration committee will, presumably, need to read and assess the expanded universe of senior managers and material risk takers. What was, perhaps, 30 in a major bank, may extend to hundreds. Likewise, a diligent board will have to be assured that the remco has done its work prior to approval.
2 . A likely outcome may be a simplification of remuneration across swathes of employees, in order to cope with the workload. Actions could include the elimination, reduction, or “dumbing down” of incentive pay, accompanied by increases in fixed pay. Hence, an unintended consequence of trying to focus employees on “doing the right thing”, to paraphrase Commissioner Hayne, may be that achieving excellent risk-adjusted outcomes for satisfied investors and a prudential regulator, becomes less likely.
3 . Costs will increase, given that the annual review will need more internal resources, and a triennial review by an independent consultant will incur consulting fees.
Pay deferral and being significant
APRA proposes to categorise Authorised Deposit-taking Institutions (ADIs) with more than $15 billion in total assets; general and life insurers (excepting for the moment, private health insurers) with more than $10 billion in total assets and RSE licensees with more than $30 billion in funds under management as Significant Financial Institutions (SFIs).
SFIs will be required to defer variable remuneration as follows:
- CEO remuneration: 60% of total variable remuneration shall be subject to a deferral period of 7 years (with pro-rata vesting from year 4).
- Senior manager other than the CEO and highly paid material risk taker : 40% of total variable remuneration shall be subject to deferral period of 6 years (with pro-rata vesting from year 4).
- Clawback: Variable remuneration must also be subject to mandatory clawback for a period of at least 2 years from vesting (or, where a person is under investigation, a further 2 years)
Implications
1 . Regulatory attention will be spread thin. Some institutions may be chuffed they are now considered significant. But the cut-off is low. For example, it captures over 20 banks. APRA may want to re-consider how titchy it wants to go. Would it not be better to save up its scarce supervisory resources for domestic systemically important banks and insurers?
2 . SFI pay will be less competitive because the deferral period is significant, if enacted. Generic jobs with easily transportable skills, such as general counsel, chief people officer, and CFO would, all else being equal, prefer to work somewhere outside of banking and insurance. Despite media and some proxy adviser critiques, Australian banker pay is already low by international standards, making it difficult to recruit talent. Increased deferral will exacerbate this as it reduces the perceived value of pay further.
3 . Fixed pay may need to increase as variable remuneration becomes too hard, and deferral too long. Yet, APRA likes variable remuneration in order to have something to reduce for poor risk management, and investors like pay to be variable with returns. Increases in fixed pay did happen in the UK when it implemented similar regulation under CRD IV. But that was mainly because of an additional rule emanating from the EU that capped variable remuneration to about 2 times fixed pay, much to the Bank of England’s chagrin (see HERE) .
4 .Remuneration structures may become more creative. UK banks have applied various inventive methods and a few somersaults to comply and yet continue to configure pay to attract and retain in a global market. Proxy advisers and institutional investors may be well placed to look at reconfiguring their guidelines along the lines that have been adopted by their UK cousins. Otherwise they will not be well equipped for the visits by remco chairs wanting to test what would be quite viable structures if it were not for existing, inadequate guidelines that many currently have.
5 . Executive contracts will have to be re-written to enable any reasonably effective clawback policy. We cannot see too many employees volunteering for such changes if they do not receive an inducement, and we do not see too many proxy advisers and investors applauding the handing out of inducements.
Prescribing a 50% cap to variable remuneration “financial” performance measures
The regulation caps the extent of financial measures used to determine variable remuneration to 50%. This includes revenue, profit, volume-based, and capital efficiency (such as ROE and ROA) measures.
APRA also lumps what we would call “market measures” into this category, although strictly they are not “financial measures”. These include share value or share return-based measures (such as total shareholder return (TSR)).
Interestingly, risk-adjusted financial measures are not considered “financial measures”. This reflects APRA’s desire that they be used, and frustration with the fact that their use to date has been limited.
Implications
Critics have indicated the prescriptions will dilute the interests of shareholders, and result in “scorecards” that will reduce pay responsiveness to shareholder returns, and deliver higher average variable remuneration to executives.
This is tosh.
Scorecards do not have to be used at all. APRA has inferred this in its discussion paper (see HERE) . There are alternatives that many profit-orientated financial services companies may want to consider.
2 . APRA has specifically excluded risk-adjusted financial performance measures from its 50% cap.
- These are very useful ex-ante measures, already used by most sophisticated banks in short term incentive plans. APRA has now given banks and insurers a little push to consider application in longer term incentive plans. This will result in better balance between short term and long term risk and return management, which was always a bit of a worry in the past.
- Some stakeholders will need to improve their financial literacy in risk-adjusted return measures. Some on the investor side may also need to re-consider guidelines that do not permit similar measures being applied over the short term and long term. There is no better way to blow up a company than by insisting on short term results on a key measure without considering the implications for longer term results on the same measure.
- Companies, including unlisted APRA-regulated entities, will need to be more transparent in the underlying methods and assumptions calculating ex-ante outcomes. As a consequence, remuneration committee chairs need to be fully up to speed to respond to questions from shareholders and/or APRA.
- Being transparent on risk-adjusted measures opens up director liabilities in regard to forward-looking statements. Australian corporate law has no safe harbour provisions for directors disclosing, for example, expected loan impairments assumed on ex-ante risk-adjusted earnings measures.
The regulation need not result in more complicated performance assessment. It is surprising that many boards, their management, and their advisers cannot see this. The regulation is an opportunity to re-visit and simplify.
Next steps
Stakeholders have been asked to respond to the draft CPS 511 by 23 October.
Prior to then, Guerdon Associates will be considering and publishing an assessment of the regulation with alternatives on our website, with summaries in our next two monthly newsletters.
See the APRA discussion paper HERE and regulation HERE .
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