As part of its 2015 workplan to reduce misconduct risk in financial institutions, the Financial Stability Board is consulting on recommendations for data reporting on the use of compensation tools to address misconduct risk. Compensation has continued to face increasing scrutiny by regulators in recent years, particularly as a tool to help manage the risk and consequences of misconduct.
The Financial Stability Board (FSB) published a public consultation on 7 May on recommendations for consistent national reporting of data on the use of compensation tools to address misconduct risk. The recommendations are intended to enhance the capacity of financial supervisory authorities to monitor the effectiveness of compensation tools and other mechanisms in promoting good conduct. The consultation closes on 6 July 2018. We set out below a high-level overview of the background to these draft recommendations, their scope, and their proposed data set.
BACKGROUND TO RECOMMENDATIONS
The FSB’s draft recommendations form part of its workplan agreed in May 2015 to address misconduct risk using different measures, including measures for effective governance and compensation frameworks. As part of this workplan, the FSB also issued guidance in March 2018 supplementing its Principles and Standards on compensation at significant financial institutions. This guidance provides a framework to consider how compensation tools—such as in-year bonus adjustments, malus, and clawback—can best be used to address misconduct.
The FSB believes that compensation tools help signal the importance that firms place on prudent management of risk and standards of behaviour. They emphasise the importance of compliance with related regulations and supervisory expectations, and also provide valuable ex ante incentives for good conduct and ex post adjustment mechanisms to ensure appropriate accountability. For instance, pillar 3 remuneration disclosures demonstrate that, since 2010, the level of malus adjustments being made as a result of risk management failings or misconduct in UK banks has risen significantly.
Since the FSB’s Principles and Standards on compensation were published in the aftermath of the global financial crisis, supervisors and firms have increasingly focused on more effectively aligning compensation with sound risk-taking behaviour. In Europe, enhanced requirements on remuneration have been brought about for different types of firms under the Capital Requirements Directive IV (CRD IV), Markets in Financial Instruments Directive II (MIFID II), Alternative Investment Fund Managers Directive (AIFMD), and Undertakings for Collective Investment in Transferable Securities Directive V (UCITS V). The draft recommendations build on existing international efforts, particularly for the banking sector, taking into account the Basel Committee on Banking Supervision Pillar 3 disclosures framework.
SCOPE OF RECOMMENDATIONS
The recommendations are not intended to establish new principles or standards beyond those already established in the FSB’s Principles and Standards, and are to be viewed consistently with existing national laws and supervisory powers. They are aimed at supervision of significant financial institutions and their application by the relevant national supervisory authorities should be risk-based, taking into account implementation costs and existing supervisory objectives. In any event, the applicable authorities should establish clear expectations on the data gathering and reporting.
As the FSB considers that conduct issues can extend beyond persons identified as material risk takers, including junior employees and employees who are not strictly in financial business units, the recommendations provide for the data gathering and reporting to cover all individuals considered in scope by the firm’s compensation framework.
PROPOSED DATA SET
The draft recommendations identify (i) a core set of data representing the minimum set of information that should ideally be available to supervisors; and (ii) additional reporting data that supervisors may consider useful, if not already collected through other frameworks. It recommends that the core data be reviewed periodically through ongoing supervision.
The proposed data set covers both firms’ frameworks and their actual implementation. It comprises elements derived from the firm’s compensation and performance measurement systems and the firm’s misconduct management system, including the firm’s
- compensation frameworks to address misconduct risk and their governance (e.g., data on the scope of persons for the application of compensation tools to mitigate and address misconduct risk; the processes for determining, monitoring, and reviewing the firm’s use of compensation in supporting effective risk management; the design of performance arrangements and measurement; and the available compensation adjustment tools); and
- compensation actions taken in the event of misconduct (e.g., data on misconduct incidents under examination by the firm and relevant measures taken, including any compensation adjustments and a listing of all compensation adjustments such as in-year, malus, and clawback, with the rationale for those adjustments).
The proposed data set is designed to support firms in putting in place various mechanisms to ensure that they are appropriately considering the impact of conduct issues in the design of their compensation and incentive systems. This will support the effective use of compensation tools in conjunction with other performance management tools, thereby promoting wider risk management goals and improving the effective identification of emerging misconduct risks.
This is consistent with the increasing emphasis placed by global regulators, including the Financial Conduct Authority (FCA), on the importance of a firm’s culture in the wider regulatory framework. It also further demonstrates the need for firms’ compliance, legal, and HR functions to work closely together in identifying and recording instances of misconduct or excessive risk-taking, taking appropriate and consistent action, and recording and reporting relevant outcomes.