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When financial services sneeze, the rest of the economy catches a cold

Executive Compensation|Total Rewards

By Shai Ganu | November 19, 2019

CPS 511 remuneration may signal some directional changes for the entire global financial services industry; and eventually impact other industries as well.

There is an old colloquialism in business that “when financial services sneeze, the rest of the economy catches a cold”. This may be particularly relevant if the symptoms relate to risk management, corporate culture and remuneration. When it comes to executive pay levels, incentive plans and risk-adjustments (such as clawback and malus provisions), banks and insurance companies tend to lead the general market practices.

We are starting to see many financial institutions across the region evolve and reshape themselves; they should keep a close watch on CPS 511 remuneration.

Indeed, we are starting to see banks and insurance companies in Singapore and across the region evolve and reshape themselves, which is why financial institutions here should keep a close watch on the recent developments in Australia.

In February this year, the Australia’s Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry found that the pervasive culture of misconduct and mis-selling in Australian banks was driven by companies’ excessive focus on sales and profits, and individuals’ focus on sales incentives and commission schemes. Subsequently, the Australian Prudential Regulation Authority (APRA) released a new draft prudential standard on 23 July to strengthen the governance requirements on remuneration in large financial institutions in Australia. Known as CPS 511 Remuneration, it is aimed at enhancing conduct, risk management and accountability in APRA-regulated institutions.

If CPS 511 is intended to remedy some of the wide-spread cultural misgivings, then it certainly has the right intent. However, this could be a very bitter medicine for many financial institutions to swallow. For the 46 APRA-regulated banks, authorised deposit-taking institutions, superannuation entities and insurance companies (both local and foreign), the changes could be very drastic.

Under the proposed framework, 60 per cent of a CEO’s variable pay, i.e. annual bonus plus long-term incentives (LTI), will need to be deferred for at least seven years, and 40% of variable pay for anybody deemed under ‘special role categories’ would need to be deferred for at least six years. While pro-rated vesting may commence from the fourth year onwards, these are significantly longer deferrals compared to current global practices. There is an additional clawback period of two years, or four years if an investigation is underway. This makes the effective deferral periods to a minimum of 11 years and 10 years respectively.

In addition to senior executives, the proposed definition of ‘special role categories’ would now include a new category of ‘highly-paid material risk-takers (MRT)’ in control functions such as risk, audit and credit. These include any employee with a maximum earning potential of more than AUD 1 million (SGD 940,000).

As a result, this would bring significant complexity and impact hundreds of employees, many of whom may not be in position of exposing the company to material risks. Imagine a middle-management IT employee with an annual fixed pay of AUD 250,000 and a historic variable pay of about AUD 400,000. With a maximum upside of between 1.5x and 2.0x of target levels in most incentive plans, it may be possible that this employee would now fall under the new definition of a highly-paid MRT. He/she will have to defer 40% of the variable pay (AUD 160,000) for a minimum of six years, causing a 25 per cent drop in annual take-home salary. This could have a material cash-flow impact for many employees and their families.

Market reforms

Another important change is that the financial performance metrics for employees must not comprise more than 50 per cent of the performance criteria for variable remuneration outcomes. This will significantly impact incentive plans, particularly LTI plans as they tend to include financial metrics. Most companies are challenged to find meaningful non-financial KPIs for incentive plans, let alone the complexity of setting performance targets four-to-seven years in advance.

The reforms also include important changes to approval responsibilities. For individuals under the new special role categories, the Remuneration Committee (RC), and in turn the board, will need to approve individual remuneration outcomes. Currently, most boards would approve the individual pay outcomes for top 10 to 15 senior executives and MRTs. Going forward, it is possible that the board would need to approve individual outcomes for more than 100 or 200 employees each year. This would bring additional workload to the RC and the board. They would also be required to actively monitor and track remuneration policy and structures for all employees and contract employees, and contingent workers. For large institutions, this may involve monitoring 25 to 30 different incentive arrangements. Furthermore, the board may be required to review the compliance of the remuneration framework with CPS 511 at least once a year, and conduct a comprehensive independent review on the effectiveness of the remuneration framework at least once every three years.

Whilst much of these reform is a codification of good governance, it could also result in some major potential unintended consequences.

Whilst much of this reform is a codification of good governance, it could also result in some major potential unintended consequences if the new standard is approved and implemented as planned in 2021. These include:

  • An increase in RC workload and governance costs:It is expected that the RCs’ workload would increase exponentially. The RC of a large company usually meet five to eight times in a year. However, it is not inconceivable that the RC would need to meet every month going forward. Henceforth, we may see an increase in the number of RC members and RC fees. Overall, this is likely to result in higher Non-Executive Director fees and associated cost of governance.
  • Deleveraging and restructuring of pay: As we’ve seen in Europe a few years ago in response to regulatory caps on variable pay, it is possible to see an institutional deleveraging of pay – with higher fixed and lower variable pay levels (except for MRTs). We are already beginning to see the elimination of sales incentives for front line staff in some institutions. Others are eliminating individual bonuses all together, in favour of common team-based bonuses based on overall company performance.
  • Talent pool implications: Historically, Australian companies have been successful in attracting global talent. However, given the new standard and in particular the long deferrals and associated tax implications, it is possible that global executives may be less attracted to relocate to Australia. Conversely, there will be more impetus for Australian talent to seek opportunities overseas. It is also possible that these executives will consider to move and work in other industries if they cannot or do not want to leave Australia.
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What’s next?

Needless to say, the changes proposed by the Australian prudential regulator are quite significant. Given the homogeneous talent pools and free-flowing capital across Asia Pacific, it is possible that Asia will eventually feel the impact of these changes as regulators in the region continue to seek and enhance accountability in the financial sector.

Increasingly banks and insurance companies in Singapore and the region are expanding their talent pools beyond hiring from just the financial services sectors; and vice versa for non-financial services companies to attract talent from banks and insurance companies. Although it is unlikely that Asian financial institutions would make wholesale changes to the remuneration structures in the next two to three years, these changes in Australia may signal some directional changes for the entire global financial services industry; and eventually impact other industries as well.

Asian boards should closely monitor the corporate culture, sales behaviours, risk-reward appetites and associated remuneration frameworks within the industry. Indeed, if the Australian financial industry sneezes, Asian banks and insurers may be among the first to catch its cold!

*This article was published in The Business Times on November 7, 2019.


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