Welcome to the fourth article in our Executive Remuneration series. In this article, we expand on considerations and issues of culture within the context of remuneration for regulated firms, which were briefly touched on in previous articles within this series. Although there are a large number of other considerations that regulated firms must take into account when making decisions regarding remuneration (including any requirements under the Remuneration Codes or Solvency II), culture must be an overarching consideration that feeds into every remuneration-related decision and policy. This article explains what the Financial Conduct Authority (“FCA”) means when it talks about ‘culture’ and explores how it relates to remuneration and why it should matter for regulated firms, especially within the context of the Covid pandemic.
What does ‘culture’ mean?
The FCA defines ‘culture’ as the habitual behaviours and mindsets that characterise an organisation and has been recognised as including the norms, which may be unwritten and unspoken, that determine a firm’s standards when carrying on its business, including in the context of designing new products, dealing with customers, incentivising staff and dealing with problems (both internal and external). As Andrew Bailey (former CEO of the FCA) said, “We define culture quite simply as the typical behaviours that characterise a firm.” Although it does not prescribe what a firm’s culture should be, the FCA both encourages and expects firms and their leaders to drive behaviours that create and foster cultures that reduce the potential for harm, both to consumers and the market.
Instead of assessing firms’ cultures directly, the FCA has identified the following four key drivers of behaviour within firms that it believes can lead to harm:
Approach to rewarding and managing people
Firms should concentrate on these drivers when assessing their culture and developing a framework through which a firm’s culture can be evaluated on an ongoing basis. For the purposes of this article, we are focusing on a firm’s approach to rewarding and managing people.
Why does ‘culture’ matter?
The answer is primarily because of the very real and potentially significant impact that a firm’s culture can have on its business and also due to the regulatory scrutiny that this will continue to come under.
As stated in the FCA’s March 2018 discussion paper, culture in financial services is widely accepted as a key root cause of the recent major conduct failings within the industry. Given this and the role that it needs to play in re-building trust in financial services, the culture of firms is a priority for the FCA. It expects firms to foster cultures which support the spirit of regulation in preventing harm to consumers and markets. The FCA’s focus on culture is also not new. Since at least 2018, the FCA has been clear as to the importance it places on transforming culture in financial services and has reiterated that culture remains a key area of focus across all sectors (July 2020 Letter to Chairs of Remuneration Committees).
In relation to the specific role played by remuneration, the FCA’s statements in speeches and announcements can leave firms in no doubt as to the FCA’s view that the way in which a firm remunerates and incentivises employees will influence their behaviour and shape the firm’s culture. The FCA has gone further regarding its expectations and in August 2019, advised Chairs of Remuneration Committees that it would review firms’ remuneration and recognition practices to ensure that approaches to rewarding and incentivising all staff reinforced healthy cultures and did not drive behaviours that would lead to harm to consumers or markets. This is also supported by guidance from the Financial Reporting Council, which states that remuneration policies and practices should be designed to support strategy and promote long-term sustainable success and executive remuneration should be aligned to company purpose and values and be clearly linked to the successful delivery of the company’s long-term strategy.
Culture and remuneration
As explained above, there has been a clear recognition that how a firm incentivises its staff is one of the drivers of culture. On the one hand, remuneration practices that place disproportionate weight on financial measures could encourage excessive risk taking and carrying on the business in a way that promotes profit over all else, including good customer outcomes. On the other hand, a more rounded approach to assessing employees’ performance may support the embedding of both good conduct and good customer outcomes within the business and encourage behaviour that aligns with the firm’s risk profile. The FCA has also identified the role of remuneration policies in positively promoting diversity and inclusion at firms, which is another key part of a firm’s culture.
Most regulated firms are already required to comply with relatively prescriptive rules when it comes to remuneration (for example, deferral requirements under the specific remuneration codes). Although complying with these rules will ensure compliance with the applicable remuneration code, the assessment of the way in which it rewards its employees requires a more abstract and holistic approach involving a consideration of the impact of remuneration practices on the firm’s culture as a whole. Some of the specific regulatory remuneration requirements may be viewed as going some of the way in helping firms to ensure that their remuneration practices are driving a good culture (for example, the remuneration principle that a firm must ensure that its remuneration policy is consistent with and promotes sound and effective risk management). However, these specific rules do not provide an exhaustive framework through which firms can assess their remuneration practices within the context of their impact on culture and importantly, do not apply consistently to all regulated firms.
To help create this framework throughout the business, firms should look beyond their remuneration practices to try and ensure their employment contracts and policies also support and promote the desired culture. In particular, contractual terms relating to employee duties and required performance standards, bonus and incentive provisions and termination clauses should reflect the culture and remuneration practices of the firm. When performance plays a part in awarding remuneration, ensuring the appraisal framework and the criteria used to assess performance are clear and targeted is key. Employment policies for things like disciplinary issues and whistleblowing also play an important part in creating the desired culture.
How to assess your firm’s remuneration practices and policies?
So how can firms critically assess the way in which they reward and incentivise their employees? There are a number of questions that firms and remuneration committees should be asking:
Does our assessment of employees’ performance for the purposes of pay reviews and bonuses consider a number of both financial and non-financial factors or is it measured solely on the basis of financial metrics?
Are we taking steps to embed conduct in our remuneration policies and practices through performance assessment criteria that include conduct objectives?
Are the performance assessment criteria for the purposes of pay reviews and bonuses aligned with the type of culture that we are trying to foster within the firm? And how do the incentives support our culture and encourage the desired behaviours?
Does our pay and bonus structure reward misconduct and unacceptable risk taking by employees?
Do we respond to misconduct by adjusting variable remuneration in a meaningful way?
Do our employment contracts and policies reflect the standards set by the firm and promote the desired culture?
Do employment contracts provide the required flexibility in order for the firm to manage remuneration effectively (e.g. provision to clawback bonuses)?
Is the pressure to turn a profit driving employees to act against customers’ interests?
Are our remuneration policies and practices aligned with our long-term business plans?
Is our firm’s position with respect to remuneration and the aims of our remuneration practices accurately reflected within our remuneration policies?
As mentioned above, the role of remuneration in relation to supporting and promoting diversity and inclusion is also integral from a regulatory perspective. The FCA/PRA expects firms to consider how remuneration policies promote equality of opportunity and ensure that diversity and inclusion is embedded within a firm’s approach to rewarding individuals, avoiding unconscious bias. Firms must therefore also be asking themselves whether their remuneration practices and policies are doing enough from this perspective, including through the use of gender and BAME pay gap reports to address any inequalities.
Remuneration during Covid
The FCA’s position on remuneration and culture has only strengthened during the pandemic. In July 2020, the FCA explained that they saw a risk that firms would deprioritise their focus on culture as they redirect resources in response to the immediate risks presented by Covid and on a longer-term basis as a result of the crisis. With respect to remuneration, the FCA/PRA’s expectation is that remuneration practices and policies remain aligned with firms’ business plans, especially if business plans have had to change as a result of Covid. Remuneration practices must also evolve as necessary in response to the impact of Covid, including with respect to bonus pools and individual remuneration outcomes.
A further consideration for firms within the context of Covid is the approach to rewarding senior management given the publicity that executive bonuses are receiving and how the details of such remuneration would be viewed by the regulators, employees and shareholders in light of the firm’s overall performance. Criticism of executives that have been seen to have profited during the pandemic while their business took a hit and employees were furloughed has been widely publicised, as well as more positive publicity for those whose bonuses and salaries have been cut (or who did not receive a bonus at all) during 2020.
Therefore, as well as considering their approach to rewarding and incentivising employees within the context of their firm’s culture, firms must continue to assess whether their existing remuneration practices and policies are appropriate on the basis of the impact that Covid has had on their business and the wider industry. For further views on how the Covid pandemic has impacted remuneration, please see the first article from this series here.
Many regulated firms will need to be considering their remuneration practices in light of the new rules under CRDV, as well as the changes that are expected under the new Investment Firms Prudential Regime (“IFPR”) (note that the FCA is yet to consult on the remuneration changes under the IFPR but details of the IFPR more generally can be found here and here and the IFR/D here). Although any changes to remuneration practices required now due to CRDV or in future under the IFPR are likely to be specific and prescriptive based on things like measurable thresholds, firms must keep in mind the overarching considerations of remuneration and how it impacts culture. Firms need to continue to ask whether the way in which employees, including senior management, are incentivised and rewarded encourages the type of behaviour and ultimately the culture that the firm is trying to foster.