First published: Insurance Day [25th July 2008]
In recent speeches, both Callum McCarthy, outgoing Chairman of the FSA, and Hector Sants, its Chief Executive, have called upon the financial sector to reconsider its incentive structures. Their criticism is focused on remuneration structures which place excessive emphasis on short-term performance, in other words where employees receive immediate rewards and do not bear the consequences of any subsequent losses.
In the FSA's view, firms should focus on ensuring, as far as possible, that employees and shareholders share in the risk of both the upside and the downside. But how practical is that and who is the FSA seeking to protect?
The FSA's statutory objectives are maintenance of confidence in the financial system, promotion of public understanding, protection of consumers and reduction of financial crime. In its comments on remuneration structures, however, the FSA appears particularly concerned with risk to shareholders rather than consumers, although this emphasis may be a reflection of the audience to whom Callum McCarthy and Hector Sants were expressing their views. And it is certainly true that a company which goes bust is of little use to consumers who will have only the FSCS to fall back on. Whatever their reasoning, the message from the FSA is that boards and shareholders must place increased focus on the incentive structures currently in place. Whilst Hector Sants has stated publicly that it is not the regulator's role to dictate quantum of individual remuneration, he has made it clear that the FSA does need to consider the implication of remuneration structures on the risk posed by individual institutions – and that they will do this with increased intensity.
But are employees motivated by long-term incentives or by short-term gains? The FSA's concerns might be understandable but some of their suggestions will surely prove unpopular. If the remuneration structures available within the financial services industry are unattractive, we could see a drain of talented individuals to less regulated industries with more attractive incentives on offer.
Achieving the goal of shared risk between employees and shareholders by deferred compensation, coupled with the use of claw-back provisions as suggested by Hector Sants, will surely meet resistance. The circumstances in which claw-back would bite would have to be very clearly set out and may be difficult to frame adequately. In practice, it may only be realistic where some element of deferred compensation is yet to be paid. That said, the ABI's own remuneration guidelines, (predominantly for companies with a main market listing, but the ABI encourages all companies to observe them in the spirit of best practice), also suggest that there should be discretion to reduce or reclaim bonus payments in circumstances where performance achievements are subsequently found to have been significantly "mis-stated". Firms must also take care to ensure that deferral of compensation or delay in vesting of share options would not be considered an unreasonable indirect restraint on trade, for example where those rights will be lost if an employee leaves under certain circumstances.
The FSA also seems to take issue with incentives being based on performance of individual parts of an organisation. The ABI's remuneration guidelines similarly talk about vesting of awards under share incentive schemes being conditional on satisfaction of performance conditions which should relate to overall corporate performance – but employees may expect to be remunerated in respect of their own performance and that of their team and not be disadvantaged by under-performing colleagues. Certainly bonus arrangements based on performance of a division rather than the company as a whole are not uncommon in the broking industry.
One thing that is clear is that FSA-regulated firms will need to take a good look at the incentive structures they have in place. Firms should consider whether to establish remuneration committees and, where a committee is already in place, its make up. Employment contracts and bonus arrangements should be reviewed with an eye to the concerns identified by the FSA – and related issues such as ensuring that no excessive bonus obligations exist in the event of early termination of employment. If firms consider that their existing arrangements are satisfactory, they should be prepared to support that position in the face of the FSA's stated intention to focus on this issue with "increased intensity". Firms that fail to do so can expect further regulatory scrutiny. For insurers subject to risk-based capital requirements, that may manifest itself in greater perceived risk coupled with potentially increased capital requirements.
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