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.
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