FSA eyes City pay structure

Financial Services Authority chief executive Hector Sants’s latest missive may not exactly have left the regulator’s subjects quaking in their boots, but could end up a bellwether document for the financial services sector.

The 13 October ‘Dear CEO’ open letter on remuneration, sent to around 28 financial institutions, set out the FSA’s belief that there is a link between remuneration in the financial services sector and the current market paralysis ­ but used such veiled language that few could tell if it was trying to hint at a future clampdown, or just having a gentlemanly word in the industry’s shell-like to please do things in a more sporting fashion.

“It is possible that [existing remuneration policies] frequently gave incentives to staff to pursue risky policies, undermining the impact of systems designed to control risk,” Sants writes, “to the detriment of shareholders and other stakeholders, including depositors, creditors and, ultimately, taxpayers.”

Friendly visit
The letter did say that the FSA will be visiting all the firms that received the letter to examine their policies. But in the same breath as saying reform was needed, Sants also made it very plain that the FSA is not interested in setting new remuneration levels, writing any new regulations or coming up with strong guidance against which banks and trading companies (the two institutions the FSA named as key perpetrators) could benchmark their pay policies. Rather, it intends only to “assist and encourage” firms to review their remuneration practices because, it seems, it has enough confidence in their ultimate goodwill to “expect firms to avoid (or to be implementing plans to eliminate) bad or poor practices concerning the measurement of performance, the composition of the remuneration and governance arrangements.”

The FSA says it does not itself know what constitutes ‘good’ or ‘bad’ remuneration policy despite the work it has done to date and its position as the market regulator. The best Sants could offer in his letter for now was to “urge all firms… to consider carefully their remuneration policies, especially in light of recent market developments”.

Next year, however, following the FSA’s visits to examine firms’ remuneration policies in more detail, the regulator will “communicate our findings regarding good practice to you and have a further discussion with you about them, if appropriate.” The FSA will also publish some “general findings about remuneration structures in the London market, on a no-names basis” ­ which should make for interesting reading.

Sants adds in his letter that he is “mindful” that action needs to be taken at an international level if it is to be effective, adding, “We hope to be able to report on the international work in our published report early next year.”

Too soft guidance
The note has caused confusion among compliance people. They used to look on the FSA’s Dear CEO notes as ‘soft guidance’, but the FSA itself pitches them merely as tools “to draw attention to areas within the existing guidance and regulations where the FSA believes more focus is needed,” as it told Compliance Reporter when quizzed about this one.

In decoding the note, Clifford Chance’s Regulatory Group said they believed that, while the letter doesn’t constitute formal guidance, “it clearly seeks to impose obligations on firms to act” and added that “underlying” the letter was “the suggestion that remuneration practices will be assessed by the FSA as part of its risk assessment of firms, and that it will take [this] into account in setting the capital requirements imposed on firms.”

Lack of clarity
Denton Wilde Sapte, another law firm, simply put Sants’s words in closed captions to denote its feelings on the lack of clarity. “The FSA is avoiding being prescriptive; instead, it is seeking to provide high-level criteria against which firms’ policies can be assessed. It already has a ‘firm view’ of what constitutes ‘bad practices’… This is accompanied by its ‘initial view’ of ‘good practices’.”

The law firm is in no doubt about one thing, however: “The FSA’s letter clearly cannot be ignored,” it tells its clients.

Sants did vaguely allude to being interested in doing something if his subjects were not shocked by the FSA’s interest into making changes. “If [remuneration] policies are not aligned with sound risk management, that is unacceptable,” he wrote. “Immediate action will be required to change the policies.”

Denton Wilde Sapte says that firms will need to “comprehensively review” their remuneration schemes, explain them to the FSA and set out their proposed actions. “Whilst the [Dear CEO] letter seems to recognise that firms cannot change their approach to remuneration overnight, it does expect them to be moving towards good practice.”

The law firm summarises what remuneration practices should be scrapped:

• Bonuses calculated on the basis of revenues, without any counterbalancing risk controls and without taking risk or capital cost into account;
• Bonuses calculated solely on the basis of financial performance and for the current financial year only;
• Remuneration that has little or no fixed component and is paid wholly in cash;
• Remuneration that does not include performance-adjusted deferred compensation; and
• Deferred compensation not linked to the future performance of business undertaken in previous years.