Risk & Economy » Regulation » FSA issues draft pay code

Last October, Financial Services Authority chief executive Hector Sants sent
a ‘Dear CEO’ letter to around 28 financial services companies and banks on the
hotly-debated link between remuneration and risk management.

In it, he said the FSA was not interested in setting new remuneration levels,
writing new regulations, or coming up with strong guidance against which banks
and trading companies could benchmark their pay policies. Instead, it intended
only to “assist and encourage” firms to review their remuneration practices.

However, to coincide with the unveiling of HM Treasury’s Asset Protection
Scheme it has now published its draft code of practice on remuneration policies,
setting out in stronger-than-expected terms what its subjects must do to avoid
unwanted attention from the regulator. Scheme beneficiaries are required to
adjust their policies accordingly.

The FSA urges compensation committees, executive boards, risk managers,
compliance and HR departments to work together to forge a stronger relationship
between pay and risk from the outset of structuring individual and team
remuneration packages. All FSA-regulated companies will be required to adopt the
code, which will be published in full shortly.

The draft sets out ‘specific principles’ ­ on governance, performance
measurement for the calculation of bonuses and long-term incentives, and
composition of remuneration ­ aimed at compelling regulated firms to acknowledge
the link between these functions and to curb “excessive” risk-taking.

“If a firm’s remuneration policies are not aligned with sound risk
management, it is likely that those policies will provide incentives for
employees to act in ways that might undermine it,” the FSA says. “The need for
firms to offer competitive remuneration packages is recognised, but industry
comparators should be a secondary rather than a primary factor in the
determination of remuneration policies.”

Some of the draft code gives strong direction on what it will look for from
financial companies and some of it refers to the need for directors to link best
practice with ethics. The FSA says the code will not concern itself with
remuneration levels as such; this, it says, is a matter for boards.

The draft states that boards and relevant remuneration committees should have
the skills and experience to reach an independent judgement on the suitability
of the remuneration policies, including the implications for risk and risk
• Remuneration committees (or equivalent bodies) should normally include one or
more independent non-executive directors with practical skills and experience of
risk management. The risk function should provide these individuals with regular
reports on the implication of the firms’ remuneration policies for risk and risk
• Non-UK firms with UK subsidiaries will be expected to have a body of oversight
for remuneration policies to assess risk links within that subsidiary.
• It may ask firms to provide an annual statement on remuneration policies,
including the implications of policies on the firm, assessment of their impact
on behaviour and group risk profile. The FSA may seek to discuss the report with
the chair of the remuneration committee and for this to be made available to
shareholders ahead of the annual vote on director remuneration.
• Risk, compliance and HR should have “significant input” in setting
compensation for business areas.
• Compensation for risk and compliance staff should be determined independently
of the business areas and they should have different performance criteria.

Performance measurement
• Measurement of performance for long-term incentive plans, including those
based on share performance, should be risk-adjusted.
• Common measures of share performance including earnings per share and total
shareholder return are not considered to be adjusted for longer-term risk by the
FSA. It is to press for a review of the use of unadjusted share performance
measures in longer-term performance-based remuneration schemes in the corporate

Composition of remuneration
• The fixed component of remuneration should be a sufficiently high proportion
of total remuneration to allow a fully flexible bonus policy. If the fixed
component (ie, base salary) is too low a proportion, it will be much more
difficult to cut or scrap bonuses in a bad year.
• In the case of bonuses that are a significant proportion of the fixed
component, it would be good practice for not less than two-thirds of that bonus
to be deferred for a minimum vesting period appropriate to the nature of the
business and its risks, and that the deferred element be linked to future
performance at the relevant division or unit overall.
• Deferred compensation paid in stock meets the code if the scheme meets
appropriate criteria, including risk-adjustment of the stock performance measure
in its guidance on measurement performance for bonus calculation. Deferred
compensation paid in cash should be subject to performance criteria too.
• Linking remuneration composition structures to future performance of a
business unit or division is “usually preferable” to future performance of
smaller departments or teams.
“Most business undertaken in banking is subject to future risk and uncertainty,”
the FSA says. “If variable compensation is paid out without any link to future
performance, the employee has less incentive to take future risk into account
and the firm is exposed to the risk of paying out variable compensation which
will prove not to be justified by results.”