The report identified four areas for improvement in the design and implementation of executive remuneration in financial institutions.
APRA indicated it plans to strengthen prudential frameworks in response to the report findings.
Key Points of the APRA Review: APRA Information Paper — Remuneration practices at Large Financial Institutions April 2018
Purpose of the review: The review examined whether policies and practices in APRA-regulated financial institutions were meeting the objectives of APRA’s prudential framework ie 'that remuneration frameworks operate to encourage behaviour that supports risk management frameworks and institutions’ long-term financial soundness'.
Scope of the review: APRA states that the conclusions in the information paper are based on detailed analysis of executive remuneration practices and outcomes from a sample of 12 regulated institutions across the banking (authorised deposit-taking institutions (ADIs))), insurance and superannuation sectors. APRA comments that the sample of institutions reviewed collectively accounts for a material proportion of the total assets of the Australian financial system.
Areas for improvement: The paper identified four improvement areas:
Next steps for the regulator – strengthening of the prudential framework: APRA writes that in response to the findings, it will consider ways to strengthen its prudential framework and that any revisions will be subject to stakeholder consultation and engagement, as per APRA's usual practice. APRA adds that a future review of the relevant prudential standards and guidance will take account of the forthcoming Banking Executive Accountability Regime (BEAR), as well as international best practice.
APRA Chair Wayne Byers' comments on the report
In his address, titled, 'The Incentive to fly safely' to the AFR Banking and Wealth Summit, APRA Chair Wayne Byers commented on the report findings (outlined above) and encouraged the sector to take steps to take proactive steps to address the issues identified 'rather than waiting to be told what to do'.
His comments included the following points.
'The incentive to fly safely'? 'Flying, like finance, is a fundamentally risky business' Mr Byers said. Throughout his address, he likened finance to aviation, comparing the challenges of finance with those of flying to illustrate his points, including the possible consequences of failure.
Commenting on the misalignment of incentives in some financial institutions he said: 'Pilots have no incentive to take off in an unsound plane. Pilots have no incentive to perform manoeuvres that stress the plane beyond its limits in pursuit of short-term thrills. Pilots, like everyone else on board, have no incentive to do anything other than land safely.' He added: 'I envy aviation regulators for one advantage they have over financial regulators: that the desire passengers of planes have for a safe flight is highly aligned with those flying the plane'.
Commenting on the issue of accountability he said: 'it’s too easy for financial pilots, unlike those who actually take to the sky, to walk away from the scene of an accident unscathed. That can do nothing other than jeopardise the establishment and maintenance of a sound risk culture'.
Results of the review showed a gap between theory and practice: Commenting broadly on the review findings, Mr Byers said: 'The headline message is that the institutions we reviewed by and large had the required frameworks, policies and processes that could provide the basis for a sound system of remuneration. But in many cases their practical application left something to be desired. In other words, they were present in form, but less so in substance'.
Misalignment of incentives: Referencing as an example, the incentive scheme at Wells Fargo, Mr Byers said that poorly designed incentive schemes could incentive bad behaviour and 'encourage actions or attitudes that are contrary to the long-run interests of the company itself'. In the Australian context, Mr Byers commented that consistent with the findings of the Sedgwick Review, 'it’s no surprise that areas where the financial sector has been dogged by scandal have been areas where the most basic form of incentive – sales or revenue-based rewards – are prevalent: financial advice, broking, mortgage lending, insurance sales, financial markets trading'. He added that evidence presented during the Round One hearings of the Financial Services royal commission 'only underlined' the point.
Incentives in the context of mortgage lending was highlighted as a specific area of concern for APRA: Mr Byers said that APRA has been concerned 'for some time' that the 'competitive drive for market share and profits in lending for housing has produced incentives to lower credit standards. Coupled with some borrowers’ own incentive to ‘do whatever it takes’ to get a loan, and the excessive comfort that comes from a period of rapidly rising house prices, there has been inadequate incentive hard-wired into the system to seriously scrutinise applicants’ ability to repay the loans they take out. This obviously has the potential to create adverse outcomes for customers, but also in extremis for the areas of APRA’s interest: the safety of the depositors whose money is being lent out, and financial system stability more broadly'.
'The carrots are large and the sticks are brittle' at senior executive level: Commenting on the perceived lack of accountability at senior executive level, Mr Byers stated: 'the perception in the community is that in the financial sector, particularly at senior executive level, the carrots are large and the sticks are brittle. Not only are rewards generous, but there are seemingly few repercussions for poor outcomes'. There were few examples found by the review, he noted of senior executives facing repercussions for poor outcomes though lower-level employees, more frequently faced 'downward adjustments in variable remuneration' where there were poor outcomes. He commented that senior executives appeared 'somewhat insulated from the consequences of poor risk outcomes'.
Lack of accountability at senior executive level could undermine the 'tone from the top': Mr Byers linked lack of accountability to poor risk culture more generally stating that lack of repercussions for poor outcomes, especially in circumstances where short term targets are met, could only serve to 'weaken the risk culture within financial institutions'. He added that 'Fine words and aspirations about the importance of risk and compliance – the tone from the top – will be undermined if it seems that senior leaders are operating in accordance with a different set of rules'.
Lack of accountability could also undermine the financial stability of the institution: Mr Byers stated that these issues are of concern to APRA on the basis that if there appear to be no 'consequences at senior levels for poor risk outcomes, it undermines sound risk management and the long term financial health of the institution'. Mr Byers went on to reference the failure of HIH Insurance as an example of the consequences of failure: 'Justice Owen, in his report on the failure of HIH Insurance a decade and a half ago, lamented that individuals in that organisation, faced with considerable pressure to sustain profitability, all too often asked ‘is this legal?’ rather than ‘is this right?’. The results of misaligned incentives and a lack of accountability for long-term outcomes, we now know, were disastrous' he commented.
Risk committees need to play a 'stronger role': Mr Byers said that action needs to be taken on the areas of improvement identified in the report and added that 'Board Risk Committees will need to play a stronger role in overseeing executive remuneration outcomes, and not be afraid to firmly exercise their discretion when events warrant it, regardless of the mechanical application of a scorecard'.
APRA plans to strengthen prudential requirements: To date, Mr Byers said, APRA had adopted a principles-based approach to its remuneration requirements. He added that this approach remains APRA's 'preferred modus operandi'. However, he said in light of the report findings, the regulator 'plans to look at strengthening the prudential framework'.
APRA is 'keen' for industry to address the issue themselves, rather than waiting for direction: Mr Byers said that it would be 'disappointing if these issues are just viewed as another exercise in regulatory compliance, or something that gets in the way of good business. Rather, when done well, appropriately structured incentives and accountability mechanisms are a critical component of sustained commercial success'. He added that 'we are keen for industry participants to take up the challenge of improving themselves, as some are already doing, rather than waiting to be told what to do. Particularly in the current environment, I hope they see a strong incentive to do so'.
[Sources: Regulatory address at the AFR Banking & Wealth Summit 2018, Sydney: The Incentive to fly safely, APRA Chair Wayne Byres 04/04/2018; APRA media release 04/04/2018; Information Paper: Remuneration practices at Large Financial Institutions April 2018; [registration required] The AFR 03/04/2018; 04/04/2018]
ASIC Chair, James Shipton endorsed APRA Chair Mr Byers' comments: In his speech to the same audience, ASIC Chair James Shipton expressed support for the views put forward by Mr Sims: 'I wanted to endorse the comments made by the Australian Prudential Regulation Authority (APRA) Chairman, Wayne Byres. For those of you who missed his remarks, I commend his speech to you – particularly the important conclusions coming from APRA’s recent review of remuneration practices.'
The key theme of Mr Shipton's address was the need for the sector to take action to address the 'trust deficit': 'we have been talking about the trust deficit in finance for far too long. It is time to move beyond the rhetoric to real solutions' he said.
Mr Shipton's address appeared to largely reiterate points put forward previously in his address to the ASIC Annual Forum in March (see: Governance News 23/03/2018) namely:
the need for the financial sector to raise standards of professionalism and for industry to take the lead on this (or face tougher regulation);
the important role the sector plays in the lives of Australians; and
the need for industry to recognise that it is 'dealing with other people's money'.
[Source: Regulatory address by James Shipton, Chair, Australian Securities and Investments Commission AFR Banking and Wealth Summit 2018 05/04/2018]