TWN Info Service on Finance and Development (Apr10/01)
5 April 2010
Third World Network

Different approaches in G20 reform of bank compensation
Published in SUNS #6896 dated 1 April 2010

Geneva, 31 Mar (Kanaga Raja) -- While there has been significant progress in the G20 countries in reforming domestic bank pay structures, and putting in place regulatory and supervisory frameworks for this, there are still differences in approach on key issues that are yet to be resolved, the Financial Stability Board (FSB) said Tuesday in a progress report.

In 2009, the FSB had enunciated Principles for Sound Compensation Practices in banks and their Implementation Standards, and these were endorsed by the G20 leaders at their Summits in London in April 2009 and Pittsburgh in September 2009. And in their Pittsburgh statement, the G20 Leaders tasked the FSB "to monitor the implementation of FSB standards and propose additional measures as required by March 2010."

In September 2009, the FSB decided to conduct a peer review of implementation.

In its peer review report published Tuesday, the FSB has found that while significant progress was made in incorporating the FSB Principles and Standards into domestic regulatory and supervisory frameworks, full implementation is far from complete.

Notwithstanding different starting points in terms of pre-existing national frameworks addressing compensation issues and the degree of misalignment with prudent risk-taking, the FSB report said, there has been, on the whole, material progress and a movement towards convergence across jurisdictions.

"However, it is relatively early in the process; some key issues are yet to be resolved and effective implementation is far from complete. There are differences in the approach to and pace of implementation and a sustained and cooperative effort will be required from supervisors and financial institutions to implement fully the Principles and Standards by the end of 2010."

Greater progress has been achieved in the areas of governance, establishing supervisory oversight and promoting disclosure of compensation. Further work needs to be done to raise standards of risk adjustment of pay structures across the industry.

The review recommends additional measures in areas where they are necessary to support the emergence of sound practice and further convergence. In addition to continuing to roll out national policies, such measures include enhanced supervisory cooperation on compensation with regard to cross-border firms, especially across the major financial centres; support in the development of sound industry practices, notably in the area of risk-adjustment of compensation (both ex-ante adjustments of bonus pools and ex-post deferral and malus mechanisms); and increased coverage of significant non-bank financial institutions.

(A "malus" is often a feature of a compensation arrangement that reduces the amount of a deferred bonus, so that the amount of the payout is less than the amount of the bonus award.)

"This work needs to be progressed on a rapid timetable so that the results can be reflected in the outcomes of the compensation reviews that most firms will be undertaking at the end of 2010," said FSB.

Mr Mario Dragi, the Chairman of the FSB, said: "We welcome the steps taken to put in place frameworks for regulatory or prudential oversight of compensation structures. But supervisors must make sure that the additional measures recommended in the review are put in place."

On 30 March, a five-member steering group of the G20 sent a letter to the G20 member countries, in which it said amongst others that there can be no let up in the G20 commitment to "address together the remuneration practices that encourage short-term and excessive risk taking by fully implementing the internationally-agreed compensation standards as set out by the Financial Stability Board."

The letter further said that there can be no let up in the G20 commitment to honouring its commitments to lead by example by implementing international standards and agreeing to undergo periodic peer reviews to evaluate the G20's adherence to these standards.

"Achieving the ambitious peer review agenda that has been set for 2010 will be an important milestone," said the letter.

The letter was signed by US President Barack Obama, Canada's Prime Minister Stephen Harper, South Korean President Lee Myung-bak, President Nicolas Sarkozy of France and British Prime Minister Gordon Brown.

The peer review on compensation by the FSB is the first such review under the new FSB Framework for Strengthening Adherence to International Standards.

According to the progress report, significant changes in regulatory and supervisory frameworks to implement the FSF (Financial Stability Forum) Principles for Sound Compensation Practices and their Implementation Standards have taken place across the FSB membership over the past year and are expected to continue into 2010 and beyond.

Many jurisdictions have adopted an implementation model that includes a mix of enforceable regulation and supervisory oversight. Australia, France, Germany, Italy, the Netherlands, Saudi Arabia, Switzerland, and the UK have issued separate regulations, or incorporated the Principles and Standards into existing regulations. New regulations are often supported by supervisory guidance that illustrates how the rules can be met.

Other jurisdictions follow a primarily supervisory approach to implementation, involving principles and guidance and the associated supervisory reviews. These include, for instance, China, Hong Kong, Korea, Japan and the US. In Canada and Spain, the approach is to include the review of compliance with the Principles and Standards directly into the regular supervisory work on significant activities, controls and oversight functions.

The FSB report says that the choice between regulatory and supervisory approaches largely depends on national preference. National authorities will have to achieve a robust framework for ensuring compensation policies consistent with prudent risk taking under either one or the other of these developing approaches.

Regulations or supervisory guidance are at the preparatory stage in Brazil, Mexico, Singapore (all expected by mid-2010), Argentina, South Africa and Turkey. Possible implementation initiatives are under consideration in India, Indonesia and Russia.

In addition, said the FSB, some jurisdictions are in the process of incorporating the requirements contained in Pillar 2 of the enhancements to the Basel II framework, issued by the Basel Committee in July 2009, into the national supervisory frameworks. A number of European countries note that with the expected approval of the proposed amendment to the EU Capital Requirements Directive in 2010, the Principles and Standards are expected to be almost entirely transposed into national regulation.

In most jurisdictions, existing legislation provides the relevant authorities with wide powers to take timely and appropriate supervisory actions, which range from requiring firms to adopt remedial measures and imposing disciplinary sanctions to raising minimum capital requirements. Many relevant national authorities also have the necessary powers to restructure compensation in the event of exceptional government intervention.

In some jurisdictions, says the report, regulatory initiatives on compensation had pre-dated the crisis, but requirements were seen more from a code of conduct than from a prudential perspective - focused on public disclosure, corporate governance and specific control or review requirements for the remuneration of senior management and executive board members - and were applicable to all listed companies rather than being specific to the financial sector.

In terms of institutional coverage, FSB members divide quite evenly between those that apply the Principles and Standards or the respective national rules to a predefined subset of significant institutions, and those that apply them to all - often subject to "proportionality".

The report finds that Brazil, Canada, Germany and Italy use a mixed approach, whereby provisions related to the Principles apply to all institutions, whereas additional provisions (often related to the Standards) apply to a subset of large institutions or conglomerates. In Switzerland, provisions are mandatory for large institutions; for smaller institutions, the Swiss rules serve as guidance and adherence to those will be discussed as part of the usual supervisory process.

Overall, and subject to the mixed approach noted above, size thresholds to determine the scope of application are in place (or planned) in Argentina, Brazil, Canada, Germany, Italy, Japan, Switzerland, and the UK.

In a footnote, the report notes that jurisdictions use different size thresholds: in Argentina, market share of deposits above 2% (80% of supervised institutions), in Brazil, institutions for which one of the following applies: (I) publicly traded; (ii) regulatory capital in excess of R$1 billion; (iii) third parties assets in excess of R$1 billion; (iv) more than R$5 billion in deposits and third parties assets (77 financial institutions in total); in Canada, six large banking and three insurance conglomerates (representing 90/80% of the market based on assets /premiums); in Japan, major banking groups and internationally active financial institutions; in Italy, six large banking groups; in Switzerland, six banks and five insurers with capital above CHF2 billion.

Jurisdictions where provisions apply (or are planned to apply) to all institutions include Australia, China, France, Hong Kong, Korea, the Netherlands, Saudi Arabia, South Africa, Spain and the US (for banking organization supervised by the Federal Reserve). In Hong Kong, the Netherlands and Spain, this is subject to proportionality.

Rules apply at the consolidated group level and, typically, to foreign affiliates and branches. Exceptions to the latter are Spain (which fully relies on home supervisors for foreign affiliates and branches) and Korea and Singapore. Within the European Union, in line with the home country control principle of the EU legislative framework, local regulations cannot apply to branches of a financial firm headquartered in an EU member state.

As noted, non-bank financial institutions are generally covered to the extent that they are part of a banking group.

In addition, says the report, insurance companies are covered (or planned, subject where relevant to the size threshold noted above) in Australia, Canada, Germany, Italy, Japan, Korea, the Netherlands (including pension funds), Singapore (expected mid-2010), Switzerland and Turkey (planned).

Investment firms and asset management companies are included under the general approach (or planned, subject where relevant to the size threshold noted above) in France, Japan, Korea, Mexico, the Netherlands, Switzerland and Turkey. Large broker-dealers are included in the UK. Some general principles are in place in Italy. In the European Union, the draft directive on Alternative Investment Fund Managers includes provisions on compensation.

According to the report, it should be noted that in the area of insurance, the International Association of Insurance Supervisors (IAIS) recently released a draft of its Standards and Guidance on Remuneration for consultation among IAIS members and observers, with final publication as part of broader work on governance scheduled for autumn this year.

The FSB said that categories of employees covered are generally broadly defined to at least include senior management, material risk-takers and staff performing important risk management and control functions. Some jurisdictions also explicitly refer to groups of employees who may together take material risks, even if no individual employee is likely to expose the firm to material risk. Other jurisdictions, such as Argentina, the Netherlands and the UK, cover all employees with significant variable compensation.

Finally, a number of jurisdictions cover all employees, subject to proportionality (e. g., Switzerland) - that is, the more senior an employee is or the higher risk such employee represents, the longer, for instance, the deferral or vesting period and the risk adjustment for such employee's variable compensation.

Many FSB members have performed substantial supervisory activity to communicate to institutions expectations with respect to compliance with the Principles and Standards or the respective national rules, and to determine the status of compliance.

Reviews of significant financial institutions' self-assessments against the Principles and Standards or national rules and plans to address deficiencies, including on-site visits and interviews with senior management and board members, and recommendations for improvement where necessary, were conducted in Australia, Canada, Italy, Singapore, Spain and the UK. In the US, such self-assessments were submitted by the largest firms in early 2010 and are currently being analyzed; firms whose plans supervisors judge to be inadequate will be required to improve them.

According to the report, South Africa is planning a self-assessment with respect to the Principles and Standards. Hong Kong and Japan have requested self-assessments against local guidance, to be followed by a review of compliance in the second half of 2010, including on-site examination for the largest firms. A supervisory review of large banks in China is planned for 2010.

Close dialogue with the industry and reviews of firms' practices, including on-site visits, took place in several jurisdictions. Surveys of practices were also conducted in Argentina, Brazil, Saudi Arabia and South Africa (the latter in 2008).

Enhanced supervision of compensation practices will continue during 2010, said FSB, and most FSB members expect that monitoring of compensation practices will become part of ongoing on-and off-site supervision going forward.

In the area of governance, the report finds that there has been significant progress in terms of rule-making. Many jurisdictions issued in 2009 domestic rules that were largely aligned with the relevant FSB Principles and Standards. For most of these jurisdictions, the rules have already come into effect. A number of the remaining jurisdictions (e. g., Singapore, South Africa) expect to issue similar rules in the first half of 2010.

On the whole, the new rules extend existing corporate governance requirements, which in a number of jurisdictions (e. g., Singapore) already impose statutory obligations on the board with respect to the oversight of compensation systems, as well as supervisory expectations on the need for staff in financial and risk control functions to be independent of business units.

Many jurisdictions are implementing the FSB Principles and Standards by way of a mix of enforceable rules and supervisory oversight (e. g., with regards to governance, Australia, France, Germany, Italy, the Netherlands, Saudi Arabia, Singapore, Switzerland, and UK). In these jurisdictions, the new rules pertaining to compensation governance take the form of legally binding requirements. In other jurisdictions, implementation is primarily by way of supervisory guidance and expectations backed by supervisory reviews.

"While there is broad consensus on the need for the new rules to be backed by vigorous review and enforcement, there are differences in actions planned. Notwithstanding these different approaches, most jurisdictions plan to include governance in their compliance reviews for 2010."

Most FSB members have incorporated in their regulatory and supervisory frameworks the requirement that compensation be aligned with prudent risk-taking, though differences remain in approach, emphasis and degree of detail. This is not an area currently addressed in India, Indonesia and Russia, though possible measures are under consideration.

About half of FSB member jurisdictions have the authority to ensure that banks limit variable compensation when it is inconsistent with the maintenance of a sound capital base. The requirement that compensation outcomes be symmetric with risk outcomes is a regular feature of existing regulatory and supervisory frameworks on compensation.

Most jurisdictions do not dictate the share of compensation that is variable, requiring instead an appropriate balance between base pay and the incentive-based component. Supervisors expect, and generally encourage, compensation schemes where variable pay increases significantly with seniority and becomes a substantial proportion of compensation for top management. This is incorporated in regulation in some cases (e. g., Brazil, France, Switzerland).

Some authorities (e. g., European Commission, Italy, Japan, UK) also note that requiring a "substantial" portion of compensation to be variable could send the wrong message and ultimately, encourage, rather than discourage, excessive risk taking. These considerations suggest the need for a balanced approach.

According to the report, several jurisdictions have incorporated deferral and malus features into their (existing or planned) regulatory frameworks. In some cases, such as Brazil, China, France, Germany and the UK, this includes specific minimum expectations for amounts that are to be deferred, and for the deferral period.

The report also points out that jurisdictions typically require that an appropriate balance be established across forms of payout - cash, equity and other forms of compensation - into national regulation and/or supervisory actions (either existing or planned). The degree of specificity, however, varies.

The report notes that there are a number of concerns raised with respect to awarding compensation through equity-based instruments, including the possible dilution of existing shareholders if these mechanisms are further enhanced; the ability of these instruments to create incentives for long-term value creation; and the treatment of unlisted companies that do not issue equity.

There has also been fairly good progress in the area of disclosure. Many jurisdictions have introduced (or will be introducing) new rules to implement Principle 9 and Standard 15 (e. g., Australia, China, France, Germany, Hong Kong, Japan, Korea, Mexico, Saudi Arabia, Singapore, South Africa, Switzerland).

For listed financial institutions in these countries, the new rules are in addition to existing public disclosure requirements (which include rules concerning compensation) that apply across all listed companies. Most of these jurisdictions plan to include disclosure in their compliance reviews for 2010.

However, the FSB said that it is too early to evaluate the quality of improvement in firms' compensation disclosures, as most such new disclosures are yet to be published. At the same time, existing requirements across jurisdictions point to some differences that may hamper the comparability of the disclosed facts and therefore the effectiveness of disclosure as a whole.

Some jurisdictions (e. g., UK, US) note that disclosure does not come under the purview of prudential supervisors. The US Securities and Exchange Commission has adopted amendments to its disclosure rules which require all listed companies to discuss their compensation policies and practices as they relate to risk management for all employees, if those policies and practices are reasonably likely to have a material adverse effect on the company.

Notwithstanding local jurisdictional issues, all FSB members are expected to implement disclosure standards that meet the higher of national or FSB standards.

On the industry progress to date, the report says that Members generally note that material changes have taken place in the compensation practices of financial institutions in their jurisdictions. Significant financial firms have engaged in major reviews of their compensation practices and are introducing substantial changes, though some are farther along in the process than others.

"Overall, practices remain diverse and are evolving, with new bodies of practice being developed, particularly in the area of pay structures. Thus, many agree that this is work in progress and it is too early to assess how effectively the Principles and Standards, and the respective national rules, are delivering change in the industry."

According to the report, progress to date can be broken down in the three main areas of governance, risk-alignment and disclosure.

Firms are moving fairly quickly to improve their corporate governance practices that relate to compensation: Compensation committees of boards are paying more attention to risk incentives and to compensation arrangements for employees below the senior executive level. Many firms have restated compensation policies to embed a clear link with risk appetite and firms' performance; the composition of compensation committees has been modified to increase the involvement of control functions, including through cross-membership between the compensation and board risk committees.

In addition, risk management has become more involved in compensation design and the decision-making process related to compensation outcomes. Many institutions have formalized interactions between the compensation committee and the risk function or risk committee. Compensation programmes for control function staff have been changed to ensure they are not based on business unit financial results (for instance, if financial metrics are used it would be based on bank-wide results rather than business unit results).

Furthermore, many firms have created specific monitoring processes to test the resilience of proposed compensation changes before implementation, and control the impact of new policies after implementation to identify and correct possible adverse incentives.

On risk-alignment, the FSB said that many banks are still in the process of considering how their compensation systems can better adjust for all material risks. Evidence from some large institutions suggests that risk is playing a greater role in both the design of remuneration schemes as well in actual decisions. Various approaches are being taken to adjust for risk.

"Overall, there is much room for improvement in this area, including on risk-based funding," says the report, adding that other areas where it is perceived that more needs to be done include linking the determination of the total discretionary compensation pool to capital planning processes; and developing mechanisms for the funding of deferred compensation, notably as regards the impact of unfunded deferrals on earnings volatility and shareholder dilution.

More progress is taking place in the area of performance-adjusted deferrals (malus arrangements). Pay structures and payout arrangements have focused a lot of the firms' efforts in 2009. The trend in the industry appears to be towards a more varied mix of payment instruments than in the past - from the predominant use of cash, equity and options to an increased use of equity-linked instruments - though information on the latter is limited at this stage. Equity or equity-linked instruments are not currently used as part of variable compensation in a number of jurisdictions (e. g., China).

There are clear signs that firms are beginning to tighten their approach to guaranteed bonuses - upon both entry and termination. The majority of the industry appears to have abandoned multi-year unconditional bonus guarantees and is waiting for existing legacy contractual obligations to lapse. When offered for recruitment purposes, it is becoming more common for entry bonuses to require certain performance targets and/or risk constraints to be met, and rarely extend beyond one year.

In some jurisdictions, guaranteed bonuses were not part of banks' compensation programs or have been limited to one year (e. g., Canada, France, Singapore, Spain and Turkey). In Switzerland, multi-year guarantees seem to be extended only in very rare cases, and this is an issue that supervisors will review in greater depth in the months to come.

According to the report, tightening of severance pay also appears to be progressing. Financial institutions have started to impose stricter conditions on severance payments offered to top executives ("golden parachutes"), and new contracts now typically exclude guaranteed severance pay provisions.

Improvements are also expected in transparency and disclosure, though for most institutions, annual reports that include the new, more granular compensation information will only become available in the coming months.

In response to regulatory changes and political pressure, firms have become more open on communicating on what was previously regarded as sensitive competitive information. Enhanced disclosures are expected, in particular, with regard to coverage of firms, levels of employees and details of remuneration policies.

"With many extra disclosures not likely to take place until later in 2010 or 2011, credibility about future changes would be enhanced if firms were to make concrete commitments today to the future disclosures that they will make."

The report makes a range of recommendations, with include amongst others that FSB members should finalize and implement regulatory and/or supervisory initiatives related to the Principles and Standards in 2010.

Firms should continue to make progress on risk and performance alignment of compensation schemes through 2010 and beyond. This would include the ability to demonstrate how their compensation schemes incorporate risk adjustments.

Furthermore, international colleges of supervisors should enhance information exchange and cooperation on compensation issues and practices at significant, cross-border financial institutions. Risk management (including as needed compensation practices) should be a standing agenda item in the supervisory colleges.

FSB members should work to ensure that all significant financial institutions across the financial services sector in their jurisdiction (as identified by the relevant national authorities), irrespective of their legal form, follow sound compensation practices.

The FSB called on the Basel Committee to develop for consultation by the end of October 2010 a report on the range of methodologies for risk and performance alignment of compensation schemes and their effectiveness in light of experience to date.

It should cover the following areas: (i) methods for incorporating risk and performance into bonus pool and individual compensation; (ii) the design of deferred compensation, such as adequate performance measures; the relation between performance measures and ultimate value of deferred compensation instruments; malus triggers; the sensitivity of payout schedules to the time horizon of risks; and the funding of deferrals; and (iii) proportionality in the application of rules, taking into account the size and complexity of the institutions, business models and risk tolerance.

This report could be used as a basis for guidance, said the FSB.

The Basel Committee in consultation with the FSB should consider incorporating disclosure requirements for compensation into Pillar 3 of Basel II, to add greater specificity to the current requirements for compensation disclosure under Pillar 2, by the end of 2010.

The FSB should conduct a follow-up review on compensation in the second quarter of 2011, to assess the impact to date of measures put in place by jurisdictions and the progress in industry compliance with the Principles and Standards and the respective national rules, the report concludes. +