Banking (prudential standard) determination No. 1 of 2009

EXPLANATORY STATEMENT

Prepared by the Australian Prudential Regulation Authority (APRA)

Banking Act 1959, section 11AF

Under subsection 11AF(3) of the Banking Act 1959 (Banking Act) APRA may, in writing, revoke a prudential standard made in relation to prudential matters to be complied with by all authorised deposit-taking institutions (ADIs) and authorised non-operating holding companies (authorised NOHCs). Under subsection 11AF(1) APRA may, in writing, determine a prudential standard in relation to prudential matters to be complied with by all  ADIs and authorised NOHCs.

APRA has made Banking (prudential standard) No. 1 of 2009 (the 2009 Instrument).

1. Background

Prudential Standard APS 510 Governance (APS 510) made by Banking (prudential standards) determination No. 1 of 2008 (the existing Governance Standard) applies to all ADIs and authorised NOHCs. It sets out minimum foundations for good governance of regulated institutions. It aims to ensure that regulated institutions are managed in a sound and prudent manner by a competent Board of directors, which is capable of making reasonable and impartial business judgements in the best interests of the regulated institution and which gives due consideration to the impact of its decisions on depositors.

In late 2008, the Financial Stability Board (FSB) formed a Compensation Workstream Group (CWG), of which APRA was a participant. The FSB was convened in April 1999 to promote international financial stability through information exchange and international co‑operation in financial supervision and surveillance. The CWG had a mandate to draft sound practice principles for large financial institutions and, at their April 2009 meeting, the Leaders of the G-20 endorsed the FSB’s Principles of Sound Compensation Practices[1] (FSB Principles).

The Declaration on Strengthening the Financial System, which was signed by the Leaders of G20 nations, including the Australian Prime Minister ‘endorsed the principles on pay and compensation in significant financial institutions developed by the FSB to ensure compensation structures are consistent with firms’ long-term goals and prudent risk taking’[2]. 

APRA’s proposals on remuneration deal with an important deficiency highlighted by the FSB’s work, in which APRA participated, namely the lack of alignment of remuneration with risk management in many financial institutions.  APRA decided to cover remuneration in its prudential framework for governance, whereby Boards of regulated institutions will be required to ensure compliance with prudential requirements for remuneration. 

2.      Purpose of the Instrument

In order to extend APRA’s prudential standard on governance to cover remuneration for ADIs and authorised NOHCs, APRA is revoking and re-making the existing Governance Standard.

3.      Operation of the Instrument

The 2009 Instrument revokes the existing Governance Standard and re-makes APS 510 with the following amendments:

(i)     paragraphs 33 to 54 have been inserted to cover remuneration; and

(ii)  paragraph 84 has been included to replace the prior transitional arrangements which are no longer applicable.

4.      Consultation

In May 2009 APRA undertook its first public consultation on the proposed extensions to the existing Governance Standard.  In response to the submissions received during the initial round of consultation, APRA undertook a second round of public consultation in September 2009.

5.      Regulation Impact Statement

A Regulation Impact Statement is attached to this Explanatory Statement.

Regulation Impact Statement

Remuneration

Proposed extensions to governance requirements for APRA‑regulated institutions

(OBPR ID: 2009/10819)

Introduction

This Regulation Impact Statement (RIS) follows the previous related preliminary assessment OBPR ID: 2009/10819 on remuneration for APRA-regulated institutions which was submitted to OBPR on 14 October 2009.  The preliminary assessment detailed APRA’s proposals to introduce standards on remuneration as part of the APRA’s prudential standards on governance, namely, Prudential Standard APS 510 Governance, Prudential Standard GPS 510 Governance and Prudential Standard LPS 510 Governance (collectively referred to as the governance standards).

APRA is primarily responsible for ensuring the safety and soundness of prudentially regulated financial institutions so that they can meet their financial promises to depositors and policyholders (‘beneficiaries’). As part of its mandate, APRA has implemented a multi-layered prudential framework that encompasses the industry Acts it administers, prudential standards that set out specific requirements to which institutions must adhere, and guidance notes designed to clarify APRA’s expectations with regard to prudential requirements.

Background

Across the globe, there is consensus amongst both regulators and industry that inappropriate remuneration practices contributed to significant losses at major institutions and therefore the severity and duration of the current market turmoil.  Increased awareness of this risk has prompted financial regulators globally to publish principles and guidance for the effective management of remuneration risk.

In late 2008, the Financial Stability Forum (FSF), recently re-established as the Financial Stability Board, formed a Compensation Workstream Group (CWG), of which APRA was a participant. The FSF was convened in April 1999 to promote international financial stability through information exchange and international co‑operation in financial supervision and surveillance. The CWG had a mandate to draft sound practice principles for large financial institutions and, at their April 2009 meeting, the Leaders of the G-20 endorsed the FSF’s Principles of Sound Compensation Practices[3] (FSB Principles).

The Declaration on Strengthening the Financial System, which was signed by the Leaders of G20 nations, including the Australian Prime Minister ‘endorsed the principles on pay and compensation in significant financial institutions developed by the FSF to ensure compensation structures are consistent with firms’ long-term goals and prudent risk taking’[4].

The Declaration of the G20 stated the principles require the following:

• Firms’ boards of directors to play an active role in the design, operation and

evaluation of compensation schemes

• Compensation arrangements, including bonuses, to properly reflect risk and

the timing and composition of payments to be sensitive to the time horizons of

risks. Payments should not be finalized over short periods where risks are

realized over long periods; and

• Firms to publicly disclose clear, comprehensive, and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies to exercise effective monitoring.

The Declaration also stated that Supervisors will also assess firms’ compensation policies as part of their overall assessment of their soundness. Where necessary they will intervene with responses that can include increased capital requirements.

APRA understands that all G-20 countries have taken steps to implement the FSB Principles with at least four financial centres namely the UK, France, Netherlands and Switzerland having already published detailed guidance.  Most recently, the Federal Reserve Board released its proposed guidance on Sound Incentive Compensation Policies in October 2009.  APRA is monitoring international developments and is satisfied that its approach is consistent with the FSB Principles.

APRA’s statutory focus is upon ensuring that our regulated entities meet their financial promises under any reasonably foreseeable adversity.  This focus upon preventing financial failure informs all our rule-making and supervision.  Prudential executive remuneration practices are therefore those practices which tend to reduce the probability that a regulated institution will fail. With this in mind, APRA proposes to address this risk by extending APRA’s governance standards. This will be supplemented by a prudential practice guide to assist Boards to comply with the standards. 

As at June 2009, there were 193 ADIs authorised under the Banking Act 1959 (Banking Act), 132 general insurers authorised under the Insurance Act 1973 (Insurance Act), 32 life companies and 19 friendly societies authorised under the Life Insurance Act and 17 non operating holding companies (NOHCs).  The proposed remuneration requirements would be applicable to all these entities.

Problem identification

In recent years, failures of a number of overseas financial institutions, and some Australian unregulated institutions, have coincided with remuneration practices that appear to encourage unsound risk-seeking behaviour, giving rise to the question as to whether remuneration structures in financial institutions are encouraging behaviour that is contrary to the stability of the economy and the soundness of financial institutions.

In the introductory section of the FSB principles, the then FSF commented that:

“Compensation practices at large financial institutions are one among many factors that contributed to the financial crisis that began in 2007. High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they imposed on their firms. Such incentives amplified the excessive risk-taking that destabilized the global financial system. The lack of attention to risk also contributed to the large absolute level of compensation in the industry”.2

Poorly designed incentives in executive remuneration may lead to undesirable behaviour, among which three behaviours stand out:

• unwise growth, in response to incentives for growth which are not balanced by considerations of risk;
• increases in risk exposure in pursuit of revenue or profits, for example through increased leverage or lower underwriting standards; and
• short term focus, as opposed to the multi-year or full business cycle focus which is necessary to preserve soundness among financial institutions.

Remuneration incentives for individuals can be designed to both encourage desirable behaviour and discourage undesirable behaviour.

APRA’s experience is that the responsible persons employed by the largest regulated institutions, most relevant in this context, are typically well qualified, effective, and display a reasonable balance between the desire to make themselves and their shareholders wealthy, and the desire to serve as effective long term stewards for the firms for which they are responsible.

ADIs in Australia, generally speaking, are profitable and well capitalised.  Australia’s general insurance companies have in the past several years demonstrated much more financial and strategic discipline than was the case previously in this country or offshore.  Australian life insurance companies could make similar claims.  In light of this, APRA’s proposed remuneration framework is not required to address an immediate local prudential emergency. Australian remuneration practices are not causing financial institutions to fail at the present time, nor is it likely that such practices will produce failures in the immediate future.  Nevertheless, as APRA continues to observe remuneration practices which at least have the potential to produce unsound results, it is necessary to implement a prudential response.

The lack of alignment of remuneration with the risk management systems of financial institutions is an important deficiency highlighted by the FSB’s work. Financial institutions are risk-taking institutions by their very nature. Their business is to determine which risks to take and which to avoid. This requires, at their centre, a robust risk management framework that defines the risk appetite of the firm and outlines the controls in place to manage the risks arising from their activities.

With this focus in mind, APRA reviewed the existing regulatory arrangements in Australia and concluded that Australian remuneration arrangements potentially contain similar weaknesses even if these have not yet manifested in practice. Additionally, in October last year, the Prime Minister requested that APRA develop prudential requirements for sound remuneration practices. APRA agreed that remuneration should be examined more closely as a risk factor for regulated entities.

The FSB intends that its principles be implemented by member countries and apply to internationally operating banks, bank holding companies and material subsidiaries and affiliates of these companies, and be reinforced through supervisory examination and intervention.  The FSB principles are enunciated in Table 1.

Table 1 FSB principles for sound compensation practices

APRA has since examined the existing regulatory arrangements in Australia. Requirements relating to director and executive remuneration are primarily set out in the Corporations Act 2001.  For listed companies, the Australian Securities Exchange (ASX) establishes additional requirements under Principle 8 of its Corporate Governance Principles and Recommendations (2nd Edition). Voluntary arrangements also exist, for example, through guidelines for listed company boards released in February 2009 by the Australian Institute of Company Directors (AICD).

With respect to executive remuneration, the Corporations Act regulates the role, responsibilities and structure of boards; termination payments; and, for listed companies, disclosure (through the remuneration report) and voting on remuneration.  The Corporations Regulations 2001 also require companies to prepare their annual financial report, including the remuneration report, in accordance with the applicable accounting standards, including valuing share-based payments.  Whilst the disclosure provisions of the Corporations Act and Regulations are administered by the Australian Securities Investment Commission (ASIC), APRA considered the objectives of its proposals against these provisions and found that there was nothing that addressed APRA’s concerns; specifically the relationship to risk is not explicitly addressed. Other deficiencies with the current statutory and regulatory framework relating to disclosure have been identified and recommendations made by the Productivity Commission’s Discussion Draft on Executive Remuneration in Australia, released in September 2009.  The Productivity Commission has liaised with and taken into consideration APRA’s proposals and its draft recommendations complement APRA’s proposed requirements.  However, nothing in the Corporations Act or the draft recommendations made by the Productivity Commission address the significant gap highlighted by the FSB in that remuneration practices are not aligned with risk management.

APRA considers that the ASX and AICD guidelines are sound, and APRA’s proposals are closely aligned with them.  However the majority of APRA-regulated institutions are not listed on the ASX and are therefore not subject to the obligations under Principle 8 of the ASX Corporate Governance Principles. The voluntary arrangements of the AICD are not binding on companies; whilst there are a number of APRA-regulated institutions which follow these guidelines, APRA cannot have complete confidence that they are uniformly and appropriately implemented.

APRA intends to address these gaps in the Australian context through its proposed prudential requirements to ensure that remuneration arrangements in APRA‑regulated institutions encourage prudent risk-taking. In this regard, APRA proposes to apply the first eight of the FSB’s principles. The ninth FSB principle, regarding public disclosure, is already catered for under the Corporations Act 2001 and, for listed companies, under Principle 8 of the ASX Corporate Governance Principles.

Regulatory intervention will assist in reforming remuneration practices by ensuring that remuneration is set in a competitive environment, and there is a ‘first-mover’ disadvantage to making remuneration practices tighter. A ‘first-mover’ company that imposes stronger risk measurement or claw-backs through its remuneration system may lose key personnel who will move to competitors that retain a less restrictive remuneration regime. A coordinated approach imposed by regulatory intervention will contribute to undesirable practices that exist in APRA-regulated industries being phased out, which will improve the overall structure of remuneration.

Further, without a framework for remuneration, Australia would not meet international best practice standards in this area, including those set out by the FSB and agreed to by the Leaders of the G-20 which includes Australia.  APRA believes that adherence to the FSB Principles would mean that locally regulated financial institutions would be held to the same standards as their international counterparts.

Objectives of APRA’s initiative

APRA’s objectives in relation to remuneration are to ensure that remuneration arrangements of APRA-regulated institutions encourage prudent risk-taking.  This supports APRA’s objective of ensuring that regulated institutions are soundly managed, and gives due consideration to the impact of their decisions on depositors and policyholders. 

Specifically, APRA’s objectives are to:

• clarify APRA’s requirements and expectations of regulated institutions with respect to remuneration matters;
• ensure that, at a minimum, the remuneration requirements applicable to APRA-regulated institutions are consistent across like institutions and industries, and reflect both domestic and international good practice;
• promote sound and prudent management of APRA-regulated institutions;
• ensure independence and authority of the Board and the Board Remuneration Committee relative to any regulated entity's management; and
• ensure that the tools and methods used for supervision are consistent across all areas of APRA.

Options

APRA currently maintains prudential standards for governance and fit and proper matters, for regulated deposit takers and insurance companies.  It is open to APRA to amend an existing prudential standard for remuneration or create a new prudential standard which, after clearing the relevant statutory hurdles, would have the force of law in Australia.  Prudential standards may also be accompanied by a prudential practice guide, which is a non-statutory instrument, to provide further guidance to industry.

The range of regulatory tools is limited by APRA’s role and powers.  Accordingly, two options are assessed in this RIS:

• Option 1 - To implement the policy proposals. 

• Option 2 - To maintain the status quo (i.e. don’t introduce standards in relation to remuneration).

Whether this is achieved through a new prudential standard or an existing prudential standard is irrelevant, as the requirements under each option will be the same.  However, as APRA does not propose to address the absolute level of remuneration, but rather the need to align remuneration incentives with good stewardship of institutions, APRA proposes to include the remuneration requirements in APRA’s governance standards. 

APRA intends to take a principles‑based approach in this area which parallels our approach to other matters of governance and risk management.  This will enable Boards to design remuneration arrangements that suit the structure of their own institution.  APRA is relying not on disclosure but on accountability by boards to APRA for meeting APRA’s principles and is concentrating on the substance not the form. Institutions will be able to design their own remuneration arrangements within the general parameters nominated by APRA.

Where these arrangements are likely to encourage excessive risk-taking, APRA will engage in supervisory action to encourage better arrangements.  Should this action prove insufficient, APRA would respond through means such as the imposition of higher capital requirements as a buffer against risks.

Option 1 - To extend the existing prudential standards to include coverage of remuneration matters

APRA’s prudential standard on governance sets out the minimum requirements for good practices of regulated institutions.  APRA’s prudential framework includes governance requirements for ADIs that date back to 1986, requirements for general insurers introduced in 2002 and certain requirements for life companies set out in the Life Insurance Act 1995 (Life Insurance Act). Those requirements were introduced after extensive consultation with industry.

The proposals contained in this RIS relate to those outlined in APRA’s discussion paper Remuneration – Proposed extensions to APRA-regulated institutions which was initially released for public consultation on 28 May 2009 and later on 7 September 2009 for a second round of consultation.  Under this option, APRA proposes to extend the governance prudential standard in two key areas, namely the requirements to have a Remuneration Policy and to establish a Board Remuneration Committee.  The extensions will apply to ADIs, general insurers and life companies as well as non-operating holding companies authorised under the Banking Act, Insurance Act and Life Insurance Act.

Remuneration Policy

Boards will be required to have a Remuneration Policy that ensures the behavioural incentives inherent in or associated with performance-based remuneration are aligned with a regulated institution’s long-term financial soundness and its risk management framework. This Policy will provide the foundation for the Board’s governance of remuneration.

APRA proposes that the Remuneration Policy cover, at a minimum, each person or group of persons within the regulated institution who, because of their roles, have the capacity to make decisions that could materially affect the interests of beneficiaries (depositors and policyholders) and owners (shareholders or, in the case of mutuals, members). For these purposes, APRA has specified certain persons who must be covered, namely ‘responsible persons’ (generally the senior executive cadre), risk and financial control personnel (FSB Principle 3), and any other personnel who receive a significant proportion of variable remuneration through bonuses, commissions and the like.

It is proposed that the Remuneration Policy addresses three key elements in order to achieve the goal of aligning remuneration with risk management. These have been based on the FSB Principles, and include:

• that the form of compensation (for example cash, equity, other benefits) be  consistent with prudent risk-taking (FSB Principle 7);
• that remuneration be adjusted for all forms of risk (FSB Principle 4); and
• that remuneration arrangements incorporate features that allow for adjustment of performance-based remuneration according to risk outcomes, recognising their time horizons (FSB Principles 5 and 6).

Many regulated institutions will already have a remuneration policy in place. Nevertheless, APRA’s emphasis on aligning remuneration with prudent risk-taking will require changes to be made to most institutions’ remuneration policies.

Board Remuneration Committee

APRA is therefore proposing that the Board Remuneration Committee consist of independent directors only. Boards will therefore be required to establish a Board Remuneration Committee comprised of non-executive directors, a majority of whom are independent.  The Committee’s functions include, at a minimum, the need to review the Remuneration Policy periodically and make recommendations to the Board on the Policy and the remuneration of executives.  APRA is mindful of the potential for conflicts of interest to arise when determining remuneration arrangements. This stance is consistent with the FSF’s discussion of FSF Principle 1. 

APRA’s governance standards emphasise that “The Board of directors (the Board) of a regulated institution is ultimately responsible for the sound and prudent management of the regulated institution”. This existing requirement will also apply in respect to remuneration. That is, the entire Board is ultimately responsible for decisions relating to remuneration matters. Consistent with this framework, APRA needs to be confident that the Boards of these institutions perform in an effective and appropriate manner, taking into consideration the interests of depositors and policyholders.

Option 2 - To maintain status quo.

Under this option, APRA would not make changes to existing standards.

Impact analysis – costs, benefits and risks

Impact group identification

The parties impacted by the identified options are APRA, policyholders and depositors, and APRA-regulated institutions.

Assessment of costs and benefits

At present, APRA does not have data to perform a detailed quantitative cost-benefit analysis on the proposed options. Impacted parties were asked to provide details of the impact on them and invited to use the Business Cost Calculator.  However, no such data in relation to these proposals was provided in submissions received as part of the consultation process.  The following analysis is based on evidence supplied to APRA by regulated institutions. Some general views on costs and benefits have been noted but this is not sufficient to allow an accurate determination of quantitative estimates of costs and benefits.

Option 1

APRA-regulated institutions

Benefits

The proposals under this option will strengthen the governance of APRA-regulated institutions by ensuring that all institutions meet the same minimum standards with respect to remuneration arrangements. Boards would be required to ensure that their oversight functions meet certain minimum requirements, designed to promote effective and efficient management practices and to ensure that the Board conducts its affairs with a high degree of integrity and transparency. The requirements in relation to the composition and independence of the Board Remuneration Committee would also assist in ensuring that directors, when making decisions, consider the effect of those decisions on all stakeholders, including depositors and policyholders.

Regulated institutions will also be able to demonstrate that their practices are in line with international expectations, as expressed through the FSB Principles and Standards. 

Costs

The changes to the prudential framework under this option could mean that regulated institutions that do not currently meet the requirements face an increase in costs associated with complying with new governance requirements. There may be costs associated with ensuring that the Board Remuneration Committee has a majority of independent directors and an independent chairperson. There would need to be a process for educating directors as to the new requirements and to ensure ongoing compliance. Costs would also be incurred on an ongoing basis for the maintenance of policies. Much of this cost would be associated with the time required for the persons involved in performing the assessment.

That said, ADIs, general insurers and life insurers are already subject to APRA governance requirements and the costs of meeting the enhanced requirements are likely to be minimal. In mandating the need for a Board remuneration committee, APRA is strengthening the current Principle 8 of the ASX Corporate Governance Principles for listed companies that suggest that remuneration committees are good practice. As almost all listed companies already have a remuneration committee consistent with the ASX corporate governance principles, we do not believe that this will result in a material burden for listed companies.  Listed companies represent approximately 10 percent of APRA’s regulated population. For the remaining population, in particular smaller unlisted entities, such as credit unions and building societies, the submissions have indicated that most of these entities have a board committee that undertakes the functions of a remuneration committee.  Therefore, the incremental cost for entities to comply with APRA’s requirements relating to establishing a Board Remuneration Committee would be marginal.

Section 300A of the Corporations Act 2001 requires that the directors’ report for a financial year for a company must include (in a separate and clearly identified section of the report) discussion of board policy for determining the nature and amount (or value, as appropriate) of remuneration of the key management personnel for the company.  Accordingly, listed companies will have a Remuneration Policy already in place.  Under APRA’s proposed requirements, regulated institutions will need to review and where necessary amend their policy to address APRA’s requirements.  Adjustments to the policy to align remuneration arrangements with risk management will likely require the most attention and resources.  However, given the size and resources available to such entities, the incremental cost from the status quo will be marginal.

For regulated institutions that are not listed on the ASX, good corporate governance practices have been promoted through APRA’s governance standards for a number of years.  Furthermore, APRA’s prudential standards on risk management require all regulated institutions to have in place appropriate mechanisms to identify, manage and monitor risks.  In line with this, unlisted entities that have performance-based remuneration will need to amend (or in limited cases develop) a Remuneration Policy that aligns remuneration and risk management.  From submissions received during its consultation process, APRA acknowledges that for mutuals, overall levels of remuneration across this sector are most, and limited incentive or bonus arrangements exist.  In such cases, APRA envisages that the proposed requirements will not apply to the same extent.  Accordingly, the Remuneration Policy for such institutions will be able to prepare a simple policy with minimal cost to the institution.  APRA proposes to make this clear in its guidance material.

If an individual institution wished to seek an exemption from any particular requirement, there would be costs associated with preparation of their case although such costs are expected to be minor. It is expected that any additional costs will generally be mitigated by the need for less intensive supervision by APRA, particularly for those institutions that are not currently meeting the requirements under this option. This is because stronger governance practices should improve the overall quality of oversight and management within APRA-regulated institutions.

Overall, APRA considers that the direct operating costs to regulated institutions are nominal.

A larger potential cost flows from the risk that regulated institutions will be rendered less competitive within Australia for talented staff, relative to unregulated institutions.  Australian institutions may also find it more difficult to compete for talented staff relative to employers operating outside Australia.  As to the first of these staff quality risks, APRA observes that the Australian financial sector has proven highly attractive to talented Australians for many decades.  As nothing about APRA's proposals is likely to materially reduce total remuneration for demonstrably successful staff, the potential for loss of talent domestically seems small.

Importantly, APRA observes that the G-20 endorsement of the FSB Principles and Standards should lead to reasonable international conformance on these matters.  It is already the case that a number of G-20 countries, including Australia, are introducing similar requirements regarding remuneration governance.  The UK Financial Services Authority, in its Policy Statement on Reforming remuneration practices in financial services acknowledges that the Australian standards are well matched to the FSB Principles[5].

Depositors and Policyholders

Benefits

The proposed remuneration requirements under this option would have a positive benefit for depositors and policyholders by strengthening the overall quality of governance of regulated institutions. The new requirements would also afford increased protection to depositors and policyholders by reducing the risk of failure of institutions that may otherwise result from inappropriate risk-taking due to poorly structured remuneration arrangements. The benefits of this reduced risk of failure, however, are not readily quantifiable.

The interests of depositors and policyholders would be further safeguarded as the proposed arrangements would strengthen oversight by the Board by encouraging them to give due consideration to the impact of remuneration arrangements on depositors and policyholders. These beneficiaries would also benefit from increased public confidence in individual institutions, and the finance system generally, due to the higher governance standards that regulated institutions would be required to meet. Strengthening governance arrangements, and the resultant reduction in risk of institutional loss, or failure, would also reduce the likelihood of loss of depositors’ funds or inability to pay policyholders’ claims. This would be particularly true for those institutions where Board oversight and management practices have raised prudential concerns.

Costs

Depositors and policyholders may be adversely impacted if new remuneration requirements were to lead to additional costs that would ultimately be reflected in higher fees, interest spreads or premiums.

However, the majority of APRA-regulated institutions, particularly those that are publicly listed, already comply with the ASX Corporate Governance guidelines.  These guidelines require Boards to have a Remuneration Policy and a Remuneration Committee in place.   APRA-regulated institutions that are not publicly listed are also likely to satisfy these requirements, as a matter of good governance practice.  APRA’s proposals will require Boards to review their policies and align them where necessary with APRA’s requirements.  Institutions that have a Remuneration Policy and Remuneration Committee in place will incur some costs in satisfying APRA’s requirements.  It is expected that these will be low. 

Boards that currently lack a Remuneration Policy or Board Remuneration Committee will need to devote some resources to establishing them. However, these entities are likely to be unlisted, smaller and less complex entities. As such, the work required to establish a Remuneration Policy should be straightforward.  The remuneration structures of such entities are likely to reflect the less complex structure of their operations. 

APRA

Benefits

The introduction of new prudential requirements on remuneration would assist APRA in supervising regulated institutions by reducing the risks of institutional failure due to inappropriate or ineffective remuneration practices.

The requirement for a Board Remuneration Committee would help to ensure that APRA-regulated institutions have appropriate arrangements covering independent oversight of the institution, including ensuring that the operation and management of the institution is in accordance with the policies and procedures of the Board. This, in turn, would help to reduce the intensity of regulatory oversight by APRA, as the measures under this option would provide greater confidence to APRA that institutions are being managed in an appropriate and effective manner. The Board Remuneration composition requirements, particularly that a majority of directors be independent not just non-executive, would minimise the potential for conflicts of interest.

The requirement for a Remuneration Policy for listed regulated institutions will build upon existing requirements set out in the Corporations Act 2001 by requiring remuneration arrangements to promote prudent risk-taking.  This will enable APRA to effectively regulate such practices and ensure that the risk associated with poorly designed remuneration practices is managed through the institution’s existing risk management frameworks.

The proposed changes would give APRA greater confidence in the governance of individual institutions, by increasing the likelihood that the Board, Board Remuneration Committee and senior management will identify, communicate and take action on potential problems in an institution in relation to remuneration and excessive risk-taking due to inappropriate remuneration practices. More focussed risk assessment by APRA would, in turn, strengthen the safety and soundness of the financial system allowing earlier intervention that would assist in the protection of depositors and policyholders and minimise the risk of contagion.  

Over time, the expected benefits of better remuneration practices in regulated institutions should result in more efficient and effective supervision by APRA of remuneration risks, and thereby allow APRA to redirect its resources away from remuneration governance to other areas identified as requiring supervisory attention.

Costs

APRA would incur direct costs by introducing new prudential requirements on remuneration. These costs would arise from development of the requirements, as well as consultation and staff training. Ongoing costs associated with supervision and monitoring of compliance with these requirements would be part of APRA’s normal supervisory processes, thereby limiting the costs that APRA would incur through the introduction of these standards.

The costs to APRA of these changes will be moderate. Additional review mechanisms to ensure compliance with the requirements should be minimal. Other costs incurred would form part of APRA’s normal operating expenditure and would be expected to be insignificant.  

Option 2 – Maintaining the status quo

APRA-regulated institutions

Benefits

Under this option, regulated institutions would not receive any tangible benefit as they would not have to meet any additional governance requirements. However, they would benefit from a cost perspective if maintaining the status quo means that existing arrangements are less robust or less comprehensive than those that would be required under option 1. Institutions would not have to incur costs (such as the appointment of new directors) to meet changed requirements or devote resources to education and other implementation issues.

Costs

There would be no direct costs to institutions as there would be no change to the existing framework. However, indirect costs could result through the possibility that poor or inappropriate remuneration practices would persist. As stated earlier, remuneration has not been singled out as a particular risk for Australia-based institutions.  However, given the numerous failures overseas as a result of poor remuneration practices, leaving this risk unaddressed in existing regulatory arrangements in Australia exposes institutions, their beneficiaries and the wider financial system to an increased likelihood of this risk occurring in Australia. As a result, the cost of this option could exceed the cost of introducing new requirements if the status quo results in poor or inappropriate remuneration practices or, in extreme cases, institutional failure, as has been evidenced overseas.

Internationally active regulated institutions would also suffer from a perception that their home country regulatory regime was sub-standard when measured against global expectations, as set out in the FSB principles and standards.

Depositors and policyholders

Benefits

There would be no additional benefits to depositors and policyholders under this option. Also, as regulated institutions would not be required to comply with additional requirements, no additional costs would be incurred that could be passed onto depositors or policyholders via increased fees and premiums.

Costs

Under this option, the direct costs to depositors and policyholders would be unchanged. The opportunity cost, however, of retaining the current supervisory approach is that the potential for improved soundness of regulated institutions arising from the remuneration requirements would not be realised. Depositors and policyholders could face continued indirect costs through a higher than necessary risk of loss from inadequate or inappropriate governance practices in regulated institutions. In the extreme case of institutional failure, depositors and policyholders may face individual losses through the absence of stronger governance arrangements for APRA-regulated institutions. Such failure could also have implications, potentially significant, at an economy-wide level when all such losses are considered in total.

APRA

Benefits

The main benefit to APRA of retaining the status quo would be the avoidance of costs that would otherwise be incurred in making changes to the governance standards, and in supervising these changes. APRA would not have to devote resources to the implementation of new requirements or in monitoring compliance with those requirements.

Costs

There would be no direct costs to APRA under this option as there would be no change to the existing framework. However, there would likely be indirect costs because of the possibility of poor or inappropriate remuneration practices by regulated institutions, which would undermine the effectiveness of the framework. Also, APRA’s objectives in seeking to update governance arrangements of regulated institutions and harmonise these arrangements across industries would not be achieved.

There would also be material costs to APRA's international reputation as a proactive and effective prudential supervisor.  Failure to implement modern remuneration governance arrangements would constitute a material shortcoming against international expectations in this area.

Consultation 

APRA released a discussion paper entitled Remuneration – proposed extensions to governance requirements for APRA-regulated institutions on 28 May 2009.  The discussion paper outlined APRA’s proposals and the basis for their introduction.  The discussion paper was also accompanied by a draft prudential standard and draft prudential practice guide (PPG). 

APRA consulted with a selection of industry experts on 28 April 2009, comments from which were taken into account in preparing the draft documents that were released for public consultation.  

APRA received 51 submissions in response to the discussion paper from APRA-authorised insurers, authorised deposit-taking institutions, reinsurance brokers, and other interested parties.  APRA staff also met directly with a number of interested parties during the consultation period for this release.

Revised draft governance standards and PPG were released for a second round of consultation on 7 September 2009.  APRA received 19 submissions during the second consultation period.

Across both rounds of consultation the submissions and meetings broadly supported the approach and intent of APRA’s proposals.  Whilst the intent of the proposals remained unchanged, APRA amended some details and clarified the wording to ensure that the proposals are better understood.

The main issues raised during the consultation rounds together with APRA’s responses are detailed below.

Remuneration practices as a risk

APRA regards inappropriate remuneration practices as a potential risk to the soundness of APRA’s regulated institutions and has issued a set of draft proposals to address this risk.  APRA has proposed that performance-based remuneration be designed to encourage behaviour that supports an institution’s long-term financial soundness and risk management framework. 

Comments received

There was general acceptance that inappropriate remuneration arrangements are a risk that had not previously been explicitly considered within the prudential framework, and acceptance that this risk should be addressed.  While generally supportive of the proposal to address risks in remuneration practices, some submissions were concerned about the prominence given to such risks relative to other risks.  These submissions suggested that risks associated with remuneration practices need to be considered as one risk among many and managed as part of the broader risk management framework.

APRA’s response

APRA agrees that risk in remuneration practices is one risk among many facing regulated institutions and its proposals are not intended to give undue prominence to this risk.    

APRA also emphasises that the risks associated with remuneration should be considered as one element of an institution’s risk management framework.  Strong governance of remuneration is fundamental to ensuring appropriate oversight of remuneration practices and structuring remuneration to align with prudent risk-taking should be pursued as one of the components, along with others, of the risk management framework.   

FSB Principles

The Leaders of the Group of Twenty (G-20) endorsed the FSB’s Principles of Sound Compensation Practices in April 2009[6].  These Principles aim to ensure effective governance of compensation, alignment of compensation with prudent risk-taking, effective supervisory oversight and stakeholder engagement in compensation.  APRA supports these Principles and has developed its remuneration proposals in a manner consistent with them.

Comments received

Submissions supported FSB’s Principles and broadly confirmed that APRA’s proposals are consistent with them.  A few submissions suggested that, in some respects, APRA’s proposals are a prescriptive interpretation of the FSB’s Principles.  On the other hand, APRA also received requests for more detailed guidance in several areas. 

APRA’s response

It is helpful that the FSB’s Principles have good support by regulated financial institutions in Australia, and that APRA’s proposals are generally seen to conform to them.   

Other international and domestic developments

There has been considerable attention given to the subject of remuneration domestically and globally during the last year.  The FSB’s Principles are intended to be implemented by all G-20 member countries and to apply to internationally operating banks, bank holding companies and material subsidiaries and affiliates of these companies. To date the United Kingdom[7], the European Union[8], France[9], Switzerland[10] and the Netherlands[11] have published plans to implement the FSB’s Principles. In October 2009, the Federal Reserve Board released its proposed guidance on Sound Incentive Compensation Policies.

As an integrated regulator across the deposit-taking and insurance industries, APRA's general approach is to ensure, to the extent practicable, that common considerations apply to common risks across these industries.  APRA’s remuneration proposals will apply to ADIs and general and life insurers.  The only other country to take this approach to date is Switzerland, where its new integrated regulator (Financial Market Supervisory Authority) is applying the remuneration principles to all regulated institutions including insurers. The other jurisdictions have focused on banks and have not included insurance companies at this stage.

The Productivity Commission[12] is examining executive remuneration for listed companies in Australia and released a discussion paper outlining its recommendations in September 2009. The Government has also announced amendments to taxation for termination payments to executives[13] and employee share schemes[14].

Comments received

Some submissions suggested that APRA was leading global change rather than waiting to consider the reforms taking place overseas, particularly for insurance companies.

Some submissions were concerned that the outcomes of the Productivity Commission inquiry might conflict with APRA’s proposals and there were suggestions that APRA should wait until the Productivity Commission’s proposals are public. 

Comments were also made in relation to potential conflicts between APRA’s proposals and the Government’s position on taxation of employee share schemes, in particular in relation to the cessation of employment being a taxation point.

APRA’s response

APRA is monitoring international developments and is satisfied that its approach is consistent with the FSB’s Principles, which were endorsed by the leaders of the G-20 in April 2009.  For banking, the Basel Committee on Banking Supervision is seeking confirmation that regulators are acting on these Principles.  At the September 2009 G‑20 meeting, a task force was established to report on progress that has been made towards implementation of the Principles. The FSA in the United Kingdom has noted that international alignment on remuneration "has not yet been achieved, but the chances are reasonably good."[15]

For both deposit-taking and insurance, APRA is ahead of developments in many countries.  APRA sees no case for deferring its proposals, because they are an important component of risk management. There is also no reason for a difference in the principles applying to ADIs and insurance companies.  APRA's experience across all its behavioural prudential standards is that sound practice in one regulated industry is very similar to sound practice in every other industry.  Accordingly, APRA ensures that, to the extent reasonably possible, its prudential standards regarding behaviour (including governance) are identical across industries.

It is inevitable that the design of remuneration arrangements will be influenced by taxation legislation.  The fact that cessation of employment is the taxation point for deferred share schemes has the potential to cause conflict between the deferral and taxation requirements. Part of the task of the Board Remuneration Committee, is to conform to the spirit and principles of APRA’s standards as far as possible while also meeting taxation requirements. 

Harmonised principles, proportionate approach

APRA’s proposed requirements on remuneration are the same across regulated industries, corporate structures and irrespective of the size of institutions.  They are principles-based to the extent this is practicable.  APRA recognises that entities of different complexity, size and risk profile may meet the governance standards in a range of ways. 

The PPG makes clear that ‘not all of the practices outlined will be relevant for every regulated institution and some aspects may vary depending upon the structure of the institution’s business including its size, complexity and risk profile.’  As such, there will be a range of remuneration practices that could meet supervisory expectations for different entities. Some of them are specifically outlined and discussed within the PPG such as how risk adjustments for capital should be made.

APRA also has the ability to exempt a regulated institution from establishing a Board Remuneration Committee, and the governance standards contain a general power for APRA to adjust or exclude a specific prudential requirement in relation to a regulated institution. 

Comments received

A number of submissions argued against a harmonised approach and some suggested there was too much prescription.  They contended that each of the proposed requirements would not be relevant or necessary for all institutions and adopting them would not achieve the intended result.  The submissions suggested that APRA should allow flexibility and consider factors such as existing risk management frameworks, size of institutions, complexities of institutions as well as the general business conducted by institutions in determining how the proposed remuneration requirements should apply.  Several submissions drew attention to issues specific to certain operating structures or practices. 

APRA’s response

The same principles for remuneration governance should apply to all APRA-regulated institutions and industries. At the same time, APRA’s risk-based approach to supervision allows it to take account of the size, complexity, business profile and risk management framework of each regulated institution.  This approach is essentially an extension of the approach already taken by APRA to risk management and governance more generally.  

More detail has been provided in the PPG on the limited circumstances in which APRA may consider an exemption from a specific prudential requirement in the governance standard for an institution.   

Board Remuneration Committee

The draft governance standards proposed that the Board Remuneration Committee be comprised solely of independent directors and that the Committee as a whole possess appropriate expertise to perform its role.

One of the Committee’s functions is to conduct regular reviews of the Remuneration Policy including an assessment of its application, effectiveness and compliance with APRA’s requirements. 

Comments received

There was a range of submissions relating to the composition of the Board Remuneration Committee, the roles and functions of the Committee and its required expertise.  

In relation to composition, some submissions questioned why the proposed requirements were more restrictive than APRA’s corresponding requirements for the Board Audit Committee. Some submissions sought clarification on what was needed to demonstrate ‘appropriate expertise’.    Some also noted that, for some corporate arrangements such as joint ventures, the proposals would be very difficult to implement.

Some smaller entities suggested that the Board should have the option to undertake the remuneration role directly without separately creating a Board Remuneration Committee.

APRA’s response

In response to submissions, APRA revised its requirements on the composition of the Board Remuneration Committee to be consistent with that of the Board Audit Committee.  This entails that all members be non-executive directors with a majority independent and an independent chair, rather than all members needing to be independent directors.

APRA is proposing a Board Remuneration Committee comprising only non-executive directors in order to maintain independence from the executives.  The governance standard allows APRA to approve an alternative arrangement.  The PPG discusses some of the limited circumstances in which APRA may consider a request for an exemption.

APRA expects that Board Remuneration Committees will have appropriate expertise to carry out their responsibilities. A variety of skills will be necessary to ensure sound governance of remuneration matters.  However, APRA recognises that it is difficult to prescribe expertise and skills of this kind in a prudential standard. As a result, APRA has removed the expertise requirement from the prudential standards and inserted guidance in the PPG as to APRA’s expectations regarding Committee expertise. 

The revised PPG also now includes more guidance on the conduct of the Board Remuneration Committee.  In particular, where the Committee relies on support from within the institution in fulfilling its duties, APRA expects the Committee to pay particular attention to the potential for conflicts of interest.

Coverage of the Remuneration Policy

APRA’s May 2009 proposals required that the Remuneration Policy apply to three categories of personnel: responsible persons (excluding responsible auditors and non-executive directors); risk management, compliance, internal audit and financial control personnel (collectively, ‘risk and financial control personnel’); and all other employees or agents for whom a significant portion of total remuneration is variable and determined by performance measures.  It also indicated that a person need not be an employee of the regulated institution and may be an employee of a subsidiary or otherwise related company, a consultant, a contractor or an agent. 

The draft governance standards specified that ‘where persons are performing services for the regulated institution but are employed and paid by a separate entity, the Board must ensure that these persons are remunerated in accordance with the Remuneration Policy insofar as they perform tasks for the regulated institution.’  The standards also proposed that risk and financial control personnel be remunerated in a manner that is independent of the business areas they oversee. 

Comments received

This topic generated the most submissions.  There was a large variety of questions relating to both the specific coverage and the ramifications of that coverage. 

The majority of submissions related to the use of the term ‘risk and financial control personnel’.  There were two interrelated issues. The first was that this term was alleged to capture too many people across an organisation.  The second related to the requirement that risk and financial control personnel be remunerated in a manner independent of the business areas they oversee.  A number of submissions expressed difficulty in separating these functions from business areas, particularly for senior risk and financial control personnel such as the chief financial officer. 

Another common issue was the treatment of non-employees. A number of submissions asked for clarity with regard to the third category of personnel.  Some submissions raised concerns about the difficulty in setting remuneration for a non-employee.  Many submissions provided examples of the variety of external parties that are engaged to perform services and argued that the standards would require changing the remuneration policies of third parties.  The use of the term ‘agent’ was ambiguous and there were questions relating to how ‘significant’ would be determined in relation to ‘a significant portion of variable remuneration’. 

Some submissions suggested amending the proposals to limit applicability to senior executives and high risk areas, such as investment banking. 

APRA’s response

It remains APRA’s intention that the Remuneration Policy cover those individuals or classes of individuals where alignment of their remuneration with prudent risk-taking can have a bearing on the financial health of the institution.  However, in light of the comments received, APRA has refined its proposals to better reflect both the practicalities for institutions and APRA’s intentions.

The definition of ‘risk and finance control personnel’ has now been modified to refer to those personnel whose roles are primarily related to risk or financial control.  The standards have also been amended to address the principle of independence and avoidance of conflict of interest rather than the manner in which that independence is achieved in relation to risk and financial control personnel.  Therefore, the September 2009 version states that risk and financial control personnel need to be remunerated in a manner which does not compromise the independence of these personnel in carrying out their risk and financial control functions.  In other words, the scope of coverage is clearer and not materially changed, while the requirements on their performance-based remuneration are based more clearly on principle.

Regarding the treatment of non-employees, it is clear from international evidence that third parties, particularly commissioned sales forces, can collectively impose potentially crippling losses on prudentially regulated entities.  Notable examples include the U.S. experience with sub-prime mortgage brokers, and the U.K. experience with pensions and investment misselling.  It is APRA’s intention that where a regulated institution contracts third parties to undertake functions on its behalf and those functions can expose the institution to risk, the remuneration of such third parties should take account of this risk.  In this context, when engaging a corporation for distribution or other services, the corporation is the ‘person’ subject to the regulated institution's contractual oversight.  Third parties undertaking business on an institution’s behalf may include, for example, mortgage broking firms, insurance agencies, or financial planners, where such firms have the collective potential to expose the institution to excessive risk if the remuneration arrangements provide inappropriate incentives.   

APRA’s intention is that where a regulated institution contracts with a third party,  the contractual terms with the third party must comply with the governance standards, rather than the remuneration of individuals employed by that third party.  Where the regulated institution contracts with individuals, the remuneration of these individuals should conform with the institution’s Remuneration Policy.  On this basis, regulated institutions are not expected to control the remuneration of employees of third parties with which they are contracting, but will need to ensure that the contract with the third party takes into consideration the principles of sound remuneration.  Further issues related to third parties are discussed separately below.

The determination of whether or not a proportion of a person’s remuneration that is variable is significant, as referred to in the standards, will vary according to the context.  This will include the circumstances of the institution, the role of the individual concerned and the institution’s risk management controls and remuneration practices.  APRA is not intending to define ‘significant’ but will expect institutions to make their own assessments of significance in the context of prudent risk-taking. 

Third Parties

In APRA’s September consultation package, the extent to which its remuneration requirements apply to non-employees was addressed and updated from the May consultation package.

The September draft governance standards and PPG proposed that, where a regulated institution enters into contracts with third parties to undertake functions on its behalf and those functions can expose the institution to risk, the remuneration of such third parties should take account of this risk.  In these circumstances, the contractual terms with the third party, rather than the remuneration of individuals employed by that third party, must comply with the governance standards.

Comments received

Submissions acknowledged that APRA had addressed earlier concerns by clarifying that contractual arrangements with third parties needed to be covered by the Remuneration Policy rather than the third party’s own remuneration policy. However, some submissions suggested that arm’s‑length business contracts should be excluded on the basis that such arrangements already incorporate risk controls via pricing arrangements. In particular, submissions questioned whether intermediaries such as financial planners, mortgage brokers and insurance brokers should be included.

APRA’s response

APRA maintains the view that payment incentives to third parties can give rise to inappropriate risk-taking behaviour. However, APRA notes that regulated institutions may have existing processes in place that already address such risks.  Where the risk management framework explicitly addresses such risks and there is a Board Committee that oversees these arrangements, such arrangements do not need to be included in the Remuneration Policy. In such cases, regulated institutions must be able to demonstrate that the matters detailed in the governance standards are being adequately addressed by those processes.  APRA is not seeking to preclude commission-based arrangements.

A number of formal and informal submissions to APRA have asserted that, variously, financial planners, mortgage brokers and insurance brokers cannot act in a manner that threatens the financial soundness of a regulated institution and that these distribution channels should not be included in the Remuneration Policy.  APRA believes that there is sufficient evidence, including some domestic examples of third‑party distribution channels creating losses for a regulated institution, to support its position.

Responsible persons

The governance standards identify ‘responsible persons’ as defined in Fit and Proper Standards as a distinct category of persons to be covered by the Remuneration Policy. Individual recommendations on the remuneration of such persons must be made by the Board Remuneration Committee to the Board.

Comments received

There was acceptance that senior executives must be covered by the Remuneration Policy and that the APRA-defined term ‘responsible persons’ covers such persons. However some submissions suggested that regulated institutions capture a wider group of individuals as responsible persons than senior executives. Submissions suggested that the requirement for the Remuneration Committee to recommend, and thereafter the Board to approve, the individual remuneration for all included responsible persons would place an unnecessary burden on the Remuneration Committee.

APRA’s response

It is APRA’s intention that the top level of management (and their direct reports) is captured under the label of ‘responsible persons’.  APRA notes that some regulated entities have applied the Fit and Proper standards for responsible persons to a much wider group. Accordingly, APRA has revised the governance standards by narrowing the persons for whom the Board Remuneration Committee must make an individual recommendation to the Board.  

The Board Remuneration Committee is now required to make recommendations to the Board on the remuneration for certain individuals, namely the CEO and their direct reports, other executive members of the Board, direct reports of the executive members of the Board (excluding administrative direct reports of executive members of the Board) and any other person specified by APRA. 

Other responsible persons will still be included in the Remuneration Policy. APRA does not require Board-level approval of their individual remuneration but rather an assessment of the remuneration of these persons as a class, or in a series of classes.

Remuneration structures

APRA’s May 2009 proposals required that performance-based remuneration be designed to promote behaviour that supports an institution's long-term financial soundness and risk management framework.  The draft governance standards also required that each relevant individual’s performance-based remuneration allow for adjustments to reflect the risks of the business activities in which the individual is engaged, the controls in place to mitigate those risks, the time necessary to reliably measure the business risks and the capital allocated to those business activities.

The draft governance standards required Boards to be able to reduce or eliminate payment of performance-based remuneration where such actions are necessary to protect the financial soundness of the regulated institution, as well as allowing for reduction of deferred remuneration if adverse outcomes lessen the assessment of the performance generating the deferred allocation.

Additional guidance was provided in the draft PPG on other elements of remuneration structures.  For executives, guidance was provided on, among other things, incoming and termination payments, equity-related components and the hedging of equity exposures.

Comments received

Several submissions argued that the requirements surrounding performance-based remuneration were too prescriptive.  In particular, concern was voiced that APRA was requiring individual design of the remuneration arrangements for every person captured under the governance standards.  The submissions argued that tailoring the Remuneration Policy to each individual would be unduly complex or impractical.  Other submissions assumed that APRA would require institutions to allocate economic capital not only to lines of business but also to individuals for remuneration purposes.

On the issue of deferrals and the requirement for Boards to be able to reduce or eliminate deferred payments if adverse outcomes lessen the assessment of the performance, several difficulties were raised.  They included the administrative difficulty in identifying all relevant parties involved in business activities, difficulty in implementing this practice and legal uncertainty about the Board’s ability to do so.  Some submissions suggested that there should be more discretion around this requirement.

APRA’s prohibition on hedging the equity exposures of executives was strongly supported.  Objections were raised, however, to APRA’s guidance that guaranteed payments to incoming and terminating executives are generally inconsistent with prudent practice.  Arguments were made on the basis that the market for executives is international and APRA’s guidance would disadvantage Australian institutions in their efforts to recruit executives from overseas.

APRA’s response

Some of the questions raised appeared to reflect inferences drawn from the consultation package that were unintended by APRA.  These questions have been addressed by clarifying the governance standards and the PPG.  Other comments highlight that aligning remuneration policies with prudent risk-taking may be a difficult task if current remuneration structures are complex.  APRA acknowledges this difficulty. Nevertheless, this task must be undertaken if the Australian prudentially regulated sector is to converge its remuneration governance with accepted international practice.

In response, APRA revised its draft governance standards to remove reference to the ‘individual’ in the design of remuneration arrangements.  The draft standards now better reflect APRA’s intention that, beyond the responsible person cadre, prudent remuneration arrangements are intended to be established for classes of personnel rather than at the individual level.    

The submissions suggested some confusion over APRA’s intention around capital allocation as a risk adjustment mechanism.  APRA does not require regulated institutions to create economic capital models solely for remuneration purposes.  The intention is that institutions recognise that high risk activities warrant higher capital than low risk activities and that the cost of capital should be recognised or acknowledged in remuneration design.  Institutions already using economic capital models for other purposes should be able to use them without material modification for remuneration purposes.  Otherwise, institutions can pursue simple risk adjustment methods.  For institutions that do not apply capital modelling to their operations, capital allocations based on, for example, regulatory capital requirements will generally suffice. 

APRA has considered the issues relating to reducing deferred performance-based remuneration in the case of adverse circumstances, and has now made adjustments to the governance standards as well as providing additional guidance on this topic.

APRA’s approach to deferred payment recognises that when performance-based remuneration is granted there is often uncertainty about the measurement of that performance.  Deferral of both the allocation and vesting of such performance-based remuneration is one method of allowing time for the outcomes of the business activities to be reliably measured.  This involves measuring results retroactively and putting performance-based remuneration at risk until performance can be validated.

In addition to such deferrals, APRA’s intention is that Boards need to retain the discretion to make adjustments to performance-based remuneration, for two reasons.  One reason is to protect the financial soundness of the regulated institution in adverse circumstances such as when the institution has incurred major losses or is short of capital.  The other reason arises in circumstances where formula-based bonus calculations create material unexpected outcomes.  Both of these discretions are intended to cater for extreme circumstances, not for routine adjustments in remuneration.

On incoming and termination payments, APRA considers that the balance between ensuring sound remuneration practices across the institution, compared with the incremental ability to attract or retain individual employees, can only prudently be resolved in favour of sound remuneration practices across the institution. APRA also notes that the G-20 countries have all agreed in principle to move towards more prudence in remuneration practices.  APRA recognises that competition in recruiting may encourage some regulated institutions to provide cash payments or cash bonuses to incoming staff.  APRA nevertheless expects institutions to place suitable deferral and performance hurdles on such payments.

Corporate groups and foreign branches

APRA’s May 2009 consultation package was silent on the treatment of groups and foreign branches.  The existing governance standards, to which the remuneration proposals are an extension, allow for group arrangements generally but the proposed extensions did not state that institutions that are part of a group might be able to use a group Board Remuneration Committee.  Foreign branches were not mentioned in the proposals. 

Comments received

Submissions highlighted that, within a group, remuneration arrangements are often dealt with at the group level and that this practice works well.  These submissions called for group arrangements to be allowed.  For example, several submissions contended that a group Remuneration Committee can fulfil the requirements of the standard. 

The absence of reference to branches led to some expectations that the standards would not apply to foreign branches. 

APRA’s response

APRA recognises that group remuneration practices can work well.  APRA has clarified its proposals to explicitly allow group arrangements in cases where such group arrangements meet the requirements of the standards. 

Under the revised standards, APRA will allow the use of a group Board Remuneration Committee for regulated institutions that are part of a group.  If the Board of a regulated institution chooses to rely on a group Board Remuneration Committee, then that Board is responsible for ensuring that the recommendations of the group Board Remuneration Committee are appropriate and are correctly applied to the regulated institution.  Guidance on APRA’s expectations is included in the PPG.

As part of the second round of consultation, APRA clarified that its remuneration requirements will apply to foreign branches. Consistent application of the requirements to all regulated institutions, whether locally incorporated or branches, not only creates a level playing field for regulated institutions in Australia but also delivers consistency of risk management.

Role of senior officer outside Australia for Foreign Branches

The May 2009 consultation package was silent on the treatment of foreign branches of banks and insurers. The September consultation package confirmed that the remuneration requirements would apply to foreign branches. Consistent application of the requirements to all regulated institutions, whether locally incorporated or branches, not only creates a level playing field for regulated institutions in Australia but also delivers consistency of risk management.

For foreign ADIs and foreign General Insurers the senior officer outside Australia (SOOA) (compliance committee for Eligible foreign life insurance companies) acts as a representative of the Board. Accordingly, the draft standards highlighted the role of the SOOA in place of the Board Remuneration Committee in conducting reviews of the Remuneration Policy, including an assessment of its application, effectiveness and compliance with the requirements of the governance standards. However, the draft standards proposed that the Board of a branch, not the SOOA, must establish, approve and maintain a written Remuneration Policy. 

Comments received

There were several comments about SOOAs. Firstly, submissions suggested that the SOOA is a responsible person but should be excluded from the Remuneration Policy, otherwise the SOOA would be required to review his/her own remuneration. Secondly, submissions suggested that the SOOA should stand in place of the Board on all issues relating to remuneration as this is the approach taken in other APRA prudential standards such as Risk Management, Outsourcing, and Fit and Proper.

APRA’s response

APRA agrees that the SOOA should not be covered by the Remuneration Policy. The governance standards have been amended so that the SOOA is excluded from the responsible persons who are covered by the Remuneration Policy. In excluding the SOOA from the group of responsible persons, APRA considers that the SOOA with delegated authority from the Board is able to perform the role of the Board. 

APRA’s expectation is that a foreign branch will be covered by the group Remuneration Policy and the SOOA, as the Board’s representative, will be required to sign-off that the group policy meets APRA’s requirements. Where a global group policy does not fully comply with APRA’s requirements, the SOOA may amend the group policy for any particular requirements relating to the Australian operations. The group policy, thus suitably amended, could still be used for the Australian branch operations.

Notwithstanding that the SOOA may approve the Remuneration Policy, the Board retains responsibility.  In this regard, it is appropriate and important for the SOOA to report back to the Board on the regular review of the Remuneration Policy applied to the Australian operations and an assessment of its application, effectiveness and compliance with APRA’s requirements. Without this communication independent oversight by the Board of the Remuneration Policy will not be ensured.

Use of external advisers

APRA’s May 2009 draft governance standards required that where the Board Remuneration Committee chooses to engage third-party experts, the Committee itself must directly select and determine the contractual arrangements for such experts, without reliance upon executives of the institution.  The PPG elaborated on these expectations, outlining that lawyers or other parties negotiating contracts or employment terms on behalf of the institution would be expected to receive instructions solely from the Committee and provide advice solely to the Committee. 

Comments received

A wide range of comments was made in submissions on this issue.  Some argued that third-party experts should be able to work with both the management and the Board, as long as conflicts of interest were recognised and managed.  Some argued that the wording in the draft standards was too prescriptive as it required the Board Remuneration Committee to determine contractual arrangements directly rather than relying on the institution’s internal resources such as the legal department to settle the contract.  Other submissions cautioned that the Committee may come to rely too much on external consultants and urged vigilance by APRA in monitoring this relationship. 

APRA’s response

A key principle underlying APRA’s approach is that the Board Remuneration Committee must be independent and, to be effective, be able to perform its role without relying upon the views and opinions of executives of the institution.  Without compromising this principle, the draft governance standards and PPG have been amended so as not to preclude the Committee from using administrative resources within the institution if it is convenient, provided that the Committee maintains its independence in preparing its recommendations and is able to demonstrate to APRA that it has maintained this independence. 

Conclusion and recommended option

Option 1 is the preferred option

Option 1 provides the most effective protection to beneficiaries through enhanced prudential requirements. This option will address the various objectives set out earlier. Under this option, APRA’s minimum foundations for good governance for regulated institutions are clearly enunciated and are harmonised across regulated industries. These foundations correspond to what is considered good practice. There would be a positive effect for depositors and policyholders as governance structures and practices under this option would serve to better protect their interests. This is consistent with the basic premise of the prudential framework in Australia that beneficiaries of APRA-regulated institutions are accorded a higher level of regulatory protection than creditors of other entities.

In addition, APRA’s analysis indicates that the majority of institutions that will be subject to the prudential standard are already meeting most or all of the core requirements as set out under option 1. Therefore, the introduction of APRA’s governance prudential standards should not involve a significant imposition in terms of administration or cost.

Option 2 falls short of meeting all of the previously stated objectives.  Maintaining the status quo would mean that APRA would be constrained in what it could do where it had clear concerns about the remuneration arrangements of individual regulated institutions. Though APRA acknowledges that evidence of poor or inappropriate remuneration arrangements has been limited to institutions based overseas, the need to regulate this risk is aimed at ensuring that such risks do not manifest in Australia. While there are powers APRA could draw on, these would be a less direct means of ensuring the adequacy of remuneration arrangements of regulated institutions. This in turn would make APRA’s supervisory task more difficult and would limit its ability to provide protection to depositors and policyholders. It may also result in the governance practices required of APRA-regulated institutions falling below what is now considered to be good practice.

Implementation and Review

The final governance standards are intended for release in November 2009. The standards will commence on 1 April 2010. There requirements will be reflected in harmonised, governance prudential standards for each of the ADI, general insurance and life insurance industries.

APRA recognises the practical issues for regulated institutions to address governance requirements in respect of the Remuneration Policy at 1 April 2010.  At a minimum, APRA expects institutions which are unable to comply will need to have conducted a self-assessment of their current practices against the final standards by the commencement date, and put in place a plan for making the transition to the new requirements. However, all institutions will be required to have a Board Remuneration Committee that complies with the governance standards by 1 April 2010, and a written Remuneration Policy in place that is largely compliant with APRA’s requirements.

For contracts in force as at 1 April 2010, APRA will allow regulated institutions time to ensure that they are fully compliant at the first reasonable opportunity for renegotiation, and in any event by 31 March 2013. 

APRA recognises that some regulated institutions may have genuine cause to be exempted from some aspects of the remuneration requirements.  These will be assessed on a case-by-case basis.

These prudential standards will be reviewed as necessary to ensure they continue to reflect good practice and remain relevant and effective, for both APRA’s prudential supervision purposes and for regulated institutions. As part of these reviews, APRA will liaise with other interested regulatory bodies to ensure that its remuneration requirements take account of other approaches to managing this risk.

[1] FSF Principles for Sound Compensation Practices, 2 April 2009, www.financialstabilityboard.org

[2] Page 4, Declaration on Strengthening the Financial System (Annex to London Summit Communiqué), 20 April 2009.

[3] FSF Principles for Sound Compensation Practices, 2 April 2009, www.financialstabilityboard.org

[4] Page 4, Declaration on Strengthening the Financial System (Annex to London Summit Communiqué), 20 April 2009.

[5] Page 38, Financial Services Authority Policy Statement on Reforming remuneration practices in financial services, August 2009.

[6] http://www.financialstabilityboard.org/publications/r_0904b.pdf

[7] http://www.fsa.gov.uk/pubs/policy/ps09_15.pdf

[8]http://ec.europa.eu/internal_market/bank/docs/regcapital/com2009/Leg_Proposal_Adopted_1307.pdf

[9]http://www.fbf.fr/Web/internet/content_europe.nsf/(WebPageList)/FBF+adopts+common+guidelines+on+the+compensation+of+financial+market+professionals?Open

[10] http://www.finma.ch/e/aktuell/Pages/mm-rs-verguetungssysteme-20090603.aspx

[11] http://www.afm.nl/corporate/default.ashx?documentid=12334

[12] http://www.pc.gov.au/projects/inquiry/executive-remuneration

[13] http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1531

[14]http://assistant.treasurer.gov.au/DisplayDocs.aspx?doc=pressreleases/2009/011.htm&pageID=003&min=njsa&Year=&DocType=0

[15] http://www.fsa.gov.uk/pubs/policy/ps09_15.pdf (paragraph 5.20)