Walker Report Recommends Creation of Board Risk Committee and Links Risk to Compensation

The Walker report on corporate governance and executive compensation contains far reaching and groundbreaking recommendations that very likely will be incorporated into UK legislation. The core principles of the Walker recommendations center on risk management, disclosure, and delinking excessive risk taking from compensation, including the creation of a board risk committee with real powers and a duty to provide meaningful information about risk in the company’s annual report.

At the same time, the Walker report supports the continued use of the comply or explain doctrine for corporate governance codes, as well as endorsing the unitary board structure. The report concluded that the two-tier model of separate executive and supervisory boards, such as in Germany, did not yield better outcomes than unitary boards in the crisis period..

Recognizing that the financial crisis involved a massive failure of risk management, the report recommended the creation of an independent board risk committee with oversight of the company’s risk exposures and future risk strategy, including strategy for capital and liquidity management, and the embedding throughout the company of a supportive culture in relation to the management of risk. In preparing advice to the board on its overall risk appetite, tolerance and strategy, the risk committee should take into account the current and prospective financial environment, drawing on financial stability assessments such by central banks, and banking and securities regulators. The board risk committee should, like the audit committee, be composed of a majority of independent directors and be chaired by an independent director.

The risk assessment process used by the committee should be qualitative and also involve quantitative metrics to serve as a way of tracking risk management performance in implementation of the agreed strategy. The approach to some form of calibration of risk appetite might include one or a combination of preferred risk asset ratios; value at risk; target agency ratings, and a system of risk or exposure limits including metrics for the range of tolerance.

In addition, the report said that board-level risk governance should be supported by a chief risk officer, who would participate in the risk management and oversight process at the highest level, covering all risks across the organization, on an enterprise-wide basis, with total independence from individual business units. The CRO should report to the board risk committee, with explicit and direct access to the chair of the committee.

In exercise of the enterprise-wide role, the CRO would provide risk assessments totally independently from the executives in individual business units, and with due regard to materiality. The CRO would assess the risk of proposed new products and the pricing of risk in a particular transaction against the risk tolerance determined by the risk committee and board, and should have veto power where necessary. On a continuing basis, the CRO will ensure that risk originators in individual business units are fully aware of and aligned with the board’s appetite for risk.

The risk committee would file a separate report to be included in the company’s annual report, describing thematically the firm’s risk management strategy, including information on the key risk exposures inherent in the strategy, the associated risk appetite and tolerance and how the actual risk appetite is assessed over time, and the effectiveness of the risk management process. The report should also provide at high-level information on the scope and outcome of the stress-testing program. Also, there should be disclosure of the membership of the risk committee, the frequency of its meetings, whether external
advice was taken and, if so, its source.

Reflecting the interconnection of risk and compensation, the report recommends that the remuneration committee seek advice from the risk committee on specific risk adjustments to be applied to performance objectives set in the context of incentive packages. Any differences of view, and appropriate risk adjustments should be decided by the independent directors.

In addition, the remuneration committee’s report should confirm that the committee is satisfied with the way in which performance objectives and risk adjustments are reflected in the compensation structures and explain the principles underlying the performance objectives, risk adjustments and the related compensation structure if these differ from those put in place and disclosed in respect of executive board members

Deferral of bonuses and other incentive payments should provide the primary risk adjustment mechanism to align rewards with sustainable performance for executive board members and high end employees within the scope of the FSA Remuneration Code.

Incentives should be balanced so that at least one-half of variable remuneration offered in respect of a financial year is in the form of a long-term incentive scheme with vesting subject to a performance condition with half of the award vesting after not less than three years and of the remainder after five years. Short-term bonus awards should be paid over a three-year period with not more than one-third in the first year. Clawback should be used as the means to reclaim amounts in circumstances of misstatement and misconduct.

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