The Australian Prudential Regulation Authority (APRA) is consulting on plans to strengthen prudential requirements for remuneration across all APRA-regulated entities in the banking, insurance and superannuation industries by issuing a proposed new prudential standard on remuneration (CPS 511).
The deadline for submissions is 23 October 2019.
A high level overview of APRA's proposed changes is below.
Proposed approach is based on consideration of better practice
APRA states that the proposed approach in draft CPS 511 is based on consideration of better practice both domestically and internationally, and is reflective of what APRA considers to be reasonable in the current industry environment.
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 Institutions and its summary of industry self-assessments of governance, accountability and culture.
In addition, standards and guidance produced by the Financial Stability Board (FSB) have also been incorporated to align APRA's requirements with evolving international practice.
Proposed changes
Draft prudential standard CPS 511 Remuneration introduces heightened requirements on entities’ remuneration and accountability arrangements in response to evidence that existing arrangements have been a factor driving poor consumer outcomes APRA states. The package of proposed measures is 'materially more prescriptive than APRA's existing remuneration requirements and will place Australia in line with better international remuneration practice'.
Application
The proposed new standard will apply to the remuneration arrangements of all employees in all APRA regulated entities
- APRA proposes to shift the remuneration requirements from the governance standards in CPS 510 and SPS 510 (CPS/SPS 510) into a stand-alone prudential standard covering all APRA regulated entities: ie authorised deposit taking institutions (ADIs), general insurers, life insurers, private health insurers and RSE licensees.
- APRA proposes that the standard will apply to the remuneration arrangements of all employees.
APRA seeks feedback on whether a separate standard for superannuation may be appropriate: With the proposed removal of remuneration requirements from SPS 510, APRA proposes that superannuation-specific issues of scope and terminology will be addressed within the new standard. APRA notes that there may be a need to adjust aspects of the proposed requirements for particular structures, such as fiduciary structures, primarily outsourced business models or entities with mutual ownership structures in order to avoid unintended consequences.
APRA invites comments on these issues and whether a separate remuneration standard for superannuation may be more appropriate.
Increased board oversight and engagement
Under the current standard, the board must approve the remuneration policy and has responsibility for reviewing and approving remuneration recommendations for senior executives and limited other staff.
APRA is proposing to strengthen board oversight with respect to accountability and oversight of remuneration across entities, by mandating:
- board responsibility for the overall remuneration framework
- board involvement in remuneration arrangements for persons in special role categories ie the new standard will require boards to approve the remuneration outcomes of all persons in special role categories on an individual and collective basis
- boards will be required to establish a clear link between remuneration arrangements and prudent risk management of the entity to ensure risk outcomes are reflected in remuneration outcomes for persons in special role categories
APRA considers that by requiring the board to approve key remuneration decisions, they will need to be more actively involved in dealing with misconduct or compliance issues when variable remuneration outcomes are being determined.
Practical difficulties for boards? The AFR suggests that the expansion of the board's oversight role may present practical difficulties. For example, it's suggested that investors may be sceptical of boards' ability to correctly assess the balance between rewarding the right cultural behaviour and driving shareholder returns, given the 'metronomic regularity' with which boards have paid bonuses in the past (despite the various issues identified over the course of the Financial Services Royal Commission for example). In addition, it's suggested that boards may also have misgivings about the scope of their expanded oversight role ie how they will deal with the practical difficulties of exercising discretion on pay across an entire organisation.
Proportionate approach
Additional new and more prescriptive requirements for larger and more complex entities (Significant Financial Institutions)
APRA considers it appropriate to be more prescriptive in certain areas for larger and more complex entities, where 'the payment of significant variable remuneration is more prevalent and where complex operations may lead to more opaque accountability'.
Accordingly, APRA is proposing a proportional implementation of the new requirements, with certain heightened expectations applied only to what APRA terms, Significant Financial Institutions (SFI), ie large, complex entities and to certain senior executives and other special roles. APRA proposes to define the group of large, complex entities for these purposes (SFIs) based on asset size: more than $15 billion in total assets for authorised deposit-taking institutions (ADIs); more than $10 billion in total assets for general and life insurers; and more than $30 billion in funds under management for registrable superannuation entities (RSE) licensees.
PHIs not included in the SFI categorisation: APRA is proposing not to include private health insurers (PHI) in the SFI categorisation at this time. APRA is in the process of modernising the PHI prudential framework more broadly, and will reassess the need to include PHIs as SFIs at a later date.
Remuneration Design
APRA is proposing to limit the use of financial performance measures, and promote a broader suite of measures of performance, including non-financial and risk-based measures.
APRA states that a key feature of its proposed new standard is to promote the use of non-financial performance criteria in designing variable remuneration incentives. In 'APRA's view financial targets have had too prominent a place in executive remuneration in some sectors of the financial industry' the regulator writes.
Accordingly, the proposed new standard proposes to: a) impose minimum design requirements for all employees (to promote prudent risk management and support remuneration objectives); b) cap the use of financial measures of performance at 50% and individually at 25% and c) impose constraints on deferral and vesting set for significant financial institutions (SFIs) (ie minimum deferral periods for variable remuneration of up to 7 years for senior executives, boards to have scope to recover remuneration for up to 4 years after it has vested).
Commenting on the changes, APRA Deputy Chair John Lonsdale said it was clear that existing remuneration arrangements in many entities were not incentivising the right behaviours 'Limiting the influence of financial performance metrics in determining variable remuneration will encourage executives to put greater focus on non-financial risks, such as culture and governance. As our recent response to the industry self-assessments made clear, this remains a weak spot in many financial institutions. Introducing the minimum holding periods for variable remuneration ensures executives have "skin in the game" for longer, and allows boards to adjust remuneration downwards if problems emerge over an extended horizon'.
In proposing the changes APRA makes clear it is not seeking to 'impose a cap on variable remuneration', or 'prescribe the proportion of variable and fixed remuneration'. Rather, it is proposing to introduce minimum standards with respect to the measures used to assess performance, as well as the time period over which variable remuneration must be deferred.
What is a financial metric? APRA proposes that financial measures that are not risk-adjusted and relate to financial performance, such as share price, total shareholder return, profit, revenue, sales and other volume measures are included in the 50% limit. However, financial measures that are risk adjusted and relate to financial soundness eg risk-adjusted capital adequacy, risk-adjusted cost of funding and RSE licensee investment return measures would not be included.
Non-financial metrics? Table 7 in the consultation paper (at p32) includes examples of non-financial metrics used in variable remuneration in large international banks over the past year. APRA's expectation is that entities select non-financial metrics most appropriate to their business. As such, APRA does not intend to identify which types of non-financial metrics are more appropriate/favourable.
Proposed new requirements and the BEAR: APRA says that it considered the operation of the Banking Executive Accountability Regime (BEAR) provisions in developing the proposals relating to deferral of variable remuneration. APRA Deputy Chair John Lonsdale said that the draft standard is intended to 'complement' the BEAR.
APRA recognises that requirements proposed in draft Prudential Standard CPS 511 Remuneration (draft CPS 511) could apply to ADIs only to the extent they are not inconsistent with the BEAR and welcomes any feedback on the application of the proposed draft CPS 511 in the context of the existing BEAR requirements and potential future extension of BEAR (to the insurance and superannuation sectors).
Consequence management
Presently, APRA requires that remuneration policies allow the board to adjust variable remuneration downwards to zero if appropriate for employees in special categories.
APRA is proposing to strengthen this requirement by:
- introducing new specific requirements for the application and oversight of adjustments to variable remuneration outcomes. Under draft CPS 511, entities will be required to: a) ensure that adjustments to variable remuneration to reflect performance and risk outcomes are being made; and b) set minimum criteria for adjusting any deferred variable remuneration through application of malus, including in response to risk management failures, misconduct or significant adverse outcomes for beneficiaries, among other things.
- requiring clawback to apply to senior roles in SFIs. The aim is to strengthen the entity's ability to adjust remuneration outcomes to reflect performance outcomes, both pre and post-vesting. APRA is proposing that clawback provisions be determined in advance for variable remuneration (short term incentives (STIs) and long term incentives (LTIs)). More particularly, APRA proposes that SFIs must allow for variable remuneration to be recoverable for at least two years after the end of the deferral period, and a further two years where an individual’s circumstances are under investigation.
APRA's intention in proposing the change is to ensure that remuneration 'pay-outs remain sensitive to risk outcomes into the future, once the impact of the current events [for example: the Financial Services Royal Commission] dissipates'.
APRA suggests that alignment of remuneration and risk outcomes may require 'significant investment in capability and cultural change' as well as review of employment contracts to ensure clawback provisions can be enacted.
Practical difficulties with the use of clawback: APRA acknowledges that use of clawback may present practical difficulties. However, in APRA's view, the fact that clawback 'may be an imperfect tool to effect ex post remuneration adjustments in all circumstances is not a sufficient argument to omit this tool from senior executive remuneration arrangements'. APRA goes on to suggest that, 'longer deferral periods could potentially be used as a substitute where clawback is seen as impractical'. APRA seeks feedback on the possibility of including prudential requirements that support entities extending deferral periods as a substitute for the use of clawback.
Regular Reviews of the remuneration framework
Similar to requirements for risk management framework reviews under CPS 220, entities would be required to conduct a triennial effectiveness review, with a prescribed scope.
APRA proposes that the reviews would be undertaken by 'operationally independent, appropriately experienced and competent persons', and cover a number of specified components in their scope. The Board Remuneration Committee would then be required to take action to ensure review findings were adequately addressed and implemented in a timely manner.
Transparency
APRA observes that presently there are no requirements (other than for ADIs) under the current standard.
APRA plans to propose additional requirements for reporting and public disclosure of executive remuneration and invites feedback on whether it should impose additional disclosure requirements on all regulated entities. This could include, APRA suggests, requirements for: publication of each entity's remuneration policy and publication of the specific performance metrics used to set variable remuneration for senior executives and their current and historical values.
APRA plans to consult on such requirements, as well as prudential guidance that would support implementation of the proposed CPS 511, following consultation on draft CPS 511.
Timeline and next steps
Following the consultation, APRA intends to publish a Response to Submissions and final prudential standard in late 2019 or early 2020.
- APRA expects that the new CPS 511 will come into effect on 1 July 2021 but will determine the effective date based on feedback regarding aspects of the implementation.
- APRA also intends to consult on an updated prudential practice guide in 2020, to support implementation of the new prudential standard, as well as reporting standards and disclosure requirements.
- APRA states that given the significance of the proposals and potential industry impact, it plans to conduct a review of the effectiveness of the prudential standard three years from its initial effective date.
