The policy statement document can be downloaded from this website using this link ps09_15.pdf
FSA confirms introduction of remuneration code of practice
FSA/PN/108/2009
12 August 2009
The
Financial Services Authority (FSA) has today introduced a new code that
will require large banks, building societies and broker dealers in the
UK to establish, implement and maintain remuneration policies
consistent with effective risk management.
The new
code is designed to achieve two objectives: firstly, that boards focus
more closely on ensuring that the total amount distributed by a firm is
consistent with good risk management and sustainability; and secondly
that individual compensation practices provide the right incentives.
Eight principles have also been added to the FSA’s handbook to ensure firms understand how the FSA will assess compliance.
The
code makes clear that it is not expected that firms will enter into
contracts with individuals which provide guaranteed bonuses for more
than one year. It is also expected that for senior employees two-thirds
of bonuses will be spread over three years.
Firms are
expected to provide the FSA with a remuneration policy statement by the
end of October. This will have to be signed off by remuneration
committees and will enable the FSA to check compliance with the code.
Non-compliant firms could face enforcement action or ultimately, be
forced to hold additional capital should they pursue risky processes.
Hector Sants, FSA chief executive, said:
"The
FSA is determined that banks' remuneration policies should be
consistent with, and promote, effective risk management. The new rules
and code of practice, which will take effect from January, next year,
are aimed at achieving this.
"Whilst there is general
international agreement on the need for supervisory action on
remuneration policies and practices we will be the first major
financial regulator to take this step. We think that it is important to
have rules in place for 2010."
The rule and code are
consistent with the recommendations of the Financial Stability Board
and with the measures being considered by others such as Switzerland
and the EU. International negotiations on common guidelines should be
concluded in the first half of 2010.
The
FSA regulates the financial services industry and has four objectives
under the Financial Services and Markets Act 2000: maintaining
market confidence; promoting public understanding of the financial
system; securing the appropriate degree of protection for consumers;
and fighting financial crime.
The FSA aims to
promote efficient, orderly and fair markets, help retail consumers
achieve a fair deal and improve its business capability and
effectiveness.
The Walker Review of Corporate Governance of UK banking Industry has published its consultation document on 16 July 2009. A link to the official site is as follows: http://www.hm-treasury.gov.uk/walker_review_information.htm
The consultation document is entitled
A review of corporate governance in UK banks and other financial industry entities
16 July 2009
and contains a significant chapter dealing with Remuneration. If the recommendations of the consultation document are implemented they will have a significant impact on the workload of Remuneration Committees. The document can be downloaded from this website Walker Review Consultation document
FSA draft code on remuneration practices
This
draft Code sets out the main rules, evidential provisions and guidance
on remuneration which the FSA is proposing to incorporate into its
Handbook.
It is a revised version of the Code originally
published on 26 February 2009. It will not apply until the FSA’s final
Code is approved and implemented. If the proposal goes ahead, we
currently plan to publish the final version in late July 2009 with the
Code in force from November 2009. Until then, firms should regard the
code as a benchmark for good practice, building on our October 2008
‘Dear CEO’ letter.
This Code applies directly to the
larger banks and broker dealers (for a full definition of the scope
please see CP 09/10, Appendix 1, SYSC 19.1.1R). The FSA encourages all
firms to review their compensation policies against the general
requirement and the principles in this Code.
The FSA code of practice set out below was published by the FSA on 26 February 2009. The FSA website link is http://www.fsa.gov.uk/Pages/Library/Other_publications/Miscellaneous/2009/cop_remun.shtml
FSA Code of practice on remuneration policies
Introduction
The principles in this Code of practice ("Code") are relevant to all FSA-regulated firms.
The
principles embodied in the Code are not concerned with levels or
quantum of remuneration, which are a matter for firms' boards.
The
aim of the Code is to ensure that firms have remuneration policies
which are consistent with sound risk management, and which do not
expose them to excessive risk.
The principles in
the Code will be used by the FSA to assess the quality of a firms'
remuneration policies and linkage, if any, between such policies and
excessive risk-taking by staff.
We may also ask
the committee with overall responsibility for a firm's remuneration
policies to provide us with evidence of how well its policies measure
against these principles, together with plans for improvement where
there is a significant shortfall. We will also ask firms to use the
principles in assessing their exposure to risks arising from their
remuneration policies as part of the ICAAP process
General principle
Firms must ensure that their remuneration policies are consistent with effective risk management.
Rationale:
If
a firm's remuneration policies are not aligned with sound risk
management it is likely that those policies will provide incentives for
employees to act in ways that might undermine it.
Poor
remuneration policies can 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
FSA's purpose in encouraging firms to create and consistently implement
better, risk-focused remuneration polices is that, while relevant
Handbook rules require firms to manage the risks in their business
appropriately, significant doubt has recently arisen over the efficacy
of other risk management mechanisms to override the specific risks
created by extravagant or excessive incentive structures, which in turn
can lead to excessive risk-taking.
Specific principles
A. Governance
1.
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. Their members should
have the skills and experience to reach an independent judgement on the
suitability of the remuneration policies, including the implications
for risk and risk management.
Rationale
Boards
and relevant sub committees should exercise their own judgement and
take account of the financial situation of their firm in drawing up
remuneration policies. The need for firms to offer competitive
remuneration packages is recognised, but industry comparators should be
a secondary rather than a primary factor in the determination of
remuneration policies.
Clarification
Remuneration
is usually the single most important cost incurred by firms after
funding costs, and "people risk", including the risks posed by
remuneration policies, constitutes one of the most important risks.
Boards, and their remuneration committees, should pay specific and
increased attention to these risks.
Remuneration
committees, or equivalent bodies with responsibility for remuneration
policies, should normally include one or more non-executive directors
with practical skills and experience of risk management. They should
receive regular reports directly from the risk function of the firm on
the implications of the firms' remuneration policies for risk and risk
management.
The FSA expects foreign firms with UK
subsidiaries to have a body with oversight of remuneration policies in
the UK entity which can meet the requirements of this Principle
relating to risk, and to any reporting requirements that the FSA might
require as explained below.
The FSA may ask a firm to
prepare an annual statement on its remuneration policies, and will
anticipate that this statement covers the implications of those
policies for the firm. The FSA will also expect the statement to
include an assessment of the impact of their policies on behaviour, and
on the risk profile of the firm. In drawing up this assessment, boards
and remuneration committees should exercise their own judgement and not
rely solely on the judgement or opinions of others. The FSA may seek a
meeting with the Chair of the Remuneration Committee (or a firm's
equivalent body) to discuss the annual statement.
It
would be good practice for a statement on remuneration policies to be
available also to shareholders, ahead of the annual vote on directors'
remuneration.
2. The procedures for setting compensation
within the firm should be clear and documented, and they should include
measures to avoid conflicts of interest. Risk and compliance functions
(in consultation with the firm's HR function as may be deemed
appropriate) should have significant input into setting compensation
for business areas.
Rationale
Conflicts of
interest can easily arise when staff are involved in the determination
of remuneration for their own business area. These need to be mitigated
by having in place independent roles for control functions including,
notably, risk departments.
Clarification
Principle
4 stresses the importance of risk-adjustment in measuring performance,
and the importance within that process of applying judgement and common
sense. It would be good practice for Remuneration Committees to ask the
risk function to validate and assess risk adjustment data, and to
attend a meeting of the Remuneration Committee for this purpose.
3.
Compensation for staff in the risk and compliance functions should be
determined independently of the business areas. They should have
different performance metrics, with greater emphasis on the achievement
of their own objectives.
Rationale
This
principle is also designed to avoid conflicts of interest, such as
might arise if the business areas had undue influence over the
remuneration of control functions.
Clarification
This
principle reflects the need to avoid undue influence by the business
areas over the remuneration of control functions is particularly
important where staff from the control functions are embedded in the
business areas. However, the principle does not prevent the views of
business areas being sought as part of the assessment process.
B. Measurement of performance for the calculation of bonuses
4.
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.
Rationale
Measuring
performance based wholly or mainly on revenues or turnover can provide
an incentive for employees to pay insufficient regard to the quality of
the business, or its suitability for the client. Profits are the
preferred measure, but they should be adjusted for risk, including
future risks not adequately captured by accounting profits. Such
adjustment may anyway become a requirement to address systemic risks
and risks associated with the economic cycle.
Clarification
Management
accounts should provide profit data at divisional/departmental/business
unit levels to the extent possible. If revenue or turnover is used as a
component in financial assessment, processes should be in place to
ensure that the quality of the business done and its suitability for
clients is taken into account. Risk-adjustment is likely to be based
upon a calculation of economic profit or economic capital. The full
range of potential risks (including, for example, liquidity risk)
should be covered. A number of techniques are available to adjust
profits and capital for risk, and firms should choose those which best
suit their circumstances. However, the FSA would expect firms to be
able to provide the FSA with information relating to the workings of
the calculations. The FSA recognises that the results of
risk-adjustment are not foolproof, and accordingly firms should apply
judgement and common sense in the final decision about performance pay.
5. Firms should not assess performance solely on the results of the current financial year.
Rationale
Profits
from banking activities are volatile and subject to cycles. The
financial performance of firms and individual employees can be
exaggerated as a result. The assessment process should include measures
to ensure that employees are assessed on their longer term performance.
Clarification
Performance assessment on
a moving average of results can be a good way of meeting the
requirements of this criterion, however, other techniques, e.g. good
quality risk adjustment (principle 4) and deferment of a sufficiently
large proportion of remuneration (principle 9) can be used.
6.
Non-financial performance metrics, including adherence to effective
risk management and compliance with regulations, should form a
significant part of the performance assessment process
Rationale
Poor
performance in non-financial metrics, e.g. poor risk management or
other behaviours contrary to company values can pose significant risks
for a firm and should if necessary override metrics of financial
performance.
Clarification
The
performance appraisal process should be clearly explained to relevant
staff, and implemented, and, secondly, the importance of non-financial
assessment factors in the process should be explained. A "balanced
scorecard" is a good way to do this. All processes and decisions should
be fully documented, with firms recognising that the FSA may consider
requiring firms, in appropriate cases, to produce such documentation.
C. Measurement of performance for long--term incentive plans
7.
The measurement of performance for long term incentive plans, including
those based on the performance of shares, should also be risk-adjusted.
Rationale
Common measures of share performance, such as earnings per share (EPS)
and Total Shareholder Return (TSR), are not adjusted for longer term
risk factors. Many "longer term" incentive plans mature within a 2-4
year period, and strategies can be devised to boost EPS or TSR during
the life of the plan, to the detriment of the true longer term health
of the company. For example, increasing leverage is a technique which
can be used to boost EPS and TSR.
Clarification
The FSA will press for
a wider review of the use of unadjusted share performance measures in
longer term performance based remuneration schemes in the corporate
sector.
D. Composition of remuneration
8.
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.
Rationale
If
the fixed component (base salary) is low the firm will find it
difficult to cut or eliminate a bonus in a poor financial year.
Clarification
A
measure of the effectiveness of this principle would be the ability of
a firm to be able to pay no bonus in a year in which the firm makes a
loss.
9. The major part of any bonus which is a
significant proportion of the fixed component should be deferred, with
a minimum vesting period.
Rationale
This
principle is designed to ensure that the interests of those receiving
significant amounts of bonus are aligned with the longer term interests
of the firms, whilst still providing flexibility for firms to devise
attractive remuneration structures measured against practices across
the corporate sector.
Clarification
In
the FSA's view an example of good practice would be that where a bonus
is a significant proportion of the fixed component, the proportion to
be deferred should be not less than two-thirds. The vesting period of
the deferred element should be appropriate to the nature of the
business and its risks.
10. 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.
Rationale
Most
business undertaken in banking is subject to future risk and
uncertainty. If variable compensation is paid out without any link to
future performance, the employee has less incentive to take future risk
into account, and the firm is exposed to the risk of paying out
variable compensation which will prove not to be justified by results.
Clarification
Deferred
compensation paid in stock can meet this principle provided that the
scheme meets appropriate criteria, including risk-adjustment of the
stock performance measure as described in principle 4. Deferred
compensation paid in cash should also be subject to performance
criteria. Linkage to the future performance of a business unit or
division is usually preferable to the future performance of a smaller
departments or teams since the latter arrangement can be less effective
in promoting teamwork. It is accepted that such schemes are complex to
administer. Nevertheless some leading investment firms have introduced
them for their senior executives, and the FSA would encourage these to
be adopted more generally across the banking industry.
The Financial Services Authority sent an open letter on 13 October 2008 addressed to CEOs. The focus of the letter is on risk and remuneration structures, and expresses concerns that remuneration structures may be a driving force behind current financial problems. A copy of letter is available here ceo_letter_13oct08.pdf
The full text of the letter follows:
Financial Services
Authority
13 October 2008
Dear CEO
Remuneration
policies
Introduction
1.There is 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. In the private sector, bodies such as the Counterparty Risk
Management Group (CRMPG) have identified remuneration structures as one of the
possible driving forces behind current problems.1The
International Institute of Finance (IIF) reached a similar conclusion and has
issued Principles of Conduct which they think should be adopted by firms.2
2.The FSA shares these concerns. It would
appear that in many cases the remuneration structures of firms may have been
inconsistent with sound risk management. It is possible that they frequently
gave incentives to staff to pursue risky policies, undermining the impact of
systems designed to control risk, to the detriment of shareholders and other
stakeholders, including depositors, creditors and ultimately taxpayers.
3.The FSA has no wish to become involved in
setting remuneration levels: that is a matter for Boards, which should ensure
that they have effective structures in place to set remuneration policies and monitor
remuneration levels throughout the firm. However we want to ensure that firms
follow remuneration policies which are aligned with sound risk management
systems and controls, and with the firm's stated risk appetite.3
4.Note that our interest in this area (and the scope of this letter) does
not extend to the remuneration of Board non-executive directors. Their
remuneration (as well as their role, eg in overseeing employee remuneration)
has been covered in the 2003 Higgs Review and earlier reviews.
Criteria for
'good' and 'bad' remuneration policies
5.It is difficult to be prescriptive about
remuneration policies. They will vary widely between firms, and within firms
between different levels of staff. They will also need to reflect many factors including the nature
of the business undertaken and the culture of each institution. Nevertheless we
believe that it is possible to set out some high level criteria against which
policies can be assessed. An illustration of our current thinking is set out in
the attached annex.
Action for
firms
6.Many firms have a remuneration process with a
year end review. Planning for that review may already be underway. I urge all
firms, whatever the timing of their remuneration reviews, to consider carefully
their remuneration policies, especially in light of recent market developments.
If the policies are not aligned with sound risk management, that is
unacceptable. Immediate action will be required to change the policies.
7.The criteria set out in the annex provide a
benchmark for this exercise. We would expect firms to avoid (or to be
implementing plans to eliminate) bad or poor practices concerning the
measurement of performance, the composition of the remuneration and governance
arrangements.
8.We would further expect firms to be moving towards good practice. We
recognise that performance-adjusted, deferred compensation arrangements are
complex to design: nevertheless, if they are not already in place we expect
firms to be considering actively how they might be incorporated into
remuneration structures within a specified time period.
Action by
the FSA.
9.During September the FSA held a number of
high level discussions with London-based firms about remuneration policies.
Between now and the end of the year we will arrange a further round of visits
to all recipients of this letter. Our aim will be to gather more specific
information about remuneration practices in your firm to assure that bad
practices are not present and to seek further input on what would constitute
good practice.
10.In the early part of next year we will
communicate our findings regarding good practice to you, and have a further
discussion with you about them, if appropriate. We will also publish our
general findings about remuneration structures in the London market, on a
no-names basis.
11.We believe that given the events of the past
year firms recognise the need to review their remuneration policies and to take
steps to change them if necessary. We believe that in working with the industry
we can assist and encourage this process.
12.Changes to remuneration policies formed part of the recommendations of
the report of the Financial Stability Forum4,
and the subject remains under active discussion internationally. The FSA is
taking a prominent part in those discussions. We are mindful that to be
effective action on this subject needs to be taken internationally. We hope to
be able to report on the international work in our published report early next
year.
Conclusion
13.This letter does not constitute formal Guidance from the FSA but is
intended to update you in regard to our work on remuneration policies and to
inform you as soon as possible of our initial thinking in this area. We would
encourage firms to review compensation policies throughout the firm (not just
in trading and investment banking areas) to be sure that they are consistent
with sound risk management. We will update firms early in the new year on the
result of our further work as well as progress in international forums, such as
the FSF.
Sincerely,
Hector Sants
Chief Executive
Financial
Services Authority
1 CRMPG III, Containing Systemic Risk: The Road to Reform, August
2008
2 IIF, Final Report of the IIF Committee on Market Best Practices,
July 2008.
3 Note that the FSA will separately control that the firm's stated
risk appetite is consistent with the firm’s obligation under Principle 4 to
maintain adequate financial resources (including adequate capital and adequate
liquidity)
4 Report of the Financial Stability Forum on enhancing market and
institutional resilience, April 2008.
ANNEX: Criteria
for good and bad remuneration policies
a)Measurement of performance for the
calculation of bonuses
Bad
or poor practice (firm view)
Good practice
(initial thoughts)
Calculated
on the basis of revenues, without any counterbalancing risk controls
Calculated
on profits, and by reference to other business goals if appropriate
Does not
take risk or capital cost into account
Uses a
measure of risk-adjusted return. Measure likely to be based upon economic
capital calculation, and should take proper account of a range of risks
including liquidity risk.
Performance
assessed entirely on the results for the current financial year
Performance
assessed on a moving average of results (link to deferred compensation, see
below)
Employee
bonuses calculated solely on the basis of financial performance
Bonuses
awarded take into account appraisal of other performance measures, including
risk management skills, adherence to company values and other behaviours
b)Composition of the remuneration
Bad
or poor practice (firm view)
Good
practice (initial thoughts)
Remuneration
which has little or no fixed component.
Fixed
component of the remuneration package to be large enough to meet the
essential financial commitments of the employee.
Paid
wholly in cash
Appropriate
mix of cash and components which are designed to encourage corporate
citizenship and alignment of interests between those of the employee and
those of the firm. (For example shares, or appropriately priced share
options).
No
deferral in the bonus element
A major
proportion of the bonus element is deferred so that the impact of the
performance (see 1 above) in one year on the firm/unit's long term profits
can be established
c) Performance
adjusted deferred compensation
Bad
or poor practice (firm view)
Good
practice (initial thoughts)
Payout of the deferred element is not
linked to the future performance of business undertaken in previous years.
A significant proportion of the deferred
compensation element to be held in a trust or escrow account, from which
funds can only be vested according to rules which take account of the
performance of business undertaken in earlier years.
Deferred compensation is determined by a
performance measure which is calculated on a moving average over a period of
several years.
Performance adjusted deferred
compensation schemes can be waived/ not enforced despite evidence of poor
performance or wrong doing.
Performance adjusted deferred
compensation schemes are legally robust and contractually enforced.
d)Governance
Bad
or poor practice (firm view)
Good
practice (initial thoughts)
No
independent oversight of remuneration policies or of remuneration awards to
executives or senior staff
Board
level remuneration committee with majority of non-executives. Committee has
effective control of remuneration policies across the firm and of individual
remuneration awards above a certain threshold
No
process, or no transparent process for managing conflicts of interest
Areas
such as HR and Risk have strong and independent role in setting compensation
for the business areas.
Business
areas can determine the compensation of staff in risk and compliance
Compensation
for staff in risk and compliance is determined independently of the business
areas.
Staff
have an ability to influence unduly the valuation of their own positions and
hence the determination of performance measures. Ability also to front load
profit from transactions
Valuations
and risk reporting subject to independent verification
Incomplete
separation of duties between front and back office: ability of the front
office to influence back office procedures. (See also SYSC 5.1.6R to 5.1.11G
on the segregation of functions).
Overall
control of the back office vested in operations.
IfsProShare has recently published a briefing note on MiFID and how it affects share plan administrators. In-house administration carried out as an internal service and not as a business can continue to benefit from existing exemptions.