FSA Adopts Remuneration Code for Financial Institutions

The UK Financial Services Authority has adopted a remuneration code for financial institutions, including broker dealers. The code takes effect on January 1, 2010; but by the end of October the firms must submit a remuneration policy statement providing the FSA with the information that it needs to verify that the firm’s remuneration policies and practices will be compliant with new code.

The FSA will be asking firms to explain in some detail how they are ensuring that their remuneration policies are consistent with effective risk management in their remuneration policy statements. The remuneration policy statement will have to be signed off by the remuneration committee. Non-compliant firms could face enforcement action or ultimately, be forced to hold additional capital should they pursue risky processes.

This is a principles-based code designed to ensure that remuneration policies and practices promote effective risk management.

There is now a consensus among regulators that inappropriate remuneration practices contributed to significant losses at major firms and therefore to the severity and duration of the current market turmoil. Cash bonuses paid out immediately without any deferral or claw back mechanism, and based on a formula that links bonuses to current year revenues rather than risk-adjusted profit, created strong incentives for managers to avoid conservative valuation policies and ignore concentration risks, thereby undermining effective risk management. In addition, market discipline has not been effective in limiting the adverse impact of poor remuneration practices on risk management, particularly at large systemically relevant institutions.

Firms must identify the incentives created by the firm’s remuneration policies and consider what risks might be created by resulting behavior and actions, including credit risks, market risks, and operational risks, and also whether these risks fall within the firm’s overall tolerance level. If the remuneration policies contribute to the firm exceeding its risk tolerance level, the policies must revised. The firm must also set up procedures and controls to ensure that the agreed remuneration policies are implemented in practice. Further, management information systems must be set up to ensure that there is effective monitoring of outcomes.

Another key element of effective risk management is the communication of the firm’s values and objectives to employees, and a high degree of transparency about what is required of them. Effective risk management would link honuses to individual objectives, including non-financial objectives, ahead of the period during which performance will be assessed.

Under the code, firms should not enter into contracts with individuals which provide guaranteed bonuses for more than one year. It is also expected that for senior employees two-thirds of bonuses will be spread over three years

The FSA plans to ask most firms to prepare an annual remuneration policy statement. However, if the FSA believes that a firm is not meeting the requirements set out in the Code, the agency may ask it to undertake a risk mitigation program and provide a remuneration policy statement on a more frequent cycle so that the FSA can monitor progress with the program. Generally, the statement should set forth the principles of the remuneration policy, and how it is applied to employees according to seniority, business line, and function. It should also discuss the intended impact on employee behavior and on the risk profile of the firm, as well as how remuneration policies are communicated to staff.

If a firm does not intend to comply with one or more of the principles, the remuneration statement should state what the firm intends to do in lieu of compliance and why this alternative course of action will promote effective risk management.

For its part, the remuneration committee should exercise independent judgment and be able to demonstrate that its decisions are consistent with a reasonable assessment of the firm’s financial situation. The committee must also have the skills and experience to reach an independent judgment on the suitability of the policy, including its implications for risk and risk management. The committee is also responsible for approving and periodically reviewing the remuneration policy and its effectiveness.

Emphasizing the need for international consistency in compensation reform, the FSA said that the new Code is aligned with the proposed compensation principles of the Financial Stability Board, which were endorsed by the G-20. For example, both the Code and the principles have the broad goal of aligning compensation with prudent risk taking and call for the establishment of a link between compensation and risk management. There is also alignment on the need for remuneration committees to be independent, to have risk expertise, and to monitor and review the compensation systems to ensure that they operate as intended. On the need for flexible bonus policies, the Board says that bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.

In early June, the US Treasury announced its intention to introduce reforms to compensation practices along the lines of the Financial Stability Board principles. The Federal Reserve Board is working on rules and/or guidance for the implementation of the reforms.

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