Executive remuneration as part of risk governance

David Lewis, General Manager - The Financial Institutions’ Remuneration Group Annual Conference, Terrigal

Thank you for inviting APRA to be part of your conference today.

In my talk today, I’d like to cover three things:

1. I’d like to take a moment to explain why regulators around the world are peering into your pay packets. There are a lot of misconceptions around this. So, I’d like to take the opportunity to explain the problem that we are trying to solve and to explain why APRA sees properly structured remuneration packages as a key component of an organisation’s risk governance.
2. How APRA’s prudential standards envisage this issue being addressed.
3. I’d like to do a stocktake on how current remuneration practices stack up against the standards and focus in on some of the main ‘sticking points’.

Earlier this year, I spoke at some forums for non-executive directors organised by KPMG on the topic of executive remuneration. The next day, the headline in the newspaper read:

‘APRA WANTS TO RAIN ON PAY-PACKET PARADE’

And, underneath, there’s some graphics showing the size of bank CEO annual pay packets and there are some photos in which they all look very pleased about it. Such a headline is very much the norm whenever this topic comes up.

It’s attention-grabbing. But, unfortunately, amongst this lavish display of multi-million dollar packages, APRA’s message can get lost.

Certainly, APRA is very much focussed on remuneration practices in regulated financial institutions. But we come at this from a different angle. For us, the issue is one of responsible governance. We don’t come to this with any value judgments about comparative wage justice. What we are concerned about is the promotion of sound risk management behaviours. For us, it’s the incentive arrangements that underpin remuneration packages that are of concern, not the amount of remuneration involved.

So, what is it about financial sector remuneration that causes prudential regulators concern?

In the financial sector, as in many other industries, performance-linked remuneration is the norm. And that’s fine. APRA has no problem with performance-linked remuneration. (Indeed, while APRA may be a public sector agency, we too employ performance-based pay structures.) Sometimes these arrangements can be quite complex and incorporate a range of quantitative and qualitative performance measures.

But, at their heart, these sort of incentive arrangements boil down to a simple proposition:

‘Sell a widget; get a dollar.’

Now, that’s pretty straightforward proposition if the ‘widget’ you’re selling is a car or a refrigerator, where the return is earned at point of sale.

But, what if the ‘widget’ you are selling is a financial product where the pay-off is not so immediate? And what if that ‘widget’ turns out to be defective?

Have you really sold a ‘widget’ at all?

After all, when a bank writes a loan, what it is getting is a future income stream. If that loan does not measure up to appropriate credit standards, then it will not pay-off for the bank and, if enough poor quality loans are written, this will expose the bank to loss.

Financial institutions are clearly at risk if their performance incentives reward underwriting without also ensuring that the payment of those incentives is aligned to the quality of the business being written.

That seems obvious. Well, it might be obvious, but that didn’t stop it happening in the lead up to the global financial crisis.

If you happen to have seen the movie Too Big To Fail, it contains a scene in which US Treasury Secretary, Henry Paulson, is discussing with his advisors how the crisis came about. He talks about CDOs; and how residential mortgages were packaged up into trusts which were funded by the issue of securities. And then how the issuers, advisors, and packagers each earned a percentage on the deal. All goes well in the rising market and business expands exponentially. But, as it expands, so does the demand for mortgages to feed the machine. And, so, more and lower quality mortgages are written. In many cases, these loans fail to pass even the most rudimentary credit standards.

The risks were obvious. How could they not see it? Paulson’s answer: ‘They were making too much money.’

And there is no doubt that the global financial crisis brought forth numerous examples of remuneration practices that spurred on excessive risk-taking, often with fatal consequences for the firms concerned.

Thankfully, most of these examples occurred overseas. In Australia, we didn’t have the explosion of sub-prime lending that occurred in the United States – all driven off the back of some very dysfunctional and highly-leveraged securitisation structures. In almost every case, these structures had a very poor alignment between the fees paid to originators - and to other service providers along the way - and their compliance with the bank’s specified risk management and underwriting standards. And, what’s worse, no one seemed to care.

But, we also shouldn’t sit idly on our hands a think: ‘that couldn’t happen here.’

Last month, on the ABC’s 7:30 Report there was an item about mis-selling by mortgage brokers. It contained the story about a single mother with three children earning just over $20,000 a year. Three years ago, she was renting and deeply in debt. She sought help from a financial advisor who was also a mortgage broker. According to the report, the broker obtained a housing loan for her by stating on the loan application that the borrower was a ‘self-employed professional earning $75,000 a year’. It should come as no surprise to anyone that this person is now struggling to meet her mortgage repayments.

No matter how you look at it, this loan was not a ‘widget’. The bank that made it now has a defaulting loan on its books (not to mention having to deal with the bad publicity). Yet, the broker who sold it received an incentive payment.

So, you can see how, if that sort of lending behaviour became the norm – as it did in the United States in the lead-up to the crisis – it has the potential to seriously threaten a bank’s viability. And all actively encouraged by poorly aligned incentive payments.

This is why APRA is interested in executive remuneration. It is not so much about the amounts being paid; it is all to do with prudent risk management.

Looked at from this perspective, most people see APRA’s prudential standards as being consistent with what any well-run board would want for its company. Indeed, when we talk to boards about business strategy, they typically talk in terms of ‘sustainable growth’; ‘sound business development’; or ‘value-adding business opportunities’. No one says that they are going to recklessly pursue growth at any cost: everyone wants to grow a performing asset book.

And that’s exactly what APRA is looking for as well. We just put a lot more emphasis on the ‘sustainable’ part.

Despite all the public angst about the size of bank executive pay packets, we’re ambivalent about that. What APRA looks at is not the ‘how much’ of executive pay, but the ‘why’. Our concern is to make sure that the remuneration practices adopted by regulated financial institutions are sound and do not imbed ‘risk time bombs’ on the balance sheet which could undermine the viability of the firm in the future.

What we look at are the performance hurdles that underpin these pay structures. Are these performance hurdles consistent with the prudent risk management of the firm? Or do the performance indicators used to reward executives promote short term profits at the expense of the firm’s long term sustainability?

For us, this is simply a matter of good governance. This is why we have chosen to implement our requirements on executive remuneration as part of our governance standards for regulated financial institutions. We think these are properly issues for the boards of financial institutions to adopt as part of exercising their responsibilities for ensuring the prudent risk management of the firm.

So, what are APRA’s prudential standards on remuneration all about?

In summary, these requirements consist of four core components:

1. Governance Processes

Each regulated financial institution should have in place a board remuneration committee, made up of non-executive directors - a majority of whom are also independent directors - and it should have in place a formal remuneration policy. The remuneration committee can take advice – either internally or externally – but the board retains the responsibility for setting the remuneration framework for the firm.

2. Coverage

The remuneration policy should specifically address remuneration and performance hurdles applicable to three classes of employee. First, there are the senior executives and directors (we term them ‘responsible persons’) who are responsible for setting the setting business direction and controlling major business functions. The second group are risk and financial control personnel. It is important that people in this category be free of potential conflicts of interest. While they need to be well-rewarded for the roles that they play, volume-based metrics are not for them! Thirdly, there are the material risk-takers (which could be individuals or groups of individuals) with substantial performance-based elements in their packages.

3. Performance Measures

Do the performance measures adopted align with the risk management objectives of the firm?

4. Risk Adjustment

Are performance-based elements of remuneration adjusted in line with risk outcomes?

Risk adjustments can be made ex ante or ex post – or both. Theoretically, if all risks could be identified with 20-20 foresight at the time of underwriting, then no ex post adjustment would be needed. But, this is hardly realistic. For this reason, prudent remuneration structures should always contain some element of deferred pay which is subject to reassessment in line with actual risk outcomes.

Also, in this vein, the remuneration policy should also include a force majeure type provision to allow bonuses to be adjusted for unintended or extreme circumstances which threaten the financial soundness of the firm.

This is simply a matter of ensuring that executives have ‘some skin in the game’ so that their incentives align with the long term health of the firm. And it says, if executives want to take a bigger slice of the pie in good times, they must also be prepared to take their share of the pain if things take a turn for the worse.

So, how do Australian financial institutions stack-up against these requirements?

Overall, Australian financial institutions do well – especially when compared with most their overseas counterparts. Of course, this is mainly because our institutions did not engage in many of the excesses that prevailed in offshore markets during the height of the boom. But that is not to say that there aren’t areas where our financial institutions can do better.

Going through each of the areas I highlighted earlier:

1. Governance

Overall, we can give a ‘tick’ here. Most Australian financial institutions have remuneration committees in place and these appear to be working well. Many seek independent advice from external sources which we think is good practice.

The only governance issue that comes up regularly is one of demarcation between the roles of the board and the CEO. Some CEOs seem to experience difficulty in ‘letting go’. While the CEO will rightly be a source of advice and input in senior executive remuneration, it is ultimately the board’s responsibility to determine the structure and outcomes of senior executive pay.

2. Coverage

In terms of coverage, all institutions appear to have had little difficulty in applying their remuneration policy to senior executives. Similarly, most firms have been able to adequately incorporate risk and financial control personnel within their remuneration policy frameworks.

However, in the area of material risk-takers, APRA is looking for more attention. Sometimes these types of remuneration arrangements can reach deep into the organisation. While we see evidence of boards reviewing, these types of arrangements, it often takes place after the fact, rather deliberating on performance outcomes in advance of award.

3. Performance Measures

Results here differ greatly from institution to institution. Our main area of concern is an excessive reliance on generic measures such as share price, market share or earnings per share. Metrics such as these are too high level to provide a reliable measure of individual performance and risk-taking.

We see merit in a balanced scorecard approach. We are sceptical of totally ‘mechanical’ or ‘formulaic’ approaches. But we are equally wary of purely subjective approaches. For us, a mix of individual performance metrics and qualitative assessment works best. Indeed, in some firms we supervise, the Risk Management Division prepares reports for the Remuneration Committee on the risk management performance of key individuals.

4. Risk Adjustment

Here, again, the results are mixed.

On the plus side, almost all regulated financial institutions incorporate an element of deferral in both their short-term incentive schemes (STI) and their long-term incentive schemes (LTI). Typical deferral periods range from 2 – 4 years for STI and 3 – 7 years for LTI.

However, what is less evident is a capacity and/ or willingness to withhold unvested entitlements based on a hindsight reassessment of actual performance. For many firms, it is apparent that deferral of benefits serves mainly as a device for staff retention, rather than as a genuine motivator for long term risk management. Often the only trigger to withhold payment of unvested benefits is a material instance of misconduct. We are looking for a more serious re-evaluation of risk outcomes.

We recognise that some of these ideas will be challenging to put into practice. But we think that the cultural message that they send is an important one. In this, APRA sees an important role for groups such as this one in helping to evolve solutions that are practical and suited to the needs of the financial sector.

With that thought, I would be happy to take up any questions you have on these themes.