UK: Remuneration policies - the FSA's draft Code of practice

On 26 February, the FSA published a Code of practice on remuneration policies in draft form, in conjunction with the government's announcement about the Asset Protection Scheme. The draft Code is to form part of the eligibility criteria for participating in the Scheme.

A formal consultation paper on the draft is likely to be published on 18 March, together with the report of the Turner review of the regulation of financial services. The Code will be added to the FSA Handbook when that consultation is complete, and will at that point apply to all FSA-regulated firms.

The final form of the Code may be influenced by further work on remuneration policies which is being undertaken at European and international level (see below).

We are in the process of devising an advisory product to assist firms in benchmarking their policies against the principles set out in the Code, as they develop in the light of these international initiatives.

The FSA expects that banks should already be operating remuneration policies that fall within the good practice outlined in the October 2008 'Dear CEO' letter to bank CEOs, to which our briefing last year referred.

The Code aims to ensure that firms' remuneration policies are consistent with sound risk management, and do not expose them to excessive risk. The FSA will use the principles in the Code to assess the quality of firms' remuneration policies. It may also ask the committee with overall responsibility for such policies to benchmark their policies against the principles, to submit plans for improvement where there are gaps. The FSA will also expect firms to use the principles in assessing exposure to risks from such policies as part of the ICAAP process.

The principles contained in the draft Code are not concerned with levels or quantum of remuneration; that will remain a matter for firms' boards. However, the Code will require a considerable number of firms to undertake a "root and branch" review of their remuneration policies and practices.

Top 10 "Need-to-Knows"

Risk adjustment

The general thrust of the requirements is to ensure that bonus and long term incentive policies take appropriate account of sound risk management practices, including long- and short-term risk, cost of capital and liquidity requirements.

Scope

The Code will apply to all FSA regulated firms, and to remuneration at all levels, with an associated significant increase in administrative burden.

Remuneration committees

The Code envisages formal "remuneration committees" being established to manage the setting of bonuses and incentive arrangements through the exercise of "independent judgement". Such committees must comprise at least one member with "practical skills and experience of risk management".

Risk and Compliance role

This is the first time that Risk and Compliance are being required to play an active role in setting and moderating remuneration policy, including an obligation to produce regular reports on the implications of that policy for risk and risk management. This signals the increased importance that the FSA will accord to the roles of Risk and Compliance staff in the new regulatory climate.

Deferral terms

It will no longer be acceptable for lump-sum remuneration to be paid without the use of deferral terms in relation to a significant proportion of the award – the amounts deferred will be expected to be subject to both upwards and downwards performance adjustment over the deferral period.

Performance

Standard performance criteria such as earnings per share (EPS) and total shareholder return (TSR) will need to be adjusted, based on the risk factors referred to above. Performance testing should relate to more than one financial year. Firms simply using annual discretionary bonus arrangements will fundamentally have to reconsider their approach.

Balanced scorecard

Firms will be expected to develop appropriate methods of testing financial and non-financial performance, setting objectives on the basis of a "balanced scorecard". Financial performance should be based on profit and not turnover. Non-financial performance should include a significant proportion of testing against compliance and risk management factors.

Resourcing

Risk and Compliance will need to ensure that they are provided with sufficient resources to enable them to discharge their new duties appropriately, or the firm will risk FSA sanctions for non-compliance. Part of the additional workload will be the preparation of regular risk reports setting out the implications of the remuneration policy adopted, and annual reports on remuneration policy.

Conflicts

Conflicts of interest must be avoided, so relying on line managers to set bonuses for their own divisions will no longer be acceptable.

FSA oversight

The FSA may seek a meeting at any time with the Chair of the remuneration committee to justify the approach taken. For the first time, the firm's remuneration policies will be taken in to account when assessing its approach to compliance and risk management.

 The FSA's work on remuneration polices should not be viewed in isolation. It is being undertaken in conjunction with various workstreams at European and international levels, including the following:

The de Larosière Committee has recommended that:

• the assessment of bonuses should be set in a multi-year framework, spreading bonus payments over the cycle;
• the same principles should apply to proprietary traders and asset managers;
• bonuses should reflect actual performance and not be guaranteed in advance;
• supervisors should oversee the suitability of financial institutions' compensation policies, require changes where compensation policies encourage excessive risk-taking and, where necessary, impose additional capital requirements under pillar 2 of Basel 2 in case no adequate remedial action is being taken.

The European Commission announced last week that it intended to strengthen its 2004 Recommendation on remuneration of directors of listed companies by April 2009, and that it would also table a new Recommendation specifically on remuneration in financial services. In the autumn, in the context of the revision of the Capital Requirements Directive as well as in other relevant sectoral legislation, the Commission intends to give supervisory authorities the power to impose capital ‘sanctions’ on financial institutions whose remuneration policy is found to generate unacceptable risk. It will also examine the application of the Basel Committee recommendations on corporate governance for banks. The Commission intends to report on current practices by the end of 2009.

The Committee of European Banking Supervisors (CEBS) published for comment its principles on remuneration policy on Friday. The scope of the principles covers remuneration policies applying throughout an organisation rather than focusing exclusively on executive pay or severance pay. They focus on key aspects of the remuneration policy, and in particular:

• Alignment of company and individual objectives
• Transparency towards internal and external stakeholders
• Governance with respect to oversight and decision-making
• Performance measurement
• Form of remuneration

The consultation will last for one month and will end on 3 April 2009.

The Financial Stability Forum is apparently close to reaching agreement on a Code of Conduct to apply equally to all financial centres. The focus of the Code is expected to be on the way the structure of remuneration can create incentives for excessive risk-taking or for risk management.

The US Treasury Department has issued new guidelines on executive pay for financial institutions that are receiving government assistance to address the current financial crisis.

Please contact us if you would like further information, and for any detailed advice on remuneration structuring and planning.