Financial Stability Board Issues Principles for Sound Compensation Practices

by Karl Hindle - London, UK

The Financial Stability Board (FSB) issued a 6-page Principles document dealing with remuneration and immediately following the announcement of the G20 Final Communique, which outlined the French-led bonus regulation agreement.

The full Principles for Sound Compensation Practices is found here.

The FSB is a very new body and established:

...to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability.

It comprises senior representatives of national financial authorities (central banks, regulatory and supervisory authorities and ministries of finance), international financial institutions, standard setting bodies, and committees of central bank experts.

Notably, the FSB is supported by a small secretariat of the Bank of International Settlements in Basel, Switzerland and on that note, nothing has so far been heard out of the Basel committee on remuneration but as the preamble states:

The Basel Committee on Banking Supervision, the International Association of
Insurance Supervisors (IAIS) and the International Organization of Securities
Commissions (IOSCO) should undertake all necessary measures to support and address prompt implementation of these standards.

More notably, the FSB is the creation of the G20 and effectively the de facto, global regulatory mouthpiece of the world's leading economies.

Pay Structure and Alignment

The main points are:

1. The total variable compensation pool and bonus allocation must take into account the full and potential risk and especially costs of capital to support the risk;
2. Losses should result in a contraction of the bonus pool and trigger clawback of paid bonuses;
3. Senior executives and employees whose actions have a material impact on risk exposure should be paid an allocation based on individual, business unit and firm-wide performance with substantial bonus amounts (40% to 60%) paid under deferral arrangements over "years"with more senior staff taking higher amounts deferred than more junior colleagues;
4. Deferral periods should be not less than 3 years;
5. More than 50% of bonus payments should be in shares or share-linked instruments and not cash and the shares should be subject to a suitable share retention policy;
6. Where bail outs and government injections have been taken, the national regulator should have the ability to restructure a firm's compensation practice; and
7. Guaranteed bonuses are inconsistent with sound risk management and should only be offered to new hires and the guaranteed period last for no longer than one year.

Analysis

The FSB view on remuneration (or bonuses) is clear; "Compensation at significant financial institutions is one factor among many that contributed to the financial crisis that began in 2007."  In other words, bonuses are going to be dealt with and form one regulatory aspect of G20 domestic regulators' remits - for the UK, this is obviously the FSA.

While requiring "significant financial institutions" adopt and comply with the Principles as well as complementary guidance from Basel et al, the thrust seems to be that total variable compensation (i.e. bonuses) will not hamper the ability to restore the capital base and that national regulators, "should limit variable compensation as a percentage of total net revenues when it is inconsistent with the maintenance of a sound capital base."

The FSB clearly, and rightly, is concerned that excessive compensation will not interfere with capital adequacy requirements but as is to be expected from global statements and guidance, it is couched in broad terms - what constitutes a significant financial institution and at what levels of capital adequacy does a given level of compensation become "inconsistent" with a "sound capital base"?  None of these terms are defined and presumably will be left to national regulators to deal with.

Clearly, guaranteed bonuses except for new hires are on the way out but how well the principles will achieve better corporate governance is unclear.  There is no global agreement as yet, only a G20 listing with some adjunct "guests" so as with the concerns over the "Tobin Tax", will we see a flight to offshore banking and tax havens where these regulations will not need to be followed?  Last week, a Barclays team led by Stephen King and Michael Keeley quit, taking 45 staff with them and commenced working offshore, mirroring a high-profile team departure from Societe Generale in Paris for exactly the same reasons - escaping European bonus controls.  

While the odd team leaving a "significant financial institution" will happen, if there is a flight to offshore tax and banking centres by high-earners, what will be done about the concentration of banking and financial activity in these havens?  Of more concern, what will happen if one of these "concentrated" havens goes under in similar fashion to Iceland?  Who will bail that out?

What is clear is that the FSA and other G20 national regulators are going to be having fun and games reviewing their own practices in the light of the G20 and FSB pronouncements but it is vital that bonuses do not allow regulators and governments to take their eye of the economic football and the wider regulatory issues.