Following two rounds of consultation, the Australian Prudential Regulation Authority (APRA) has released its final remuneration prudential standard - CPS 511 Remuneration - together with a response to feedback received during consultation.
As previously indicated by the regulator, the final standard is very similar to the revised draft version (summarised here) with some relatively minor changes/clarifications.
The finalisation of CPS 511 addresses Hayne recommendations 5.1, 5.2 and 5.3.
A key GCRA milestone
Announcing the release of the final standard, Deputy Chair John Lonsdale described it as a 'key milestone in APRA's drive to transform industry practices in governance, risk culture, remuneration and accountability'.
Mr Lonsdale said,
'As the Royal Commission made clear, poorly designed or implemented remuneration practices can incentivise behaviour that is harmful to consumers, and detrimental to long-term financial soundness. CPS 511 will impose genuine financial consequences on senior banking, insurance and superannuation executives when their decisions lead to poor risk management or conduct that is contrary to community expectations. It ensures financial performance alone is no longer enough when companies reward employees; companies must also consider their impact on customers and risk management outcomes. Where executives fall short, they now stand at risk of losing their bonus'.
How does the final standard differ from the second consultation draft?
Though APRA states that submissions on the revised draft standard were generally supportive, the final standard includes three revisions to address certain industry concerns. These changes and the rationale behind them are briefly outlined below.
Threshold for determining Significant Financial Institutions (SFIs)
Under CPS 511, Significant Financial Institutions (SFIs) will be subject to stronger prudential requirements than smaller/less complex entities.
APRA's response paper observes that a number of submissions sought greater clarity around the process for determining SFIs. In particular, some submissions raised concerns that APRA's proposed approach to setting quantitative thresholds was inconsistent with existing requirements under the Banking Executive Accountability Regime (BEAR).
Though the regulator rejected calls for asset thresholds to allow for indexation and the use of rolling averages, APRA has adjusted its approach in the final CPS 511.
Under the final CPS511:
- For the purposes of determining ADI SFIs, APRA has increased the quantitative asset threshold to $20 billion (up from $15 billion). APRA has flagged that it will revisit the appropriateness of quantitative thresholds periodically, including when the standard is reviewed in 2027.
- APRA has also clarified that foreign ADI and insurer branches will not be SFIs, unless otherwise determined by APRA based on factors other than asset thresholds.
- For the purposes of determining superannuation SFIs, APRA has clarified that the $30 billion asset threshold applies to all RSEs of RSE licensees ie the $30 billion asset threshold will apply at the RSE licensee level and therefore to the aggregate asset value of all RSEs of an RSE licensee.
For clarify, under the final CPS 511 the final asset thresholds for each industry are:
- Authorised deposit-taking institutions > $20 billion
- General and life insurers > $10 billion
- Private health insurers > $3 billion
- RSE licensees > $30 billion
Remuneration arrangements of service providers
In its second round of consultation on draft CPS 511, APRA proposed that regulated entities be required to take steps to identify and address any inconsistencies arising from the remuneration arrangements of third party service providers and the objectives of their own remuneration framework.
APRA notes that a number of submissions sought greater clarity around this proposed new requirement, and in particular, what steps APRA expects entities to take to address inconsistencies, given that entities may have limited influence over how third parties remunerate their employees.
Some submissions also requested 'greater consideration of materiality', suggesting that APRA should take a more risk-based approach to this requirement.
In response to these concerns, the final CPS 511 clarifies that an APRA-regulated entities are expected to 'identify and mitigate material conflicts to the objectives of its remuneration framework that may result from third-party service provider compensation arrangements'.
The response paper gives a number of examples of the possible actions entities could take, depending on the conflict.
The response paper makes clear that:
- APRA does 'not expect changes to a third-party service contract or termination of an arrangement where a regulated entity has put effective mitigants in place'.
- Where third-parties are subject to legislation covering compensation structures or remuneration arrangements, 'CPS 511 does not require third-parties to make changes to these arrangements'.
APRA also plans to include additional examples of better practice in the final accompanying guidance, CPG 511 which is due to be released in October 2021.
Downward adjustments to variable remuneration
In its second round of consultation, APRA proposed specific requirements for the application of risk and conduct adjustments to variable remuneration, including in-period adjustments, malus and clawback.
Submissions requested further clarity on the difference between 'significant' and 'material incidents'. Some respondents also suggested that APRA’s focus should be on the overall adjustment to variable remuneration, rather than prescribing the specific tools that entities must use in particular circumstances.
In response to this feedback, final CPS 511 requires APRA-regulated entities to ensure that adjustments to variable remuneration are 'proportionate to the severity of the risk or conduct incident, but provides flexibility regarding the type of adjustment tool to be used'.
The draft guidance, CPG 511, provides better practice examples to assist entities in assessing severity.
Other issues raised in consultation
No change to minimum deferral periods in CPS 511
The response paper states that a number of submissions raised concerns around APRA's proposal to establish minimum deferral periods for variable remuneration that were longer than those implemented under the BEAR and/or under the proposed FAR.
Some insurers and RSE licensees also questioned whether they should be held to the same standards as banks.
However, the final CPS 511 maintains the proposed minimum deferral periods put forward in the consultation. The requirements will also continue to apply to SFIs across sectors.
APRA states that this 'risk-based approach reflects that failings in risk management at large and complex entities can have significant adverse consequences for the financial system. APRA has aligned its requirements for SFIs to international better practice'.
Alignment with the proposed FAR
Aside from the issue of minimum deferral periods outlined above, APRA intends that the requirements in CPS511 will align with the relevant requirements in the proposed FAR. In particular, APRA states that it is working closely with Treasury to ensure there are no inconsistencies in definitions and terminology across CPS 511 and the FAR.
APRA has also flagged that it may also make additional consequential amendments to CPS 511 or CPG 511 in due course, 'should this be considered necessary to achieve appropriate alignment with the FAR'.
No change in the approach to non-financial metrics
Despite industry feedback suggesting that measures such as Total Shareholder Return (TSR) or Return on Investment (ROE) already provide a balanced approach to incentives, and concerns that the use of non-financial measures in remuneration incentives remains immature and will therefor require a longer transition, APRA has not adjusted its proposed approach to the weight given to non-financial and financial metrics in the final CPS 511.
Accordingly, under the final CPS 511 SFIs be required to give 'material weight' to non-financial measures in the determination of each component of a person’s variable remuneration and also be required to have risk adjustment mechanisms that could reduce variable remuneration, potentially to zero, for adverse risk and conduct outcomes. To support entities in implementing the change, CPG 511 will include examples of better practice.
APRA explains that the aim of this requirement is encourage both the prudent management of risk and ensure that financial performance measures are not the sole or the primary driver of remuneration outcomes. Moreover, APRA observes that existing mechanisms have proven to be inadequate. The response paper states,
'experience has shown that TSR and ROE are not adequate measures to capture all financial and non-financial risks. In particular, these measures typically do not effectively promote accountability for sound risk management. While these metrics might be appropriate as part of a suite of measures to determine variable remuneration, on their own they are inadequate to deliver the objectives of a prudent remuneration framework'
Consistent with the proposed implementation timeline in the second round of consultation, industry will be required to comply with the new CPS 511 requirements from 1 January 2023, under a staged implementation approach.
- ADI SFIs will need to comply with CPS511 requirements from 1 January 2023
- Insurance and RSE licensee SFIs will need to comply with CPS 511 requirements from 1 July 2023
- Non-SFIs (across all APRA-regulated industries) will need to comply with CPS511 requirements from 1 January 2024.
Timeframe: Variable remuneration requirements
CPS 511 requirements will not apply to a person’s variable remuneration if the opportunity to earn the variable remuneration arose before the relevant commencement dates of the Prudential Standard. APRA states that:
'In practice, this would mean that an ADI SFI with a 30 June financial year-end must have incorporated CPS 511 requirements into variable remuneration arrangements from 1 July 2023. APRA generally expects that all variable remuneration arrangements would comply with CPS 511 requirements within the first 12 months of the implementation date'.
APRA suggests that 'it would be prudent for entities to begin transitioning to the new requirements as soon as possible, allowing time for learnings and refinement ahead of CPS 511 coming into force'.
- Pre-implementation review: APRA states that implementation of CPS 511 will be a key area of focus over the next 18 months. APRA expects entities to self-assess their readiness to meet CPS 511 requirements and develop plans to implement any changes in 'a timely manner'. APRA intends to undertake a 'detailed review' of the progress being made towards implementing the new requirements, including benchmarking against peers for a 'subset of entities'. APRA will begin engaging with entities that will be included in this review in late 2021. Thematic findings of this review will be published to support all entities with implementation of the new requirements.
- Repeal of existing remuneration requirements in CPS 510 and SPS 510: APRA’s Prudential Standards CPS 510 Governance (CPS 510) and SPS 510 Governance (SPS 510) include certain minimum requirements of APRA-regulated entities in managing their remuneration arrangements. APRA intends to repeal the remuneration components in both CPS 510 and SPS 510 to ensure there is no unnecessary duplication with the new CPS 511. Further detail will be provided to industry ahead of CPS 511 coming into force.
New disclosure requirements: APRA plans to consult on new disclosure requirements for remuneration early in 2022. The new requirements will require entities to publicly disclose the steps they have implemented to strengthen their remuneration arrangements in line with CPS 511. This increased transparency is intended to enable stakeholders to hold entities to account for 'prudently managing remuneration'.
- Post-implementation review in 2027: To ensure that the remuneration reforms are achieving their intended objectives, APRA will review CPS 511 in 2027, four years after its implementation. This post-implementation review will also provide an opportunity to update guidance on better practice, to reflect improvements that are made by industry over the period ahead.
[Sources: APRA media release 27/08/2021; Final CPS 511; Response paper]