Putting pay to misconduct

What you need to know

• The Final Report contains recommendations concerning the remuneration of executive and frontline employees.
• APRA will update its prudential standards. They will limit the use of financial metrics in calculating long-term variable remuneration and require regulated entities to make provision for the claw-back of vested remuneration in appropriate circumstances.
• The Commission also calls on APRA to take a more energetic role in supervising the implementation of remuneration frameworks by regulated entities.
• Banks are asked to implement fully the recommendations of the Sedgwick review "both letter and in spirit".

What you need to do

• Regulated entities should prepare for changes in how their remuneration frameworks are designed and supervised. Consider what changes may be required to existing remuneration policies, employment contracts and conditions of grant to accommodate the recommendations.
• Expect APRA to enhance its monitoring activities and make more and greater information requests about how remuneration frameworks are applied in practice.
• Continue implementing the Sedgwick reforms, and be careful to ensure that non-financial metrics used in balanced scorecards are not ultimately driven by sales. 

On Monday 4 February 2019 the Government released Commissioner Kenneth Hayne’s Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Final Report).

The Final Report contains a number of recommendations concerning the remuneration of executive and frontline employees. APRA is urged to redouble its efforts in regulating and supervising executive pay arrangements. Regulatory intervention is not proposed for frontline remuneration but entities are asked to sustain their focus on review and reform in this space.

This article reflects on what these recommendations mean for banks and other regulated entities, and how they can prepare going forward.

Revised prudential standards

APRA expects to issue revised prudential standards and guidance on remuneration for consultation this year. The Final Report contains certain recommendations on the content of the revised standards, designed to ensure a focus on the management of misconduct, compliance and other non-financial risks.

One recommendation is that the revised standards require boards (through their remuneration committee or otherwise) to make regular assessments of the effectiveness of the remuneration system in encouraging sound management of non-financial risks, and reducing the risk of misconduct. This recommendation is intended to build on the existing requirement under CPS 510 for a remuneration committee to assess the effectiveness of an entity’s remuneration policy.

Similarly, the Final Report recommends that the revised standards require regulated entities to design their remuneration systems to encourage sound management of non-financial risks, and to reduce the risk of misconduct.

Two particular recommendations warrant careful attention — that APRA should set a limit on the use of financial metrics in connection with long-term variable remuneration; and requiring entities to make provision for claw-back of vested remuneration, in appropriate circumstances.

For many entities, these two recommendations represent a significant departure from existing practice. They will likely require a re-evaluation of their approaches to rewarding its most senior executives, and the way they look to hold those senior executives accountable. What should regulated entities do to prepare?

• Reflect on the changes required to existing remuneration policies, employment contracts and conditions of grant to accommodate these recommendations.
• Consider the current design of long-term variable remuneration, and the type of non-financial metrics that can be used.
• Consider the circumstances in which claw-back of vested remuneration could occur in light of practical, and possibly legal, impediments.

A more energetic APRA

The Final Report calls for a bolder, more energetic APRA. In particular, APRA is encouraged to develop expertise and confidence to enhance its supervisory activities and challenge regulated entities on the implementation of their remuneration frameworks to reduce the risk of misconduct. What are the consequences for APRA-regulated entities?

• Regulated entities should prepare for more and greater information requests about how their remuneration frameworks are applied in practice.
  APRA’s review of remuneration practices at large financial institutions in 2017 indicates what such information-gathering exercises could look like. That review sought extensive and detailed information on remuneration practices from 12 regulated entities, including board committee papers and minutes,performance assessments, and remuneration outcomes for executives. APRA is likely to cast its net even wider in the future, collecting more information from a greater range of entities. Its approach will likely be informed by the Financial Stability Board’s recommendations of late last year concerning how supervisors report on the use of compensation tools to address misconduct.
• Regulated entities should expect APRA to take a greater role monitoring and enforcing the way remuneration frameworks are implemented. APRA will seek to test whether remuneration frameworks are working as intended and whether boards and remuneration committees are being provided with adequate information to make decisions on remuneration outcomes. APRA is set to publish a new enforcement strategy later this year that will signal what such enforcement action will look like.

Sedgwick reforms

As to remuneration on the front line, one of the Final Report’s recommendations is that banks implement fully the recommendations of the Sedgwick Review. It came as a surprise to some commentators that Commissioner Hayne did not take this recommendation further given he had, in the Interim Report, commented that despite the Sedgwick recommendations, banks continued to remunerate employees in ways that emphasise sales. Moreover, the 21 Sedgwick recommendations had already been widely embraced by the banking community and, indeed, many had been implemented ahead of the proposed 2020 deadline. However, the Sedgwick reforms are in their infancy and still have work to do. What should banks do in response?

• Banks should continue to implement the Sedgwick recommendations to the extent possible, and do so expeditiously. They should be implemented “in both letter and in spirit”. This will require, at a minimum, ensuring that balanced scorecards are truly balanced: non-financial metrics must be genuinely non-financial.
• Banks should continually assess whether changes made in response to the Sedgwick reforms are having the intended effect. It is worth noting that one of the Sedgwick recommendations is that a further review take place in 2020 to assess the implementation of the reforms and whether further regulatory or legislative change is required. Banks should prepare for this review by ensuring they can properly measure, record and analyse the impact the reforms are having.

Regular reviews of remuneration systems

As mentioned, APRA’s revised prudential standard will require boards to make regular assessments of their remuneration systems. Similarly, the Final Report also recommends that all financial services entities review, at least once each year, the design and implementation of their remuneration systems for frontline staff. This is to ensure that those systems focus on not only what staff do, but how they do it.

Observations in the Final Report indicate that entities should consider the use of tools other than variable remuneration to encourage desired behaviour. Examples of positive reinforcement include the provision of positive feedback and encouragement, higher fixed remuneration and promotions. Conversely, disciplinary action and withholding of promotion or other privileges can be used as a deterrent.

Conclusion

Contrary to some expectations, the Commission did not look to prescribe particular remuneration frameworks or prohibit the use of variable remuneration. Rather, its recommendations promote greater regulatory control and oversight for executive remuneration, and endorse ongoing reforms affecting frontline remuneration. Financial services entities should expect, and prepare for, greater internal and external scrutiny of their remuneration frameworks and outcomes, and particularly how they use variable pay.

Authors: George Cooper, Partner; Daniel Fawcett, Lawyer; and Lucy Cameron, Lawyer