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.

1. Policy statement: ‘Reforming remuneration practices in financial services’ can be found on the FSA website.
2. 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.
3. 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.

FSA draft code on remuneration practices [PDF]

also available on this website at: FSA draft code updated 18 March 2009

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.

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.¹ The 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

                        b)  Composition of the remuneration

c) Performance adjusted deferred compensation

                        d)   Governance

  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.  

The full note follows: http://strategicremuneration.com/doc/MiFID_Briefing_Note_FINAL_Jun07.pdf