Guerdon Associates’ response to draft APRA regulation

The latest draft APRA amendments to prudential standards are entirely focused on remuneration (see HERE).  However, unlike more recent government regulatory and tax announcements, APRA has allowed considerably more time for interested parties to provide considered reponses to their draft.

Guerdon Associates submitted its response to the draft regulation on 23 July 2009.  Our submission goes into the draft standards and guidance note in some detail.  However, for this article we highlight the parts of our response that try to put remuneration in context as it relates to the global financial crisis, while also summarising some of the issues and implications of the regulation.

APRA regulated remuneration in context

It is important to keep in mind that remuneration was not a primary cause of the global financial crisis (GFC), nor was it a necessary pre-condition.

Lord Turner, the chairman of the FSA, admitted it is difficult to gauge the extent of the role of remuneration 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.”

Lord Turner’s comments can be found in “A regulatory response to the global banking crisis”, FSA, March 2009 (see HERE).

Many of the proposed solutions on pay already featured in the pay packets of failed executives. For example, most failed bank CEOs received significant equity based pay, with a relatively large deferred component, and in many cases were required to hold an amount of vested equity as a multiple of their annual pay. 

Nevertheless, while the focus on remuneration is probably out of proportion to its impact on the GFC, Guerdon Associates does not believe that additional attention to remuneration matters is misplaced.  We recognise that it must feature as part of APRA’s purview if it is to properly meet its charter.  In addition, it will highlight an aspect of remuneration management that we have identified and commented on as an essential and missing ingredient of executive remuneration since our firm was founded, and has been a feature of all client incentive plan advice since then.  That is, the requirement to manage risk as well as return.

We believe that the APRA prudential standards go a long way to redress this imbalance.  Whether, in the total scheme of good economic management, APRA and other agencies around the world have got the regulatory balance right is an unknown. But the attention on remuneration’s role in the management of risk is welcome.

Consequences overview

Guerdon Associates has reviewed the draft APRA remuneration amendments to the prudential standards and accompanying discussion guide relative to other regulatory standards published in the UK and European Union.  In Guerdon Associates’ opinion the APRA standards are superior in that the principles they encapsulate better allow competitive differentiation across the sector, while staying true to the FSF Principles for Sound Compensation Practices.

However, there is no doubt that the standards will require significant additional costs associated with employing external advisers, employment of additional internal risk management and remuneration personnel, record keeping, administration and controls. Executive fixed pay levels may increase, and become less variable with annual outcomes.  These additional costs will probably be passed through to consumers of financial services.

There are also implications for the demand for, and supply of, suitably qualified NEDs.  The supply side will be affected by:

  • Significant additional workloads on board remuneration committee and board risk committee members
  • The requirement for NEDs with expertise in remuneration

Given the scope of the standards we would expect that the remuneration committee members’ and chairman’s hours would double.  The additional requirements would also add to board chairman hours.  This would go some way to bringing to reality predictions that some NED roles, such as the board chairman, would become a full time independent director, rather than a NED.

We are also aware of the views held by some governance experts that the supply of potential NEDs could be greater if the “clubby monopoly” is broken down.  This additional workload may lead to that breakdown.  While Guerdon Associates does not believe there is sufficient data to opine on the NED supply issue, we point out that there could be a risk if supply as a result of these additional requirements is not sufficient. So, while there is no doubt that the regulation will add considerably to the workloads of independent NEDs, the impact that this will have on demand and supply of suitably qualified NEDs for this sector is, in itself, a risk factor.  This unintended consequence needs to be carefully monitored.

Another “known unknown” is associated with the supply of independent external advice (defined as a provider of services to boards only).  In the specialist field of remuneration this is currently limited to two main suppliers  (Guerdon Asscoaites is one of these).  In accounting, taxation and legal matters there are no advisers, to our knowledge, that can position themselves as free of conflicts of interest in these matters.

Obviously, this lack of supply will require most boards to continue to rely on conflicted advice.  APRA could require advice to be unconflicted.  If this were to be the case, it would precipitate a major industry shake up as non-independent firms restructured (or, as in the US, decided to be advocates for management), and laid off staff put out shingles as independents, albeit without the infrastructure and support present in broad based firms that often adds value.  There is risk in such a regulatory requirement, and so it is not advocated by Guerdon Associates.  Instead, we suggest that the board remuneration committee acknowledge and monitor conflicts in order to acquire the full range of services it needs.  This is reflected in our detailed suggestions.

Lastly, we have reviewed APRA requirements in terms of executive supply.  Many Australian APRA regulated organisations participate directly in global labour markets for executives.  Given that most global financial services cities will be subject to national remuneration guidelines or regulation that respond to FSF requirements, we believe that the APRA regulations and guidelines allow sufficient flexibility to allow adaptations for key employee attraction and retention from outside Australia.

Guerdon Associates’ submission to APRA can be found HERE.

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