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Australian bank regulator raises concerns around the risk management of executive pay saying executives' remuneration must not incorporate 'risk time bombs'

Australian bank regulator raises concerns around the risk management of executive pay saying executives' remuneration must not incorporate 'risk time bombs'

By Gareth Vaughan

The Australian Prudential Regulation Authority (APRA) says bank executives' remuneration must not incorporate "risk time bombs" that could undermine the future viability of banks. Furthermore, if executives want a bigger slice of the pie in good times, they must be prepared to share the pain in bad times.

In a speech entitled Implementing APRA's prudential standards on executive remuneration, APRA general manager David Lewis said the regulator's concern was to make sure the remuneration practices adopted by financial institutions APRA regulates are sound and do not imbed "risk time bombs" in the balance sheet that could undermine the future viability of the firm.

APRA has oversight of the big four Australian banks whose subsidiaries - ANZ New Zealand, ASB, BNZ and Westpac NZ - dominate the New Zealand banking scene. The New Zealand chief executives at these four banks were paid a combined A$11.7 million (NZ$15 million) last year with soon to depart Westpac NZ CEO George Frazis the highest paid, receiving A$4.13 million.

Also at Westpac NZ last year, selected executives and senior managers received a NZ$13 million annual rise in share-based payments to NZ$15 million with the bank saying the increase included a "catch up" on prior years.

Asked by interest.co.nz last year whether the Reserve Bank of New Zealand had any particular views on, or concerns about, bank executive pay, a spokeswoman said it wasn't something the bank had a comment on.

Lewis said, however, that APRA looked at the performance hurdles that underpin the pay structures.

"Are these performance hurdles consistent with the prudent risk management of the firm? Or do the performance indicators used to reward executives promote short term profits at the expense of the firm’s long term sustainability? Is too much emphasis being placed on revenue growth today and insufficient regard being paid to the quality of assets being brought onto the firm’s balance sheet?" Lewis asked.

"The remuneration policy should also include a force majeure type provision to allow bonuses to be adjusted for unintended or extreme circumstances which threaten the financial soundness of the firm."

"This is simply a matter of ensuring that executives have ‘some skin in the game’ so that their incentives align with the long term health of the firm. It says, if executives want to take a bigger slice of the pie in good times, they must also be prepared to take their share of the pain if things take a turn for the worse," added Lewis.

Risk management, not size of pay packets, the concern

Nonetheless, Lewis said APRA wasn't interested in remuneration in and of itself. Rather, what it's concerned about is risk management.

"So, when we see remuneration policies that encourage risky behaviour - yes - we get very interested."

"And there is no doubt that the global financial crisis brought forth numerous examples - mainly from overseas - of remuneration practices that led to excessive risk-taking, often with fatal consequences for the firms concerned. We don’t want to see that dynamic developing here, which is why APRA has moved early to put in place prudential standards to address this issue. These standards are consistent in most respects with those set internationally by the (Basel) Financial Stability Board."

Rather than concerning itself with the "how much" of executive pay, APRA focuses on the "why".

Lewis divided APRA's requirements into four core components: Governance, coverage, performance measures and risk adjustment.

"Overall, Australian financial institutions measure up well - especially when compared with most of their overseas counterparts. Of course, this is mainly because our institutions did not engage in many of the excesses that prevailed in offshore markets during the height of the boom. But that is not to say that there aren’t areas where our financial institutions can do better," Lewis said.

He gave a tick to their governance, saying the only governance issue that comes up regularly is one of demarcation between the roles of the board and the CEO.

"While the CEO will rightly be a source of advice and input in senior executive remuneration, it is ultimately the board’s responsibility to determine the structure and outcomes of remuneration arrangements for senior executives."

On coverage APRA wants remuneration policies to specifically address remuneration and performance hurdles applicable to three classes of employee being senior executives (“responsible persons”), risk and financial control personnel, and material risk-takers (who could be individuals or groups of individuals with substantial performance-based elements in their pay packages).

Lewis said all institutions seem to have had little difficulty applying their remuneration policy to senior executives, with most firms able to adequately incorporate risk and financial control personnel within their remuneration policy frameworks.

"However, in the area of material risk-takers, APRA is looking for more attention. Sometimes these types of remuneration arrangements can reach deep into the organisation. While we see evidence of boards reviewing, these types of arrangements, it often takes place after the fact, rather deliberating on performance outcomes in advance of award," Lewis said.

Results differ from bank to bank

On performance measures, results differ greatly from institution to institution.

"Our main area of concern is an excessive reliance on generic measures such as share price, market share or earnings per share. Metrics such as these are too high level to provide a reliable measure of individual performance and risk-taking," Lewis said.

"Better practice is to adopt a balanced scorecard approach incorporating a mix of individual performance metrics and qualitative assessment. Indeed, in some firms we supervise, the risk management division prepares reports for the remuneration committee on the risk management performance of individuals covered by the remuneration policy."

On risk adjustment the results were also mixed.

"On the plus side of the ledger, almost all regulated financial institutions incorporate an element of deferral in both their short-term incentive schemes (STI) and their long-term incentive schemes (LTI). Typical deferral periods range from 2 - 4 years for STI and 3 - 7 years for LTI."

"However, what is less evident is a capacity and/or willingness to withhold unvested entitlements based on a hindsight reassessment of actual performance," Lewis said. "For many firms it is apparent that deferral of benefits serves mainly as a device for staff retention, rather than as a genuine motivator for long term risk management."

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1 Comments

It is likely the truth was..."it wasn't something the Reserve Bank was allowed a comment on."...!

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