Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents


Conclusions and recommendations


Remuneration in the banking sector

1.  We note the concern expressed about the wide disparity in remuneration between different groups of employees in the banking industry, and recommend that Boards examine these disparities. (Paragraph 13)

2.  The banking crisis has exposed serious flaws and shortcomings in remuneration practices in parts of the banking sector and, in particular, within investment banking. Whilst the causes of the present financial crisis are numerous and diverse, it is clear that bonus-driven remuneration structures prevalent in the City of London as well as in other financial centres, especially in investment banking, led to reckless and excessive risk-taking. In too many cases the design of bonus schemes in the banking sector were flawed and not aligned with the interests of shareholders and the long-term sustainability of the banks. (Paragraph 25)

3.  Against this backdrop, and despite the widespread consensus that remuneration practices played a key role in causing the banking crisis, the apparent complacency of the Financial Services Authority on this issue is a matter of some concern. The Turner Review downplays the role that remuneration structures played in causing the banking crisis, and does not appear to us to accord a sufficiently high priority to a fundamental reform of the bonus culture. Such a stance sends out the wrong signals and will only serve to encourage some within the banking sector to believe that they have a green light to continue with the same discredited remuneration practices as soon as the political and media spotlight moves away from them. While the overall level of remuneration paid in the private sector should not be regulated, there is a legitimate public interest in the way in which the structure of remuneration packages might create incentives for particular types of behaviour. We urge the FSA to make tackling remuneration structures in the banking sector a higher priority. (Paragraph 26)

4.  There is a widespread consensus that remuneration practices in the banking sector must change, especially in those banks which have had recourse to any form of support from the taxpayer. The regulatory authorities must grasp the nettle and implement far-reaching reforms which will sweep away the broken remuneration models of the past. The failure to act meaningfully in this area would be viewed with incredulity amongst the general public and further erode trust and confidence in the banking sector. (Paragraph 33)

5.  The FSA was extremely slow off the mark in recognising the risk that inappropriate remuneration practices within the banking sector could pose to financial stability. Its inattention in this area provided the essential backdrop against which deleterious remuneration practices were allowed to flourish in the UK banking sector. The very modest action that the FSA took on this issue prior to the current financial crisis—the occasional speech which referred in passing to remuneration—was far too little and far too late in the day to make any tangible difference to prevailing practices in the banking and the financial sector. (Paragraph 37)

6.  The Financial Services Authority has confirmed that it intends, if necessary, to impose higher capital requirements on banks and other financial services firms whose remuneration practices do not comply with its code of practice on remuneration in the banking sector. We endorse this approach, but urge the FSA not to shy away from using its powers to sanction firms whose activities fall short of good practice. We believe that alongside a greater willingness to penalise such firms who fall short of good practice, the FSA must also provide regular reports on what action it has taken on remuneration policy in the banks. This would enhance transparency and provide reassurance to the public that changes in remuneration practices within the sector are being enforced. (Paragraph 42)

7.  There is much public resentment at the large salaries and bonuses awarded to some bankers. Vociferous calls have come from some quarters for the FSA to regulate pay levels in the City of London. Whilst such demands are understandable in the present crisis conditions, the FSA's role is to examine and penalise inappropriate remuneration practices in the banking sector solely with respect to their financial stability implications of those practices. We do not believe it should be the FSA's function to regulate levels or the amount of pay within the banking sector. (Paragraph 46)

8.  The use of mechanisms to defer or clawback bonus payments from senior and board level staff should be encouraged to align the interests of senior staff more closely with those of shareholders. We support the more widespread use of such tools within the sector, which would help discourage excessive risk-taking and short-termism. (Paragraph 51)

9.  The banking sector and, in particular, the investment banks are clear outliers in terms of the extent to which they rely upon variable pay and bonus payments to reward staff. We note that the prevalence of variable pay practices within the sector partly reflects the cyclical nature of investment banking. There is, however, considerable scope for the bonus element to be linked more closely to long-term performance and the achievement of shareholder value. (Paragraph 53)

10.  We note that some sections of the banking industry have adopted a proactive stance to reforming remuneration policy and that some firms have already begun to review and amend their practices. That said, whilst there has been much discussion of the need for reform, we are concerned that genuine action continues to lag behind. We have a suspicion that many bankers remain unconvinced by the need for change and believe that, once 'the storm dies down', it will be a case of 'business as usual'. For this reason, self-regulation or a light-touch approach to regulating remuneration in the banking sector is unacceptable. The Government, the FSA and relevant international institutions must exercise vigilance and ensure that the discredited practices of the past do not creep back in under the radar of the authorities. (Paragraph 60)

11.  It is not uncommon for many of the highest paid individuals in an investment bank to be below board level. Despite this, there is currently no disclosure of remuneration for senior and highly-paid individuals who happen not to sit on the board. We believe that there is a compelling case to reform the disclosure rules in the remuneration report of banks and other financial services companies to include disclosure of remuneration of senior managers at sub-board level. Such firms should be required to report details of the remuneration structures in place for high-earning individuals falling within particular pay bands, including the use of deferred bonus payments or clawback mechanisms. The provision of such information is necessary in order to strengthen the ability of shareholders to provide more effective oversight of compensation practices in financial firms and assess the appropriateness of those practices. (Paragraph 65)

12.  Shareholders have had an advisory vote on companies' remuneration reports since 2002. However, our evidence suggests that this advisory vote has largely failed to promote enhanced scrutiny of, or provided an effective check on, remuneration policies within the sector. We believe the time is now ripe for a review of how institutional investors with holdings in the financial services sector have exercised these rights. We expect the Walker Review on corporate governance in the banking sector to examine this issue as part of its work. (Paragraph 68)

13.  Remuneration is the primary responsibility of management. Management controlled by the board have responsibility for setting pay throughout the organisation. The role of remuneration committees is more limited. They have responsibility for the oversight of remuneration for senior executives within their firm. The events of the last eighteen months have demonstrated clear failings in the operation of many remuneration committees in the banking sector. Too often remuneration committees appear to have operated as 'cosy cartels', with non-executive directors all too willing to sanction, as the ABI notes, the ratcheting up of remuneration levels for senior managers whilst setting relatively undemanding performance targets. The failures of remuneration committees to fulfil their function effectively demonstrates the need for reform in this area. We believe that there is a pressing need for increased expertise on remuneration committees as well as increased transparency and independence of mind. (Paragraph 75)

14.  We believe that there is a compelling case for strengthening the links between the remuneration, risk and audit committees, given the cross-cutting nature of many issues, including remuneration. (Paragraph 76)

15.  It is our view that remuneration committees would also benefit from having a wider range of inputs from interested stakeholders—such as employees or their representatives and shareholders. This would open up the decision-making process at an early stage to scrutiny from outside the board, as well as provide greater transparency. It would, additionally, reduce the dependence of committees on remuneration consultants. We expect Sir David Walker seriously to consider this issue as part of his review of corporate governance in the banking sector. (Paragraph 77)

16.  We have received a body of evidence linking remuneration consultants to the upward ratchet of pay of senior executives in the banking sector. We have also received evidence about potential conflicts of interest where the same consultancy is advising both the company management and the remuneration committee. Both these charges are serious enough to warrant a closer and more detailed examination of the role of remuneration consultants in the remuneration process. We urge Sir David Walker to examine these issues and, in particular, to consider whether remuneration consultants should be obliged to operate by a code of ethics, a proposition which we find attractive. (Paragraph 82)

17.  There is understandably considerable public resentment and anger at the fact that both RBS and the Lloyds Banking Group are continuing to pay bonuses despite relying upon taxpayer support for survival. This has been fuelled further by the lack of transparency and uncertainty regarding the exact cost of bonus payments, including deferred bonus promises, made by the two banks and to whom such payments have been made. The Government and UKFI must urgently address the problem of a lack of transparency in bonus payments at the part-and wholly nationalised banks and ensure that clear and comprehensive information about bonus payments and promises made by these banks is brought into the public domain. (Paragraph 94)

18.  We wholeheartedly support the continuation of bonus payments to staff on modest salaries within RBS and Lloyds Banking Group when justified by their own performance and the commercial performance of the organisations as a whole. Such staff played no role in the downfall of their banks and they should not be penalised for failures at the top of their organisations. The need to protect lower paid staff in the two banks must be separated from continuing bonus payments to higher paid employees. Whilst we believe that there is a strong case for curbing or stopping bonus payments for staff on higher salaries and, in particular, for senior managers, we accept the argument put forward by the Government and UKFI that the position of the banks would be worsened if they could not make bonus payments. We agree that unduly strict restrictions on bonuses to such staff would result in the banks struggling to recruit and retain talented staff and that this would be to the detriment of the taxpayer as a major shareholder in both institutions. (Paragraph 95)

19.  Lord Myners' account of events on that complicated weekend in October is at variance with that of Sir Tom McKillop and both have forcefully presented their perspectives. The truth is that this was an incredibly pressured 72-hour period in the history of British banking. We are not surprised that accounts differ. But we do not believe that Lord Myners' assertion that his precept to the RBS Board—that there should be no reward for failure—represents an adequate oversight of the remuneration of outgoing senior bank staff. Such a precept is open to different interpretations, as events have proved. It would have been far better if Lord Myners had given a stronger, clearer direction of Government requirements for a bank in receipt of public funds and had assured himself by demanding to be kept informed of the detailed negotiations that were taking place. This task could quite properly then have been subordinated to an appropriate Treasury official but should not have been neglected altogether. (Paragraph 121)

20.  Secondly, we are not convinced that Lord Myners was right to take on trust RBS's suggestion that there was no option but to treat Sir Fred as leaving at the employer's request. It would, we believe, have been open to Lord Myners to insist that Sir Fred should be dismissed. Glen Moreno, Acting Chairman of UKFI, told us that in his view sometimes there came a point when a Board had to agree to dismiss someone who had failed even if that might trigger law suits. We think in this case that should have been the response of RBS and that the Treasury should have insisted on this as a condition of support. We further are not impressed by the argument that there would have been a collapse in confidence for the rescue if Sir Fred had been dismissed and his deputy had taken over as acting chief executive for that short period, which was the RBS position. (Paragraph 122)

21.  Thirdly we are not convinced that the Treasury was right to rely on the current RBS Board to handle these negotiations without direct Treasury involvement. The RBS Board had shown itself to be incompetent in the management of the Bank, steering it towards catastrophe, and also possibly dominated by Sir Fred; there were no grounds for trusting them with this operation. We suspect that Lord Myners' City background, and naiveté as to the public perception of these matters, may have led him to place too much trust in the RBS Board. Indeed, in evidence to us he described the RBS Board as 'distinguished' . (Paragraph 123)

22.  However, returning to the bigger picture, we accept that the Treasury's key responsibility was to support the banks at a time when markets were exceptionally jittery and when a grave systemic crisis was only hours away. (Paragraph 124)

Corporate governance

23.  The apologies we have heard from RBS and HBOS had a polished and practised air. These witnesses betrayed a degree of self-pity, portraying themselves as the unlucky victims of external circumstances. There should be no doubt that, prior to their public fall from grace, some of whom were regarded as among the most able and competent leaders in British industry. Discriminating between the personal blame that should attach to bank executives, and that appertaining to the force of global circumstances is difficult. Yet it is self-evident that some banks have weathered the storm better than others; and some have not required taxpayer assistance to navigate through the 'credit crunch'. These facts alone make the charge of management failure impossible to resist. Banks have failed because those leading and managing them failed. Much criticism has been levelled at the city culture which encouraged excessive risk taking. The banks' boards must also take their responsibility for failing in their duty to establish a culture within their institutions which supported both innovation and risk management. (Paragraph 134)

24.  The current financial crisis has exposed serious flaws and shortcomings in the system of non-executive oversight of bank executives and senior management in the banking sector. In particular, the evidence shows that many non-executive directors—in many cases eminent and highly-regarded individuals with no shortage of experience in the business and banking worlds—failed to act as an effective check on, and challenge to, executive managers. Too often non-executive directors in the banking sector have operated as members of a 'cosy club' rather than viewing their role as being that of providing effective checks and balances on executive members of boards. (Paragraph 151)

25.  This failure to act as an effective check on senior managers has a number of causes, which policy makers must address. First, there is the lack of time many non-executives devote to their role. We were surprised to learn that some non-executive directors appear able to combine their non-executive role with that of chief executive of a FTSE 100 company, or to hold four or five director or trusteeships. Secondly, too many non-executive directors within the banks lack relevant banking or financial experience; we wonder how, in such instances, they can effectively challenge, scrutinise and monitor business strategy and the executive management in a sector as complex as banking. Finally, we are concerned that the banks are drawing upon too narrow a talent pool when appointing non-executive directors to the detriment of diversity of views. The Walker Review must address as a matter of urgency the issue of broadening the talent pool from which the banks draw upon. (Paragraph 152)

26.  We believe that there are a number of areas of reform which are worthy of further consideration. Firstly, whilst there may be a case for limiting the number of non-executive director or trusteeships that an individual can hold, we believe an alternative way forward would be to apply the 'comply or explain' approach where an individual who holds more than a certain number of posts would have to provide an explicit defence of how they will be to fulfil this role in addition to their other duties. Secondly, serious consideration should be given to whether all non-executives—or a proportion of non-executives—sitting on bank boards should be required to have professional qualifications relating to banking or other areas of relevance such as accountancy. Thirdly, we believe that there is a strong case for non-executive directors in the banking sector to have dedicated support or a secretariat to help them to carry out their responsibilities effectively. Finally, there is a need to examine ways in which the relationship between institutional investors and non-executive directors could be strengthened. (Paragraph 153)

27.  We believe that the scale of the current banking crisis stands as testament to the fact that risk has not been well managed by the boards of banks across the globe. It is vital that non-executive directors in particular exercise more effective oversight and resist the urge to ally themselves too closely with the managers they are charged with scrutinising. We believe that within banks, the risk management function should report directly to the non-executive members of the board. This is something that the FSA should vigorously pursue. (Paragraph 158)

28.  Sir David Alan Walker was previously chairman of Morgan Stanley International and remains a senior advisor to that firm. He has also served as chairman of the Securities and Investments Board (1988-92), Executive Director for finance and industry at the Bank of England (1989-95), and Deputy Chairman of Lloyds TSB (1992-94). In 2007 Sir David was commissioned by the UK private equity industry to produce guidelines for disclosure and transparency in private equity. His experience and professional background means that he undoubtedly fits the description of a 'City grandee'. However, we are not convinced that Sir David's background and close links with the City of London make him the ideal person to take on the task of reviewing corporate governance arrangements in the banking sector. (Paragraph 161)

29.  Institutional investors have failed in one of their core tasks, namely the effective scrutiny and monitoring the decisions of boards and executive management in the banking sector, and hold them acountable for their performance. We note David Pitt-Watson's evidence to us which questioned the extent of investor engagement with the banks prior to the current crisis. We accept that there has been increased engagement by investors once signs of the crisis began to emerge, although some appear to have chosen to sell their stakes in the banks rather than intervene or challenge bank boards. Those that did not just sell up appear to have been asking the wrong questions or, as Lord Myners told us, just gave up. This may reflect the low priority some institutional investors have accorded to governance issues. The lack of resources devoted to corporate governance appears to reflect a range of factors including the fragmented and dispersed ownership and the costs of detailed engagement with firms—resulting in the phenomenon of 'ownerless corporations' described by Lord Myners. The Walker Review on corporate governance in the banking sector must address the issue of shareholder engagement in financial services firms and come forward with proposals that can help reduce the barriers to effective shareholder activism. (Paragraph 179)

Credit Rating Agencies

30.  It is worrying that markets appear to have used credit ratings for more than they were designed to do. Their primary role should be to provide an outside opinion on the credit risk of a product, not as a potential guide to its overall market price or liquidity risk. This 'overuse' may have been more prevalent among smaller investors, though our suspicion is that they had become a convenient short-cut for more experienced market professionals as an alternative to their own due diligence. (Paragraph 188)

31.  We cannot accept the credit ratings agencies' argument that they were well-equipped to rate the complex financial products that marked the recent period of exuberant market expansion. History has proved otherwise. Ratings agencies, whether they like it or not, are significant market participants, and their decision to rate a product is an important step to ensuring a market develops in a product. Credit ratings agencies should ensure a greater lead time before rating new products, so that the default characteristics of such products can more assuredly be measured, and therefore commented upon. (Paragraph 195)

32.  We remain deeply concerned by the conflict of interests faced by credit rating agencies, and have seen little evidence of the industry tackling the problems highlighted in our report on Financial Stability and Transparency with any sense of urgency. We do, however, recognise that there are conflicts inherent in every payment model. It is our view that transparency offers the best available defence against conflicts of interest and we recommend that CRAs publicise more widely the safeguards they have in place to mitigate the risks posed by conflicting interests. It remains that case that, with the major rating agencies being US based, global coordination of regulatory efforts in this area is required. (Paragraph 204)

33.  We believe the issues of over-reliance and the quality of ratings are interconnected: if the flaws and limitations of ratings were more widely recognised over-reliance would naturally decline. To some extent many of the problems engendered by CRAs will disappear as a consequence of market forces. There is unlikely to be a great deal of appetite in the near future for complex securitised instruments which have been most poorly measured by CRAs. We support the European efforts to throw light on the methods and methodologies of rating agencies and we call upon the regulators and the CRAs to ensure that new information reaches all users of their service. (Paragraph 210)

34.  We note that the major credit rating agencies are global organisations. We call upon the Government to take forward efforts with other governments so as to ensure that a globally consistent approach to regulating credit rating agencies is achieved. (Paragraph 215)

Auditors

35.  We have received very little evidence that auditors failed to fulfil their duties as currently stipulated. The fact that some banks failed soon after receiving unqualified audits does not necessarily mean that these audits were deficient. But the fact that the audit process failed to highlight developing problems in the banking sector does cause us to question exactly how useful audit currently is. We are perturbed that the process results in 'tunnel vision', where the big picture that shareholders want to see is lost in a sea of detail and regulatory disclosures. (Paragraph 221)

36.  We are not convinced that auditors are particularly well placed to provide additional assurance regarding the risk management practices of financial institutions. Bearing in mind the view of the Chief Executive of the Financial Reporting Council, that auditors were not competent to perform such a role, it would be perverse to come to any other conclusion. A better way to ensure that banks manage their risks would be to concentrate on the banks' own internal risk management functions, complemented by more invasive regulation of risk by the FSA. (Paragraph 225)

37.  The FSA's piecemeal approach to garnering auditor knowledge about individual banks indicates to us a wasted opportunity to improve the effectiveness of bank supervision. In future, the FSA should make far more use of audit knowledge, on a confidential basis. We are grateful for the response by the ICAEW in bringing together audit firms and drawing up some suggestions to strengthen links between the FSA and auditors. We recommend that the FSA should respond to each of the five suggestions made by the ICAEW. (Paragraph 231)

38.  We remain concerned about the issue of auditor independence. Although independence is just one of several determinants of audit quality, we believe that, as economic agents, audit firms will face strong incentives to temper critical opinions of accounts prepared by executive boards, if there is a perceived risk that non-audit work could be jeopardised. Representatives of the investor community told us of their scepticism that audit independence could be maintained under such circumstances. This problem is exacerbated by the concentration of audit work in so few major firms. We strongly believe that investor confidence, and trust in audit would be enhanced by a prohibition on audit firms conducting non-audit work for the same company, and recommend that the Financial Reporting Council consult on this proposal at the earliest opportunity. (Paragraph 237)

39.  The Financial Reporting Council should build on steps it has already taken to ensure that users of accounts are sufficiently well informed about going concern considerations that the issuance of modified audit opinions does not result in undue panic. With a view to the longer term, we believe there is a case for the FRC to consider the introduction of a graduated ladder of concern, along the lines suggested by Professor Power. We would welcome a system whereby the auditor could transparently express an opinion on a bank's future, without triggering emergency action by the FSA. (Paragraph 243)

40.  We believe that the complexity and length of financial reports represent a missed opportunity to improve the understanding that users of accounts possess of the financial health of firms and recommend that the FSA consult on ways in which financial reporting can be improved to provide information in a more accessible way. At the moment, financial reports can be used for finding specific bits of information, so are useful for reference, but they do not tell the reader much of a story. We would like them to read less like dictionaries and more like histories. A useful approach would be to insist on all listed firms setting out their business model in a short business review, in clear jargon-free English, to detail how the firm has made (or lost) its money and what the main future risks are judged to be. (Paragraph 247)

Fair value accounting

41.  Fair value accounting has led to banks publishing some very dispiriting financial results, but this is because the news itself has been bad, not the way in which it has been presented. The uncomfortable truth for banks is that market participants had over-inflated asset prices which have subsequently corrected dramatically. Fair value accounting has actually exposed this correction, and done so more quickly than an alternative method would have done. Important features of accounting frameworks are that they encourage transparency and consistency across firms and asset classes. But it is a bridge too far to expect them to also lead to intelligent decision-making. We do not consider fair value accounting to be a suitable scapegoat for the hubris, poor risk controls and bad decisions of the banking sector. (Paragraph 254)

42.  We consider that fair value accounting has featured an element of pro-cyclicality through its interlinkage with the Basel capital requirements. This is not a fault of the accounting standards, but rather a result of published accounts being used too crudely in the calculation of regulatory capital requirements. The primary audience of accounts are the shareholders, who have a desire to see the true worth of their firm. The FSA, as the banks' supervisor, is a secondary user of the accounts, and has a legitimate interest in ensuring that firms are run prudently. This is not the same objective as that of the shareholder, so the regulator need not rely, and certainly should not rely exclusively, on the published accounts in calculating capital requirements. We will consider ways in which the FSA might introduce such an element of prudence in the capital regime in our forthcoming report on public regulation. (Paragraph 257)

43.  The existence of the European Commission's carve-out power seriously undermines the ability of the International Accounting Standards Board to project itself as a truly global setter of accounting standards, and indeed threatens the integrity of published accounts. Both are profoundly regrettable. Any threatened carve-out effectively presents the IASB with an invidious choice between losing the IASB's coverage of the European Union on the one hand, or acceding to the Commission's demands at the expense of a loss of credibility in other nations on the other. We are concerned that the IASB has already become tarnished by the accusation that it gave in too easily to the Commission's demands over fair value accounting, and by its suspension of its usual consultation process. We recommend that the Treasury consider the impact of the Commission's carve-out power on the prospects for the IASB's reputation and continuing work in establishing a global set of accounting standards. (Paragraph 267)

The role of the media

44.  Our evidence does not support the case for any further regulation of the media in response to the banking crisis. A free and functioning press is a basic requirement of a democracy. Regulation of the media in the context of internet publication would be impractical as well as undesirable. We are not convinced by the need to draw up a parallel system of 'financial advisory' notifications to mirror the system applying to defence. The press has generally acted responsibly when asked to show restraint in particular areas. Too often, indeed, those responsible for creating the current crisis have sought refuge in blaming the media for their own conduct. (Paragraph 283)

45.  We acknowledge the sensitivity of much of the material broadcast by the media during the current crisis. We appreciate the pressures of competition and of the 24-hour news cycle. These can coarsen financial journalism, preventing reflection and reducing the space for verification and balancing material. It is important that editors take a responsible approach to breaking news and in particular that they verify their sources with scrupulous care. But it is crucial that the public are kept informed about institutions holding their money. If the public is to trust the banks in the future it needs to be confident it has sufficient information on how they are operating, and that such information is not restricted to those on the inside. Indeed, the Government may wish to look carefully about the disclosure obligations applying to banks and other financial institutions to see if further transparency would be beneficial. (Paragraph 284)









 
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