Remuneration: Reactions and Responses
Thank you very much for the opportunity to be here today, and to support Women in Banking and Finance in the important work that it does promoting female leadership in the financial sector.
My topic for today is one that all leaders should think deeply about: remuneration. In particular, what role does remuneration play in driving sustainable organisational performance, and how does it influence the behaviours and attitudes of individuals in the workplace? And particularly when variable remuneration is involved, what incentives does it create, and are those incentives aligned with organisational goals and values?
Incentive-based remuneration is common in financial firms. It is a major tool used to align the interests of managers and staff with the perceived interests of the firm’s owners. Well-designed remuneration arrangements should produce a win-win: companies generate higher productivity, more sales or better quality output, and staff are financially rewarded for their efforts. But unfortunately that’s not always the way it plays out. There is ample evidence of improperly designed incentives encouraging actions and attitudes that are contrary to the long-run interests of the company itself, let alone other stakeholders. In those cases, it has been a lose-win: firms were being damaged, but were rewarding staff for causing that damage along the way.
Recent events, including the Royal Commission, have raised the question of whether financial firms, occupying as they do a very privileged position in society, should have greater regard to interests beyond that of their shareholders. While many firms would no doubt assert they operate their businesses with a broader set of stakeholders in mind, there remains a very strong commitment to maximising short-term financial performance within remuneration schemes (particularly for senior executives).
To promote and support both a wider set of interests and a longer-term perspective, APRA has recently been consulting on major reforms to the way remuneration in prudentially regulated firms might work in future. Our proposals have generated much interest, and considerable angst – problematic, misguided and unworkable are some of the epithets used. The consultation period for the proposals recently closed, so today I’d like to talk about what we are trying to achieve, and some of the key messages and feedback that we have received.
About 18 months ago, I gave another speech on incentives. In that speech, I highlighted the difference between bankers and pilots. At the heart of it, both jobs involve risk-taking. But the interests of pilots and their passengers are highly aligned: pilots want to take off and land safely just as much as their passengers. Recently, I experienced this personally: I was due to travel from Sydney to an important commitment in Canberra, but the pilot declared that he would not fly because, due to high winds that day, it was not safe to take off. As anxious as I was about missing my commitment, I was no more enthusiastic than the pilot about a risky take-off.
The interests of financial firms and their customers are less well aligned. To stretch the analogy a bit further, the financial pilots often have parachutes when their passengers do not. Particularly because financial risk is taken today, but may not crystallise for many years (well after those involved may have left the scene of an accident), it is much more difficult to maintain an alignment of interests between financial firms and their customers. At the same time, the long-term interests of customers and the short-term interests of equity investors often pull firms in different directions. We therefore cannot rely solely on the self-interest of financial pilots to deliver a financial system that is financially sound and producing fair outcomes to consumers.
Our own 2017 review of remuneration frameworks and outcomes, which was the basis of the speech I referred to earlier, concluded remuneration practices amongst the largest financial firms – in design, governance and outcomes – did not consistently and effectively meet APRA’s objective of sufficiently encouraging behaviour that supports strong risk management and long-term soundness. Meaningful frameworks and policies existed in form, but not always in substance.
The impact of these weak practices was reinforced by the Royal Commission into misconduct in the financial services sector. Commissioner Hayne concluded, amongst other things, that
“remuneration and incentives, especially variable remuneration programs, tell staff what the entity rewards. Hence, remuneration and incentives tell staff what the entity values. …. As the Commission’s work has shown, and is now not disputed, poor remuneration and incentive programs can lead, and have led, to poor customer outcomes.” 
The remediation bill for many of these outcomes is in the many billions of dollars.
The Royal Commission recommended that APRA should upgrade its largely principles-based remuneration requirements to:
- give effect to the latest international guidance, and ensure its standards give sufficient attention to non-financial risks, including misconduct;
- set limits on the use of financial metrics associated with long-term variable remuneration;
- provide for ‘clawback’ of rewards to ensure more ‘skin in the game’ for a longer period of time; and
- equip, and then require, Boards to play a more active role in assessing remuneration outcomes.
Pleasingly, at least some in the industry have also got the message about the need for change. Sales practices amongst frontline staff are being substantially overhauled in line with the Sedgwick review. And at a more senior level, for example, over the past two years the CEOs, CFOs and CROs of ten of the largest Australian banks and insurers received, on average, 74 per cent of their target short-term incentives (STIs), compared with 96 per cent in years prior to the Royal Commission. So some good progress has been made. But despite many of the problems having their genesis some time ago, long-term incentives (LTIs) have been far less impacted, and there has only been limited impact on those who – as I referred to earlier – had already left the scene. In our view, there remains more to do to make sure remuneration arrangements in the financial sector are robust and can be relied upon to genuinely deliver the sorts of outcomes we think are important.
Taking all of this together, and looking at international practice, in July this year we proposed a substantial upgrading to the prudential framework for remuneration in APRA-regulated firms. The core elements of the package involve:
- an expectation of more active Board involvement in determining remuneration outcomes, in aggregate and for individuals, shifting away from formulaic approaches to more active application of judgement to better align rewards with outcomes;
- a cap on the use of financial metrics when determining remuneration outcomes, designed to promote a more holistic assessment of performance through, amongst other things, elevating the importance of non-financial risks (including conduct) in the assessment of variable remuneration outcomes. We suggested a cap of 50 per cent; and
- longer vesting, combined with malus and clawback, to retain more ‘skin in the game’ for a longer period of time, and ensure short-term rewards cannot be enjoyed without regard to longer-term outcomes.
The proposed framework is undoubtedly more prescriptive than has traditionally been the case, reflecting the need to drive change. That said, we have not sought to go so far as to cap the amount of variable remuneration as has been done in other jurisdictions, as we have not seen evidence that this more prescriptive approach has been effective in generating better outcomes, and it may well simply encourage remuneration arrangements primarily designed at circumventing specific rules. We have also sought to avoid prescribing specific remuneration structures or forms. And we have not prescribed which performance metrics should be used, as we think it important firms retain the flexibility to choose these to suit their particular circumstances.
Consultation on our proposals closed in late October, and has been extensive. We received 74 submissions, and met with over 30 industry bodies and other stakeholders to discuss the proposals, provide greater clarity on our objectives and intent, and hear feedback first-hand. This has been a very useful process for us, and hopefully helped those we have engaged with to understand the trade-offs we are grappling with.
Our proposals have undoubtedly caused a fair amount of angst, as they would require significant change to established practice. Many large investors and proxy advisors, in particular, have been uncomfortable with what we have proposed largely, I suspect, because they have been very influential in designing current practices to suit their particular interests. At least some Boards have apparently been told that if they change their arrangements to comply with APRA’s requirements, they will be met with protest votes at AGMs. That is a strange and disappointing response to a Board that would be seeking to comply with the law, but is illustrative of the passion that this topic has aroused.
There is also concern on a number of fronts that APRA’s proposals will not achieve our objectives, will be too onerous and therefore cannot be justified on a cost-benefit basis, and/or will have unintended consequences (such as challenges in attracting new talent, and significant shifts from variable to fixed remuneration). We are considering these issues very carefully. Any regulatory intervention involves trade-offs, and we obviously do not want to impose new regulation that does not deliver to the community the benefits it is designed to achieve. Equally, the community wants to see action in response to, in particular, the Royal Commission’s recommendations. Balancing these trade-offs is our biggest challenge – inevitably, not everyone’s preferences can be met.
Notwithstanding these concerns, there does appear to be an underlying desire to improve remuneration practices in the financial system: few sought to argue that the status quo was optimal. Sadly though, there is no consensus on what improvement looks like. Finding the right balance will therefore not be easy. Let me quickly highlight a few of the key issues we are grappling with.
One area where we and many submissions are on common ground is the need for Boards to do a better job of exercising their discretion to adjust remuneration to ensure appropriate outcomes are achieved. Indeed, more Board discretion is often put forward as an alternative to some of the more prescriptive components of the draft standard. The key issue is how much it can be relied upon. It would certainly make the standard much simpler to design, but having failed to exercise much, if any, discretion for many years, the challenge is why there should be confidence this will deliver genuine improvements in the future? We want to see more discretion used, but other reinforcements would seem necessary to help this take effect.
The proposed cap of 50 per cent on the use of financial metrics has been highly contentious. Aside from the proposition that management should for the most part be incentivised by profitability and returns to shareholders, arguments against such an approach are that it:
- entrenches the use of a balanced scorecard approach, which not everyone supports;
- discourages consideration of other remuneration tools e.g. gateways, modifiers, pool allocation methodologies etc.; and introduces complexity around how these other tools would count towards a limit;
- places undue weight on non-financial metrics that may not be as reliable, verifiable or transparent as profit-based measures; and
- possibly undermines, by setting a hard limit, APRA’s broader goal of encouraging active use of Board discretion.
None of these are unreasonable concerns. But, for example, that some non-financial metrics are not perceived to be reliable is not a reason to avoid using non-financial performance measures altogether. It is accepted practice, for example, for the mining, industrial or aviation industries to use safety metrics within their remuneration frameworks – why should the finance sector not be able to produce something similar? It should not be beyond the wit of the industry to develop better measures that are suitably objective, transparent, reflect underlying performance and are subject to independent verification. Moreover, it should not be forgotten that some of the purportedly reliable financial metrics are themselves not free from management influence.
To recall the blunt assessment of the Royal Commission: ‘from the executive suite to the front line, staff were measured and rewarded with reference to profits and sales’, leading to ‘the pursuit of short term profit at the expense of basic standards of honesty’ . The cap is one way of helping to tackle this problem, but we remain open to others. Unfortunately, consultation did not generate as many alternative ideas as we might have hoped. The vast majority of submissions certainly commented on the cap, but some offered no alternative and most others proposed something that could be described as the status quo, with greater use of Board discretion. Unhelpfully, therefore, the most common response didn’t really address the Royal Commission’s recommendation.
We are not locked in to the specific 50 per cent proposal, and certainly recognise there are trade-offs involved, so will be looking at other options. These could include, for example, a higher limit, a narrower definition of ‘financial metrics’, or an alternative way to use non financial metrics. Whatever we do, however, the challenge is to find an alternative that gives sufficient comfort that a ‘profit alone’ approach will not re-emerge in another guise.
As for the expanded requirements on Boards and Remuneration Committees, the primary concern raised during consultation has been the extent of Board involvement in remuneration decisions. At its heart is a concern that Boards are being forced to undertake responsibilities that are more correctly the domain of management.
Here we will need to find a balance. History tells us Boards have been, at least until more recently, relatively hands off in exercising much discretion and judgement even in the case of the most senior executives. Our goal of having more engaged Boards exercising more discretion based on a holistic assessment of performance will require Boards to do more than they have traditionally done. But equally there is little value in asking Boards to do something they cannot properly do. We will be looking further at where to appropriately draw the line, and how to define a clearer and tighter set of Board responsibilities that allow Boards to exercise the discretion that we are expecting them to exercise, while at the same time not overloading them with responsibilities they cannot, as non-executives, fulfil.
The final issue I wanted to acknowledge was the extent of deferral obligations, and the desire for some more flexibility. This reflects two main concerns raised:
that the deferral obligations may be too long for some individuals, and not reflective of their accountability, ability to influence and contribution to the outcomes of the firm; and
whilst generally aligned to international better practice, the proposals don’t recognise that deferral requirements in other jurisdictions are typically shorter for non-banks than they are for banks.
Aligning risk and return is a key objective for us, so recognising that risks crystallise (or dissipate) differently in different types of businesses is certainly a legitimate issue to be concerned about. As submissions note, this applies as much within banking – the risk horizon of, for example, spot FX trading and a long-term project finance deals are very different – as it does between banking and other industries. But, notwithstanding international practice, the risk horizon is, on the whole, not necessarily longer in banking than it is elsewhere. Life insurance, annuities and superannuation, to name a few, are businesses with long risk horizons. Disability income insurance has, over the past five years, lost the industry $3 billion from business that, in many cases, was poorly designed and written many years earlier. Fees-for-no-service problems persisted for many years before being detected and rectified. So we will certainly look at international practice in thinking about how to address this issue, but it won’t be the sole determinant of how we ultimately set Australian requirements.
Remuneration is undoubtedly one of the most significant and far-reaching reforms on APRA’s agenda at present. Whether it be through excessive financial risk-taking or poor conduct, there is plenty of evidence that ill-designed incentive schemes can inflict material damage to both firms and their customers. The goal of achieving a better alignment of incentives with desired outcomes, a more holistic assessment of performance across a range of dimensions, and clearer accountability for (good and bad) performance should be uncontentious amongst all leaders of businesses.
From the issues I have outlined today, however, it should also be obvious that we have our work cut out for us in the months ahead. We need to work through all of the submissions and settle on a new framework for remuneration that will balance a wide variety of competing priorities and concerns. Inevitably, it will involve some difficult trade-offs.
It is too early to say much more about where we will end up. Given the fervent views that have already been expressed, about the only thing I can confidently predict today is that not everyone will be happy! But, of course, that is not our objective: rather, our goal is remuneration systems that provide appropriate incentives, improve accountability and support the effective management of financial and non-financial risks. Achieving that will undoubtedly be a win:win for all.
1 See ‘The Incentive to fly safely’, Regulatory address at the AFR Banking & Wealth Summit, April 2018.
2 Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (February 2019), Volume 1, p335.
3 The key recommendations of the Royal Commission with respect to APRA remuneration standards are recommendations 5.1, 5.2 and 5.3.
4 Retail Banking Remuneration Review (April 2017), conducted by Steven Sedgwick AO.
5 Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Finance Services Industry (September 2018), Volume 1, p xix