UK FSA Sets Best Practices for Executive Compensation at Financial Firms

There is growing concern that inappropriate executive compensation schemes at investment banking and trading firms may have contributed to the present market crisis. Specifically, remuneration structures of firms may have been inconsistent with sound risk management since they frequently gave incentives to pursue risky policies, undermining the impact of systems designed to control risk. With that in mind, the UK Financial Services Authority has set forth best practices for executive compensation. While the FSA has no wish to become involved in setting remuneration levels, since that is a matter for boards, the authority wants to ensure that firms follow remuneration policies which are aligned with sound risk management systems and controls, and also with the firm's stated risk appetite. In a Dear CEO letter, the FSA warned that compensation policies not aligned with sound risk management will be unacceptable.

The FSA wants compensation calculated on profits and not on the basis of revenues. Compensation should take into account a range of risks, including liquidity risk, and not take capital cost into account. Bonuses should not be calculated solely on the basis of financial performance. Rather, in addition to performance, bonuses must take into account risk management skills and adherence to company values.

Importantly, the FSA wants the fixed component of the executive compensation package to be large enough to meet the employee’s essential financial commitments. Also, compensation should never be wholly paid in cash, but rather should be a mix of cash and components designed to encourage good corporate citizenship. Deferred compensation should be calculated on a performance measure averaging over several years.

There must also be sound corporate governance of executive compensation centered on an independent board compensation committee with effective controls of firm-wide compensation policies and even larger individual awards. Risk management must play a strong role in setting compensation, with the compensation of risk managers determined independently of the business area. Along with this, there must be a transparent process for managing conflicts of interest. Further, valuations and risk reporting must be subject to independent verification.