In a speech to the Women in Banking and Finance Series Luncheon, Australian Prudential Regulation Authority (APRA) Chair Wayne Byres provided an update on the status of the consultation on proposed remuneration changes. Mr Byres spoke on the topic of remuneration, APRA's rationale for the proposed changes to remuneration and the response to consultation.
[Note: APRA released a discussion paper and new draft Prudential Standard (CPS 511) proposing stronger and more prescriptive prudential requirements for remuneration across all APRA-regulated entities in the banking, insurance and superannuation sectors in July. The deadline for submissions was the 23 October. The proposed new standard aims to address the remuneration-related recommendations made by the Financial Services Royal Commission (Recommendations 5.1, 5.2 and 5.3) as well as insights gained from the Prudential Inquiry into the Commonwealth Bank of Australia (CBA), APRA’s Review of Remuneration Practices at Large Financial Institutionsand its summary of industry self-assessments of governance, accountability and culture. For a summary of APRA's proposals see: Governance News 24/07/2019]
The case for change
Though some progress has been made, APRA considers that more work is needed
Mr Byres said that ultimately, the interests of financial firms and others (their customers, investors) are not always in alignment and that in this context, relying on self-interest to deliver a financial sound financial system, producing fair outcomes for consumers won't work.
The weaknesses in the current system are reflected, he said in both the findings of APRA's 2017 review of remuneration frameworks and outcomes and were also highlighted by the Financial Services Royal Commission in recommendations 5.1,5.2 and 5.3.
'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' he said.
Having said this, Mr Byres said that 'pleasingly' some firms have accepted the need for change and have taken some steps in this direction, but that APRA considers 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'.
APRA's proposed changes
Mr Byres summarised the 'core' aspects of APRA's proposed, more prescriptive changes as follows:
- a shift away from 'formulaic approaches' to determining remuneration outcomes in aggregate and for individuals, to an expectation of active board involvement and the application of judgement to better align rewards with outcomes.
- a suggested 50% cap on the use of financial metrics when determining remuneration outcomes, in order to promote a more holistic assessment of performance through elevating the importance of non-financial risks (including conduct) in the assessment of variable remuneration outcomes.
- 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.
Mr Byres said that the proposed framework is 'undoubtedly more prescriptive than has traditionally been the case, reflecting the need to drive change' but noted that it retains a measure of flexibility. For example, APRA has not sought to: 1) cap the amount of variable remuneration; or 2) prescribe specific remuneration structures or forms; or 3) which performance metrics should be used.
Industry response to the proposed changes
'Strange and disappointing'
Mr Byres said that APRA's 'proposals have undoubtedly caused a fair amount of angst, as they would require significant change to established practice'.
He said that many large investors and proxy advisors had raised concerns about the proposed changes, largely, he suggested 'because they have been very influential in designing current practices to suit their particular interests'. Some boards, he said had been advised that if they change their arrangements to comply with APRA's proposed requirements, 'they will be met with protest votes at AGMs'. Mr Byres described this as a 'strange and disappointing response to a Board that would be seeking to comply with the law'.
Mr Byres said that there is also concern 'on a number of fronts' that APRA’s proposals will not achieve the regulator's 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)'.
Mr Byres said that APRA is considering these issues 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'.
There is an 'underlying desire to improve remuneration practices' – but no consensus on what improvement looks like
Mr Byres went on to say that 'notwithstanding these concerns, there does appear to be an underlying desire to improve remuneration practices in the financial system' with few arguing that the status quo should be maintained, but that there is 'no consensus on what improvement looks like'.
Can boards be trusted to exercise more discretion?
Mr Byres said that one area where APRA and 'many submissions' are in agreement, is the need for boards to exercise more discretion to adjust remuneration to ensure appropriate outcomes are achieved. He added, that 'board discretion is often put forward as an alternative to some of the more prescriptive components of the draft standard'.
Mr Byres said that a key issue for APRA to consider 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 50% cap on financial metrics: response from industry
Mr Byres said that the proposed cap of 50% on the use of financial metrics was highly contentious. Arguments against the approach included that it: a) entrenches the use of a balanced scorecard approach (which is not universally supported); b) discourages consideration of other remuneration tools eg gateways, modifiers, pool allocation methodologies (among others); c) introduces complexity around how these other tools would count towards a limit; d) places undue weight on non-financial metrics that may not be as reliable, verifiable or transparent as profit-based measures; and e) potentially undermines, by setting a hard limit, APRA’s broader goal of encouraging active use of board discretion.
Mr Byres went on to say that 'none of these are unreasonable concerns' but argued that, some concerns could be overcome. For example, he argued that the fact that some non-financial metrics are not perceived to be reliable as financial metrics is not a reason to avoid using them all together. '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' he said.
Mr Byres further observed that few submissions suggested an alternative means to address the Commission's concerns, beyond the exercise of increased board discretion.
APRA is 'not locked in to the specific 50% proposal'
Mr Byres said that APRA is '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'
He said that these options could include 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' he said.
Expanded requirements on boards and remuneration committees: APRA will need to find a balance
Commenting on proposed expanded requirements on boards and remuneration committees, Mr Byres said that the primary concern raised during consultation was 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' Mr Byres said.
Responding to this, Mr Byres said that APRA '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' he said.
Proposed deferral obligations
Finally, Mr Byres spoke about proposed deferral obligations, and calls for APRA to allow more flexibility. He said that concerns had been raised that the proposed 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 though 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.
Mr Byres responded to this by saying that aligning risk and return is a key objective for the regulator and 'recognising that risks crystallise (or dissipate) differently in different types of businesses is certainly a legitimate issue to be concerned about'.
He added that APRA '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'.
Still working through submissions
Mr Byres said that APRA is still working through all of the submissions and settling on a new framework for remuneration.
'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'.
