In this briefing we take a look at the draft Code of Practice on remuneration policies which the FSA believes is relevant to all regulated firms. The Code will be the subject of a formal FSA consultation later this year. When finalised the Code will form part of the FSA Handbook.
On 13 October 2008, the FSA published a Dear CEO letter, which acknowledged the widespread concern that inappropriate remuneration schemes (particularly but not exclusively in the areas of investment banking and trading) may have contributed to the present market crisis. According to the FSA, it was crucial for regulated firms to recognise the need to review their remuneration policies and to take steps to change them if necessary.
Implementation of the Code
Following on from this, on 26 February 2009 the FSA published a draft Code of Practice on remuneration policies (the Code).
The Code is published in conjunction with the Government’s Asset Protection Scheme (the Scheme) and HM Treasury has indicated that the Code will form part of the eligibility criteria for participating in the Scheme.
However, the FSA believes that the Code is relevant to all FSA regulated firms. The Code will be the subject of a formal FSA consultation this March. Once that consultation is finished the Code will form part of the FSA Handbook. For banks not participating in the Scheme it will become effective after the consultation is completed.
The Code starts with a general principle which provides that firms must ensure that their remuneration policies are consistent with effective risk management.
The rationale for the general principle is that the FSA is concerned that poor remuneration policies may lead to implicit or explicit expectations of performance from the employee, which are misaligned with the firm’s risk appetite and contrary to sound risk management. The intended effect of the Code is therefore to ensure that regulated firms have remuneration policies which are consistent with sound risk management, and which do not expose them to regulatory risk.
The Code then sets out 10 specific principles which are relevant to all FSA regulated firms, which can be categorised under the following headings:
- Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm’s financial situation and future prospects. Such committee members should have the skills and experience to reach an independent judgement on the suitability of remuneration policies, including the implications for risk and risk management.
- A firm’s internal procedures for setting compensation should be clear and documented, and should include measures to avoid conflicts of interest. Risk and compliance functions (in consultation with the firm’s Human Resources function as may be deemed appropriate) should have significant input into setting compensation for business areas.
- Compensation for staff in the risk and compliance functions should be determined independently of the business areas. Such staff should have different performance metrics, with greater emphasis on the achievement of their own objectives.
Measurement of performance for the calculation of bonuses
- Assessments of financial performance to calculate bonus pools should be principally based on profits. The bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.
- Firms should not assess performance solely on the results of the current financial year, given that profits from banks are volatile and subject to cycles. The assessment process should include measures to ensure that employees are assessed on their longer term performance.
- Non-financial performance metrics, including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment process.
Measurement of performance for long-term incentive plans
- The measurement of performance for long-term incentive plans, including those based on the performance of shares, should also be risk-adjusted.
Composition of remuneration
- The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.
- The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.
The FSA’s Code of practice on remuneration policies
- It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.
The Code is published at a time when popular sentiment against large bonuses is running high, particularly at banks which have sought assistance from the Government. However, the FSA has made it clear that it has no wish to become involved in setting remuneration levels, and that it considers this to be a matter for the boards of regulated companies who should ensure that they have effective structures in place to set remuneration policies and monitor remuneration levels throughout the firm.
The FSA recognises that it is difficult to be prescriptive about remuneration policies, which will vary widely between firms, and between different levels of staff within the same firm. However, as many have already pointed out, the Code itself needs more work on its details.
Many have welcomed the emphasis on governance on the basis that no technical provision can be a substitute for well constituted and implemented governance. Some commentators have noted that one of the key elements regarding the governance principle is that the FSA has said that it may ask a firm to prepare an annual statement on its remuneration policies and that this statement will include an assessment of the impact of their policies on the behaviour and risk profile of the firm. The FSA has also said that it wants the annual statement to be made available to shareholders, ahead of the annual vote on directors’ remuneration. Further, the FSA has indicated that it may also ask a firm’s remuneration committee to provide evidence of how well its policies measure against the principles contained in the Code. The FSA may interview the chair of a firm’s remuneration committee (or equivalent body) on the contents of the statement.
If firms have remuneration policies that are not aligned with sound risk management, then they should start taking action to change those policies paying particular attention to the principles set out in the Code.
The FSA has also made it clear that it will ask a firm to provide plans for improvement if it considers that there is a significant shortfall in the information provided of its remuneration policies. The FSA will also ask regulated firms to use the principles in the Code when assessing exposure to risks arising from their remuneration policies as part of the Internal Capital Adequacy Assessment Process.