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‘Room for improvement’ in remuneration frameworks

‘Room for improvement’ in remuneration frameworks

The design and implementation of remuneration practices at large financial institutions leave “considerable room for improvement”, the prudential regulator has warned.

In its new information paper titled Remuneration practices at large financial institutions, APRA examined how the stated remuneration frameworks and policies were translating into outcomes for senior executives.

The review, which was primarily undertaken between July and December 2017, analysed the remuneration process and outcomes of approximately 280 senior roles (800 data points) from a sample of 12 regulated institutions across the authorised deposit-taking institutions (ADIs), insurance and superannuation sectors for the three years to the end of the 2016 financial year.

Overall, the review found that remuneration frameworks and practices across the sample “did not consistently and effectively meet APRA’s objective of sufficiently encouraging behaviour that supports risk management frameworks and institutions’ long-term financial soundness”.

Chairman Wayne Byres suggested that the incentives of the finance industry do not necessarily align to risk.

Speaking after the release of the report on Wednesday (4 April), Mr Byres said: “Financial regulation is designed to make financial institutions safer, just as aviation regulation is designed to make flying safer. But 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. 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.

“The business of flying might be risky, but pilots have strong personal incentives to minimise the risk. The same alignment of interests, and the natural incentive towards risk aversion, doesn’t exist in the business of finance.”

The APRA chairman went on to highlight that the regulator had been raising concerns “for some time” that the competitive drive for market share and profits in lending for housing had produced “incentives to lower credit standards” and that there was a general perception that, for senior executives of financial entities, the “carrots are large and the sticks are brittle”.

“Not only are rewards generous, but there are seemingly few repercussions for poor outcomes,” the chairman said.

Mr Byres added: “A key driver of risk culture [is] the formal and informal incentives that individuals face within their organisations, and the accountability (or lack thereof) shown when outcomes are not what they should be.”

For example, APRA’s review found that although all institutions had remuneration structures that satisfied the minimum requirements of APRA’s prudential standards, the frameworks and practices often “fell short of the sound practices set out in the relevant prudential guidance and were therefore some way from better practice”.

Specifically, the report identified the need for improvement in:

  • ensuring practices were adopted that were appropriate to the institution’s size, complexity and risk profile
  • the extent to which risk outcomes were assessed, and weighted, within performance scorecards
  • enforcement of accountability mechanisms in response to poor risk outcomes
  • evidence of the rationale for remuneration decisions

In response to the findings, APRA said that it will consider ways to strengthen its prudential framework.

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.

It suggested that changes could include (but would not be limited to):

  • improving the design of remuneration frameworks
  • enhancing implementation and outcomes
  • strengthening board remuneration committee oversight
  • enhancing reporting and disclosure

Mr Byres said that APRA encouraged all regulated institutions to review their remuneration frameworks and address any areas where APRA’s findings indicated room for improvement.

“Both the design and implementation of performance-based remuneration must support effective risk management and the long-term financial soundness of each institution. In this regard, there is considerable room for improvement,” Mr Byres said.

“APRA does not believe institutions should be satisfied with simply meeting the minimum requirements on remuneration.

“Well-targeted incentive schemes and firmly enforced accountability systems should be viewed not simply as a matter of regulatory compliance but as essential for sustained commercial success.”

He added: “Boards and senior executives should consider the findings of this review and take action to better align their remuneration arrangements with good risk management and the long-term soundness of their institutions.”

Remuneration and its effects on conduct and culture has been of increasing interest to the regulators recently, with ASIC looking at broker remuneration and conflicted remuneration last year, and with both the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and the Productivity Commission’s inquiry into competition in the Australian finance system scrutinising how remuneration influences behaviour.

[Related: ‘Excessive’ banker salaries under scrutiny]

‘Room for improvement’ in remuneration frameworks
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