Implementing APRA's prudential standards of executive remuneration

David Lewis, General Manager - Opening remarks to KPMG Executive Remuneration Forum for Non-Executive Directors, Sydney and Melbourne

Thank you for inviting me to be part of your forum today.

I’m sure that many of you will have come across Andrew Sorkin’s book, Too Big to Fail. Well, as is often the case with a best-selling book, Hollywood has made it into a movie. And I happened to see it on the in-flight movie channel on a recent overseas trip. It has an all-star cast including William Hurt as US Treasury Secretary Henry Paulson, James Woods who plays Lehman CEO Dick Fuld and Paul Giamatti who is perfectly cast as Ben Bernanke. The film gives a ‘fly-on-the-wall’ account of how the global financial crisis emerged and of how Henry Paulson attempted to deal with it.

In the film, there is a scene where Paulson is trying to explain to his media advisor, Michelle Davis, how the crisis came about. So, he explains CDOs; and how residential mortgages are packaged up into trusts which are funded by the issue of securities. (In essence, what we know as the ‘shadow banking’ market.) The securities sell because they are backed by residential mortgage assets which are seen as safe. But, as business grows, so does the thirst for more mortgages to go into the process. And, as a result, more and more lower quality assets are fed into the machine. In many cases, these loans fail to pass even the most rudimentary credit standards.

So, Davis asks: "But, surely the banks could see the risks. Why would they do that?" And Paulson replies: "They were making too much money."

The reason I tell that story is that, it illustrates quite neatly what can happen when remuneration practices fall out of line with a financial institution’s risk management objectives.

Even so, when APRA was developing its prudential standards on executive remuneration, we were often asked: "In a free market economy, why are regulators interested in financial sector remuneration?"

And the simple answer to that is: "We’re not." At least, we are not interested in remuneration in and of itself. What we are concerned about is risk management. So, when we see remuneration policies that encourage risky behaviour – yes – we get very interested.

And there is no doubt that the global financial crisis brought forth numerous examples – mainly from overseas - of remuneration practices that led to excessive risk-taking, often with fatal consequences for the firms concerned. We don’t want to see that dynamic developing here – which is why APRA has moved early to put in place prudential standards to address this issue. These standards are consistent in most respects with those set internationally by the Financial Stability Board.

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

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’ in the balance sheet which could undermine the future viability of the firm.

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? Is too much emphasis being placed on revenue growth today and insufficient regard being paid to the quality of assets being brought onto the firm’s balance sheet?

Looked at from this perspective, I’m sure this approach would not be out of line with that of any well-run board.

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.

In summary, our requirements can be divided into four core components:

1. Governance

Regulated financial institutions 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: (1) senior executives ("responsible persons"); (2) risk and financial control personnel; and (3) 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. 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 measure up 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. Not surprisingly, given Australia’s listing requirements, all our large financial institutions have in place well-established remuneration committees with clear and robust governance procedures. The only governance issue that comes up regularly is one of demarcation between the roles of the board and the CEO. 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 remuneration arrangements for senior executives.

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.

Better practice is to adopt a balanced scorecard approach incorporating a mix of individual performance metrics and qualitative assessment. Indeed, in some firms we supervise, the risk management division prepares reports for the remuneration committee on the risk management performance of individuals covered by the remuneration policy.

4. Risk Adjustment

Here, again, the results are mixed.

On the plus side of the ledger, 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.

I would be happy to take up any of these themes – or any other aspect of our guidelines – in the Panel discussion.