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Unravelled: Regulating bonuses: will Australia be next?

5 August 2015

Written by Associates Georgia Cleeve and Rosie Thomas

The UK's Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) released, in June this year, their joint policy statement 'Strengthening the alignment of risk and reward: new remuneration rules'. It sets out rules to further tighten what are already fairly onerous restrictions on the payment of bonuses to staff in banks, building societies and certain big investment firms in the UK.

The world's financial regulators have, for some time, been espousing the message that inappropriate remuneration structures (relating to bonuses particularly) beget excessive risk-taking and excessive risk-taking begets financial crises. The EU Parliament and Council legislated (and required EU member states to legislate) on this in 20101. The US also took action in 20102 and Hong Kong moved this year3. Separate EU-wide initiatives also regulate (or are soon to regulate) remuneration for wholesale fund managers, retail fund managers, insurers and other investment firms.

All of this suggests a trend among the world's financial regulators. Couple this with the fact that it tends to make good political sense to go after bankers earning huge sums in a sector riddled with scandals (and, in some jurisdictions, still benefiting from government bailouts), and it begs the question – will Australia be next?

Where did the UK rules come from?

A Remuneration Code regulating remuneration structures in banks has been in place in the UK since 2010 and was strengthened in 2014 as part of the introduction of the newest EU-wide Capital Requirements Directive (CRD IV). At the same time that the CRD IV changes were being implemented, the UK Parliamentary Commission on Banking Standards (PCBS) was reviewing the professional standards and culture of the UK banking sector, and working on its report, Changing banking for good, which was released in June 2013. This report made recommendations regarding remuneration that went even further in some respects than CRD IV and the rules released in June are one part of the response to the PCBS report. The other (very significant) part of the response is the UK Senior Managers and Certification Regime, which includes some fairly innovative (and onerous) measures to increase individual accountability. We will look at some of the implications of this in next month's Unravelled, so stay tuned.

What are the UK rules?

Turning back now to the blunter tool for changing individual behaviour – regulating remuneration and, more specifically, bonuses. The net effect of all these iterative changes to bonus payment regulation is that the payment of bonuses in banks, building societies and investment firms in the UK (including branches of non-EU firms) will be associated with the following key constraints (although there are also many more):

  1. Firms need to identify who is subject to the rules (broadly 'material risk takers'), but this group will need to be broken down to subsets of: senior managers; risk managers; and other material risk takers. The administrative and political difficulties of carrying out this scoping exercise alone in large and complex financial organisations should not be underestimated.
  2. Despite some UK blustering about rejecting it on the basis that it placed UK banks at a competitive disadvantage to their US/Hong Kong peers, the UK has eventually had to come to the party and apply a cap on bonuses. As such, bonuses for relevant staff must, as a general rule, be capped at 100 per cent of fixed remuneration (although higher levels might be permitted if shareholder approval is obtained, or if the bonus is paid in non-cash instruments and meets certain deferral requirements).
  3. The new rules, as part of the broader aim of 'strengthening alignment of risk and reward', appear to be focused on ensuring that in-scope employees and firms alike view bonuses as rewards for good (and prudent) behaviour rather than for meeting short-term targets. The new rules will require firms to implement (and will void provisions in agreements that are inconsistent with) the following requirements:
    • Deferral: payment of bonus payments to in-scope staff must be deferred (subject to some allowance for earlier pro rata vesting) for at least seven years (for 'senior managers'), at least five years (for 'risk managers') and at least three years (for 'other material risk takers').
    • 'Malus': firms should reduce or cancel deferred bonuses to in-scope staff that have not yet vested (ie apply 'malus') where there have been individual conduct issues, there has been a material downturn in financial performance or there is a material failure of risk management. The FCA and PRA have provided some guidance to firms about how malus should be applied (for example, the amount of any reduction should depend on the consequences of the event and, for example, whether fines, regulatory actions or reputational damage ensued), but the regulators expect firms to have their own policies for applying this.
    • 'Clawback': even where a bonus has been paid, firms must be able to 'clawback' bonuses from in-scope staff for up to seven years after they are awarded in the event of 'misbehaviour' or material error by individuals or failures of risk management. The period increases to 10 years for senior managers if, at the end of the seven-year period, there are ongoing internal/regulatory investigations that might give rise to a clawback.

In reality, the new rules are really just tinkering at the edges of bonus regulation for UK banks, building societies and significant investment firms but contrasting these with the Australian position does bring into focus just how accommodating the Australian regulators have been in this area (and how far they could still go).

How is remuneration regulated in Australia?

One thing is clear: none of the Australian regulation comes close to the prescriptive requirements in the UK.

APRA's prudential standards require that APRA-regulated instututions have certain governance arrangements in place in relation to executive remuneration. Broadly, this involves having an appropriate Board Remuneration Committee and a suitable Remuneration Policy. The Remuneration Policy must address the things set out in the prudential standard. This includes that remuneration must be designed to align with 'prudent risk taking' and must incorporate adjustments to reflect the outcomes of business activities, the risks related to the business activities; and the time necessary for the outcomes of those business activities to be reliably measured. This leaves a lot of room for judgment and we understand that the practices adopted within the industry vary widely. There are also certain remuneration disclosure requirements (which, for ADIs, extends to disclosures for 'material risk takers' in addition to 'senior managers').

Other than APRA's broad requirements, the regulation of remuneration in the financial sector is fairly limited. If financial product advice is being provided, then a person's bonus or other remuneration cannot be conflicted remuneration. For listed companies, the 'two strikes rule' and related shareholder rights might also play a role.

Could the UK approach be adopted here?

In theory, APRA could change its prudential standards to introduce rules similar to those in the UK. (As noted above, the concept of a 'material risk taker' is one that has already been introduced). However, whether APRA would in fact do so is another question. APRA's 2012 review of remuneration practices did raise some questions and concerns about remuneration, but there hasn't been much more on the issue since then. Nevertheless, the recent focus on 'culture' in financial services is likely to lead regulators straight to remuneration practices and so we could see regulators talking about the issue once again.

Despite APRA's prudential standard making power, any attempt to introduce rules like those in the UK would likely require consideration of constitutional issues about whether there could be an unjust acquisition of property (namely, an existing right to a bonus under a policy that does not comply). We think that the employment lawyers will also have lots to say. We'll be watching closely for any signs of life on the remuneration front and, as always, will keep you updated.

Footnotes
  1. See Recital EU Directive 2010/76/EU (ie Capital Requirements Directive III).
  2. The Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit and Insurance Corporation and Office of Thrift Supervision released 'Guidance on Sound Incentive Compensation Policies' in 2010, which aimed to align compensation and risk.
  3. The Monetary Authority of Hong Kong (HKMA) released guidelines setting out its expectations for ensuring bonuses do not encourage undue risk-taking.

Other articles in this edition of Unravelled

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Financial System Inquiry: where are we at?
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Broadening approved product lists – would it really achieve anything?
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