Today, the Bank for International Settlements published a consultative document entitled, “Range of Methodologies for Risk and Performance Alignment of Remuneration.” The document, which is open for comment until December 31, 2010, (1) analyzes the methods used by banks for incorporating risk into bonus pools and individual compensation schemes and (2) identifies issues affecting the effectiveness of risk alignment adjustments. The goal of risk alignment adjustments, according to the BIS, should be to ensure that “incentives to take risk are constrained by incentives to manage risk.”
Among the recommendations for effective risk alignment adjustments are the following.
- Supervisors should be aware of how their institution’s remuneration scheme relates to the objectives of the institution and how such objectives have influenced the design of the remuneration scheme.
- In order for incentives-based remuneration to work, the variable part of remuneration should be truly and effectively variable, with the possibility of being reduced to zero.
- While most of the attention in the wake of the crises has been devoted to highly paid employees, such as senior executives, it is important to extend risk-adjusted remuneration to all material risk-takers.
- Methodologies used should be tailored to each institution’s specific circumstances.
- To be effective, the risk adjustment process needs to be supported by strong corporate governance and a culture of prudent risk-taking.
- To have the greatest impact on employee incentives, the variables used to measure risk and performance should relate as closely as possible to the level of the decisions made by the employee.
- In the case of risks which are difficult to measure, to model or are simply not known at the time of the award, deferral of remuneration can be particularly useful because ex ante risk adjustment is less likely to work effectively.
The BIS intends for this report to help support and facilitate the broader adoption of sound compensation practices in the banking sector.