10 April 2011

Regulators Encouraging Complexity in Remuneration Policies and Practices

Recently I happened to read the Remuneration Reports and Compensation sections in the Annual Reports of a few European banks. First I thought: “Why, the hell, are the compensation schemes that complex? Is it really worth it?” Then I took a look to the regulatory framework set out in CRD III and Guidelines on Remuneration Policies and Practices by CEBS. As the new CEBS guidelines are very detailed, present an attempt to summarise the previous and current practices of market participants, and add strong focus to the risk alignment, they seem to rather encourage complexity across the institutions than promote simplicity and transparency. In my opinion, regulators have gone too far with micro-measures on remuneration instead of trying to solve the more fundamental issues like too-big-to-fail / too-big-to-save and creating debt without creating money. But read the following summary of the above-referred CEBS guidelines and decide on your own.

Clearly, the regulatory focus is on prudent risk taking, capital and liquidity planning. A distinction has been made between the two groups of staff:
* Identified Staff, i.e. those whose professional activities have a material impact on the institution’s risk profile, and
* All others

General requirements

General requirements that should apply to institutions and their staff as a whole include requirements like:
* Consistence with sound and effective risk management
* Remuneration policy being in line with the business strategy, objectives, values and long-term interests of a given credit institution
* Presence of measures to avoid conflicts of interest
* Periodical reviews of the remuneration policy and its implementation
* The need for and roles of a remuneration committee in significant institutions
* The total variable remuneration not limiting the ability of the credit institution to strengthen its capital base
* Guaranteed variable remuneration being exceptional and allowed to occur only when hiring new staff (limited to the first year of employment)
* Rules for remuneration in case of government intervention
* Staff members not being allowed to use personal hedging strategies or remuneration- and liability-related insurance to undermine the risk alignment effects embedded in their remuneration arrangements
* Variable remuneration not allowed to be paid through vehicles or methods that facilitate the avoidance of the regulative requirements

Specific requirements

More detailed specific requirements are given regarding remuneration of the Identified Staff. Of course, voluntary institution-wide application is always possible and in certain cases strongly recommended.

The total compensation consists of fixed remuneration and variable remuneration. An institution should set in its remuneration policy explicit maximum ratio(s) on the variable component in relation to the fixed component of remuneration. By that, the fixed component must represent a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component. Variable remuneration shall include a component that is deferred (the minimum proportion of 40 to 60% of variable remuneration for which the minimum deferral period shall be three to five years) and may include a component that is not deferred. In terms of instruments, at least 50% of any variable remuneration shall consist of equity-lined instruments and the rest may be in cash.

Variable remuneration should be performance-based and risk adjusted (combined assessment of the individual results, business unit results and the overall results of the institution). For achieving this, three processes have been identified:
1. Performance and risk measurement process. A staff member’s performance during the accrual period (the period during which the performance of the staff member is assessed and measured for the purpose of determining its remuneration) is to be measured against the defined institution’s objectives and aligned with the risk appetite of the institution. Risk alignment can be achieved by using risk adjusted performance criteria or by adjusting performance measures for risk afterwards.
2. The award process, i.e. translating performance assessment into the variable remuneration of each staff member. This should include the so-called “ex-ante risk adjustment” for potential adverse developments in the future.
3. The payout process. As mentioned above, variable remuneration is partly paid out upfront (short-term) and partly deferred (long-term). The short-term component is paid directly after the award and rewards staff for performance delivered in the accrual period; at the same time there is still a retention period of let’s say 6-12 months during which the staff member cannot sell its shares. The long-term component is awarded to staff during and after the deferral period (i.e. the period during which variable remuneration is withheld following the end of the accrual period) which is three to five years; the deferred remuneration pay-out can be a once-only event at the end of the deferral period or may be spread out over several payments in the course of the deferral period, according to a pro-rata vesting scheme; again there is an additional retention period for the instruments received.

The process during which the staff member becomes the legal owner of the remuneration is called “vesting”. Before vesting, i.e. during the deferral period, he/she is not the legal owner of the instruments he/she has been awarded. The institution can prevent vesting all or part of the amount of a deferred remuneration award if it turns out during the deferral period that that ex-ante risk adjustment wasn’t correct (referred to as “malus” or “malus arrangement”, a form of ex-post risk adjustment). After vesting under clawback clause (a contractual agreement) the staff member may still be required to return ownership of an amount of remuneration to the institution in certain circumstances (when related to risk outcomes, clawback is another form of ex-post risk adjustment). Clawback can be applied to both upfront and deferred variable remuneration.

An institution should be able to make both ex-ante and ex-post risk adjustments into the amount of remuneration, i.e. take risks into account when originally assessing the (risk adjusted) performance and the size of variable remuneration, and adjust the variable component later if it turns out that the initial ex-ante risk assessment has been imprecise. Under no circumstances (incl. even when the outcome turns out to be better than expected) should the ex-post risk adjustment lead to an increase of the deferred part of compensation.

Further requirements

An institution needs to consider the risks associated with its remuneration system with regard to the possible impact to its capital base, as well as take remuneration into account for liquidity planning purposes. This includes back testing and playing through a number of possible scenarios to test how the remuneration system will react to future external and internal events.

In order to ensure adequate transparency to the market of their remuneration structures and associated risk, institutions should disclose detailed information on their remuneration policies, practices and aggregated amounts for those members of staff whose professional activities have a material impact on the risk profile of the credit institution or investment firm.

I think that the major issues in the described regulatory framework include  following (but are not limited to):
* Connecting variable remuneration with the internal risk assessments (further) stimulates the institutions to underestimate through-the-cycle or long term risks internally. This is the case even if the risk control function is claimed to be independent from the business. Despite of the use of statistical data, the estimated level of risk still very much depends on expert judgement, and clearly there is pressure from management and the other Identified Staff to judge towards lower end of risk scale (already because the ex-post risk adjustment cannot lead to an increase of the deferred part of compensation).
* Complexity for the employees to assess the employer’s value proposition as well as uncertainty about the future actual earnings; this is bound to lead to higher total compensation and increased costs for the institution at the end (higher risk for the employees -> higher expected return)
* Increased uncertainty regarding the institution’s future payments for the work already done
* More just formal decisions by the members of supervisory board and by shareholders (i.e. deciding what is proposed without having a real possibility to make changes) as it becomes increasingly difficult to discuss the details of remuneration policies and practices (e.g. to evaluate the effects of the use of risk-based metrics)
* A lot more bureaucracy and non-productive work for the institutions (essentially centralising remuneration policies and practices, a lot more every kind of analyses etc.) and for the regulators (one more rather time-consuming “ticking box” exercise in the area where we actually need a well functioning market)

Once again, the introduced regulations and guidelines on remuneration policies and practices are micro-measures, and indicate that the regulators are not able and/or willing to deal with the real problems in the design of financial system.

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