Changing Banking for Good - Parliamentary Commission on Banking Standards

Changing Banking for Good - Parliamentary Commission on Banking Standards Contents

8 Remuneration

Introduction

806. In Chapter 3 we described how elements of remuneration in banking contributed to the problems of standards and culture in the sector. In particular, we noted:

· Remuneration is still higher than can be justified on the basis of performance;

· Incentives in investment banking and at the top of banks are linked to inappropriate measures that incentivise short-termism and a distorted approach to risk-taking; and

· Poorly constructed incentive schemes in retail banking have incentivised poor conduct.

807. In this chapter and Annex 6 we consider:

i. the underlying causes of the flawed approach to remuneration in banking;

ii. the current public policy framework, nationally and internationally, in relation to remuneration in the UK banking sector (see Annex 6);

iii. the relationship between fixed and variable remuneration;

iv. the various ways in which variable remuneration is set, the conditions on the release of variable remuneration and the forms which variable remuneration can and should take;

v. the particular characteristics appropriate for remuneration for Board members;

vi. the challenges of effecting change in this area given the international dimension; and

vii. the implementation of proposed policy changes and the monitoring of underlying trends in remuneration in the sector.

Rewards out of kilter

INTRODUCTION

808. There are many causes of the flawed remuneration schemes that have contributed to problems of banking standards. In Chapter 3, we presented evidence that bankers have been paid in a fashion that incentivised undesirable conduct and risky behaviour. In turn, remuneration reinforced a culture whereby poor standards were considered normal. There are further underlying causes:

i. senior bankers have enjoyed an imbalance between the potential personal upsides and downsides of their activity that has incentivised unduly risky decision-making;

ii. distortions to the market, including the implicit guarantee and the related entrenched oligopolies that characterise parts of the industry, enable banks to extract value in excess of their economic contribution, much of which is distributed to staff; and

iii. structural imperfections in bank corporate governance that tend to contribute to the escalation of remuneration.

These further underlying causes are considered in further detail below.

THE ONE-WAY BET

809. At the heart of the problem with much of bankers' remuneration is a misalignment of risk and reward. The potential rewards for bankers if things go well are huge, but if things go badly, there is less downside. Remuneration practices have brought about what Virgin Money termed a "'heads we win, tails you lose' culture".[1321] This problem is not new, as Box 14 demonstrates.

Box 14: The One Way Bet

The 1929 crash was investigated by US Senate Committee on Banking and Currency in the "Pecora Inquiry". The Committee took evidence from Albert H Wiggin, Chairman of Chase National Bank on his high pay and bonuses. For example, in 1928, Mr Wiggin was paid a salary of $175,000 and a bonus of $100,000, equivalent to approximately $2.4 million and $1.4 million in today's prices.[1322] The Pecora Report noted "additional compensations were paid in profitable times, without any charge-off in the periods when losses were sustained by the bank":

Senator Adams: Upon what theory were those bonuses paid?

Mr Wiggin: Additional compensation in profitable times, on the theory that the salaries of the officers, which were distributed all through the entire staff, you know----

Senator Adams: They credited you with being responsible for some of their added profits in the good years

Mr Wiggin: I think so, sir.

Senator Adams: In the bad years did they charge you in any way with responsibility for losses?

Mr Wiggin: No, sir.

Senator Adams: It has only worked one way?

Mr Wiggin: Only one way.

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810. Historically, British merchant banks and their US counterparts, investment banks, were private partnerships. The ABI told us that partners were rewarded for risking their wealth:

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Andy Haldane told us that in a partnership model, bankers "have skin in the game right up until the death".[1325] Sir Mervyn King argued that investment banking "is an activity whose natural form of activity is a partnership, rather than a limited liability company".[1326]

811. In 1999, Goldman Sachs, under the co-Executive Chairmanship of Jon Corzine and Hank Paulson, became the last major investment bank to float.[1327] All the major international banks that operate in London are now public companies. Michael Cohrs noted that financial services firms with partnership models, such as many hedge funds, tended to perform better in the aftermath of the financial crisis.[1328] Referring to Goldman Sachs' strong risk management record, Sir Mervyn King said that "for over a century they were a partnership and learned how to manage risk, and they say they have not forgotten it".[1329] However, Michael Cohrs cautioned that it was "hard to imagine" a return to a partnership structure given the size of modern banks.[1330]

812. Employees of listed banks face much more limited personal losses or exposures in the event of assets defaulting or the company failing, than do partners. Dr Alexander Pepper of the Department of Management at the London School of Economics and Political Science said that:

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As a result, as the ABI told us, "bonuses have become a free option on the upside for banks" employees, with no corresponding share in the downside".[1332] This creates incentives for bankers to make risky bets with shareholders' capital. We noted in Chapter 3 that remuneration systems based on short-term financial measures have similar effects.

813. Due to the long term nature of the assets and the liabilities in banking, risks often do not materialise until some years after the event from which they arise. So-called "Long Term Incentive Plans" (LTIPS) typically defer pay for three to five years.[1333] This does not reflect the length of time over which risks in banking can materialise. For example, a business cycle lasts around seven years,[1334] while, in the case of mis-selling, "the poor quality and suitability of the product often does not become apparent until many years after it is sold".[1335]

814. In addition, the proportion of remuneration that is currently deferred is low. The following table sets out the outstanding aggregate sums of deferred remuneration at the five quoted UK banks, for the years this information was disclosed:

At Barclays, which has the largest investment banking business of the five banks, deferred compensation outstanding was equivalent to one-sixth of total compensation in 2012. In the other banks, it was lower still: the total outstanding sum of deferred compensation at LBG was just £52m at the end of 2012. This represented less than one per cent of 2012 staff costs and compared with a total aggregate of £6.8bn provided against PPI related costs.[1336] Deferred remuneration has also generally been on a downward trend, as variable compensation has fallen and the proportion that is fixed has risen.

815. A further characteristic of deferral as it has operated in recent years is that it is common for employees to lose their entitlement to deferred payments when they leave a firm. A new firm will often therefore offer to "buy out" the deferred payments to compensate the employee for these lost payments and incentivise them to change allegiance. Andrew Williams, UBS Head of Global Compliance, explained how this affected the ability to claw back sums from a former employee of that bank implicated in LIBOR misconduct:

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816. Pension entitlements also act to reinforce the one way bet, enabling individuals to accumulate substantial pots of wealth insulated from the effects of failure. James Crosby retired from HBOS in 2006, two years before that bank's collapse, with a pension transfer value of £10.4m.[1338] Because Fred Goodwin was asked to retire early, the value of his pension increased by £8.3 million in 2008, reflecting the full pension rights he would have accrued had he worked until aged 60, assuming, of course, that RBS still existed. The following table sets out the transfer values of the accrued pension rights,[1339] of the executive directors of UK banks that received equity support from the taxpayer during the crisis:

After significant public pressure, Fred Goodwin agreed to reduce the value of his pension rights by one-third to £12.2m, comprising a lump sum of £2.7m and an annual pension of £342,500.[1340] Following our Report into the failure of HBOS, James Crosby announced that he would voluntarily forgo one-third of his pension entitlements, leading to reduction in his annual income from that source from about £580,000 to around £400,000.[1341]

HARVESTING THE FRUITS OF MARKET DISTORTION

817. In Chapter 3, we described the implicit taxpayer guarantee, made explicit in the aftermath of the financial crisis, which continues to be enjoyed by banks. Douglas Flint, Group Chairman of HSBC Holdings, argued that "the implicit subsidy that the Government gave was passed on to customers".[1342] Other witnesses disagreed. Andrew Bailey directly linked high pay to the implicit subsidy:

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Sir Mervyn King concurred:

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The concept of rent-seeking is considered in Box 15.

Box 15: Economic rent

Economic rent is income in excess of the minimum needed to attract an individual or firm to conduct a task. If a model would not get out of bed for less than $10,000, but is paid $15,000 for doing so, she is extracting economic rent of $5,000.

Economic rent derives from imperfections in the market. In a perfectly competitive market, economic rent is entirely driven out: the model is undercut by other models until she is only paid $10,000, just enough to do the work. This equivalent to her opportunity cost: the value to her of staying in bed instead.

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The Trouble with Markets, Saving Capitalism from Itself

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818. Bill Winters told us that investment banker remuneration in universal banks was inflated by the guarantee. The subsidy allowed "banks to operate with tremendous advantages relative to any others participating in capital markets". The consequence was a "transfer of value from taxpayers to banks and from banks to bankers".[1349] The taxpayer guarantee has a mutually-reinforcing relationship with oligopoly. Andy Haldane has dubbed this a "self-perpetuating doom loop":

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819. Roger Bootle has suggested that investment banking itself operates as an oligopoly, noting that market concentration has increased since the 2007-08 financial crisis, an issue discussed. He has linked this lack of competition to high levels of remuneration:

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Paul Volcker said that the spread of the compensation culture of investment banking was behind some of the worst excesses seen in retail banks:

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Referring to his experience of the merger between J.P. Morgan & Co, an investment bank, and Chase Manhattan, primarily a retail bank, in 2000, Bill Winters noted that "there were people running mid-sized businesses in credit cards, mortgages, consumer loans or small business lending who were paid well above their counterparts at pure retail banks, because they were being measured against investment banking-type metrics".[1353]

820. Many bank staff are not highly paid. Antony Jenkins told us that Barclays "employ people who make £12,000 per year and […] people who make many, many multiples of that".[1354] The latest Barclays Annual Report showed that, while it hands out very large rewards to hundreds of staff, more than half of its 140,000 employees, concentrated in its retail division, earn less than £25,000 per year.[1355] Ged Nichols and Helen Weir both told us that staff selling PPI in branches would have been paid around £20,000 per year.[1356] However, high remuneration is not restricted to investment banking. Lloyds Banking Group is predominantly a traditional banking institution, with 90 per cent of its assets already inside the anticipated ring-fence.[1357] In 2012 it paid 25 staff over £1 million, including five between £2 million and £3 million.[1358] The most highly paid executive, Chief Executive Antonio Horta-Osório, received total emoluments of £3.4 million.[1359] Santander UK, a retail bank, awarded its Chief Executive, Ana Botín, £4 million in 2012, including a salary of £2 million. It paid a further 18 staff over £1 million.[1360]

BANKS WILL NOT SOLVE THIS THEMSELVES

Introduction

821. It is not in the interests of companies or their owners systematically to pay staff more than they are worth for a sustained period. Likewise, it is not in their interests to encourage staff to take unsustainable or reckless risks with the firm's money or reputation. However, banks and their shareholders have sanctioned and, in many cases encouraged, such practices. In this section we consider why banks consistently pay bankers too much to do the wrong things.

Shareholders

822. We noted in Chapter 3 that shareholders are not adequately incentivised or equipped at present to discipline or constrain banks' behaviour.[1361] On the contrary, shareholders have, on occasions, increased pressure upon bank management to adopt high-risk, short-term strategies.

823. Profits in a public company are split three ways. Shareholder returns, in the form of dividends, compete with employee remuneration and retained profits held as capital. The ABI told us that with respect to banks, "in recent years this balance has been inequitable, with too much value being delivered to employees in contrast to the dividends paid to shareholders".[1362] Sir Mervyn King concurred:

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The NAPF said that there was "there is a need for a fundamental rethink of executive pay structures to ensure better alignment between rewards to management and the interests of long-term investors".[1364] PwC set out evidence that this distribution is currently further out-of-kilter than it was pre-crisis:

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824. Virgin Money told us "excessive remuneration reflects weak market discipline by shareholders".[1366] Sir David Walker said that deleveraging required to meet more stringent post-crisis capital requirements should result in shareholders being "much more attentive" to the "carve out" of returns between them and employees.[1367] However, there has been little evidence of meaningful shareholder action. Even during the 2012 AGM season, which was dubbed the 'shareholder spring', only two FTSE 100 companies, neither of them banks, had their remuneration reports defeated. Barclays, which had the largest dissenting vote among banks, had its Remuneration Report accepted by 73 per cent of votes cast in 2012. This rose to 95 per cent in 2013.[1368] Dr Tracy Long, founder of Boardroom Review, told us that the lack of shareholder engagement was:

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The talented Mr Ricci

825. Rich Ricci left his position as head of investment banking at Barclays in April 2013, a few weeks after receiving £18 million in deferred remuneration. The Financial Times reported that Mr Ricci "enjoyed £67.4 million of deferred share awards" during four years he served on the Barclays Group Executive Committee.[1370] He had joined that Committee in 2009, on the same day as Jerry del Missier, Tom Kalaris and Antony Jenkins. The accompanying press release described the appointments as "promoting new talent to the most senior executive level".[1371] Talent at Barclays did not come cheap.

826. Antony Jenkins told the Commission that "levels of pay are important because you have to be competitive to attract the best talent".[1372] Banks, including Barclays, UBS and RBS in investment banking, convinced themselves during the pre-crisis boom that to grow quickly, they should pay over the odds for talented individuals. Andrea Orcel, Chief Executive Officer of the UBS investment bank, explained:

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As well as driving the expensive recruitment of staff, the retention of talent also inflated the salaries of incumbent staff, as David Bolchover, a management writer, explained:

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827. David Bolchover argued that high remuneration in banking had been justified by the flawed argument that "only an extremely limited amount of people can do these jobs and therefore, by the laws of supply and demand, their pay should be extremely high". He suggested that this claim was not backed up by "proper evidence",[1375] and that it benefited people with "no particularly rare talent, who have not taken a risk and whose impact is questionable, capitalising on the fact that they are meeting very little resistance to their arguments".[1376] Justifying his own $1.5 emoluments for two days per week of work for the Board of a non-UK subsidiary of HSBC, John Thornton argued that "It is not full-time, but it is very involved."[1377] Adam Posen dismissed "the idea of the magical CEO or CFO, or future CEO […] someone of great perspicacity and leadership", arguing that "very few people are irreplaceable [and] can substitute for one another".[1378] The Salz Review of Barclays cited an interviewee who claimed that the system rewarded mediocrity:

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828. Alison Carnwath, the former Chairman of the Barclays Remuneration Committee (RemCo), argued that Bob Diamond used high remuneration as a management tool:

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Ms Carnwath suggested that Mr Diamond, "notwithstanding Barclays overall results[,] felt it necessary to retain bankers in anticipation of an upswing in business activities and to retain their loyalty".[1381]

Boards, benchmarking and the ratchet effect

829. PwC suggested that the "role of benchmarking and competitiveness considerations" in investment banking remuneration has increased in recent years. This was, they contended, partly due to banks competing to "build investment banking capability".[1382] Lloyds Banking Group referred to the creation, by fears of losing staff, of a "ratchet effect on pay and bonus levels as companies sought to protect their franchise".[1383] The TUC explained this effect in more detail:

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830. Fidelity Worldwide Investment said that the "inflationary dynamic fuelled by a desire to achieve a second quartile reward profile" was fuelled by "progressively more complex remuneration arrangements encouraged by a new profession of remuneration consultants".[1385] David Bolchover argued that there was "an extremely powerful nexus" comprising "headhunters, remuneration consultants and remuneration committees [with] a vested interest in high pay".[1386] Mr Bolchover argued that "a clear conflict of interest" led to remuneration consultants acting to inflate pay in banking, because they were "hired by the executives, whom they then recommend to be paid very well".[1387] Carol Arrowsmith, a remuneration consultant, denied this, stating that they are generally appointed by non-executives and, most typically, the Chairman of the Remuneration Committee.[1388]

831. The FSA summarised the role of RemCos as "to exercise competent and independent judgement on the bank's remuneration policies and practices".[1389] However, several witnesses told us that a shared outlook with the Chief Executive and Chairman, rather than independence, was vital to the success of a Remco. Alison Carnwath said that it was important that they were "on the same wavelength".[1390] Paul Sharma stated that "the RemCo works very well when it is aligned with the Chairman and the Chief Executive. Really it gets quite difficult when it is not".[1391]

832. Mr Sharma told us that reforming RemCos "can only take you so far" in improving standards. This, he said, was because "the basic culture issue is not addressed. The RemCo in and of itself can't solve the problem".[1392] The evidence we took from one RemCo Chairman, Sir John Sunderland, Chairman of the Barclays RemCo, in particular drew into question the ability of his Committee to effect cultural change through remuneration reform. Sir John stood by his support, as a then member of the RemCo, for the board's decision, against the advice of Alison Carnwath, the then RemCo Chairman, to award the then Chief Executive, Bob Diamond, a bonus for 2011. Sir John explained why he felt the bonus, of over £1.7 million[1393] in addition to a salary of £1.35 million,[1394] was deserved despite the poor financial performance of Barclays and emerging evidence of conduct failures:

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Sir John Sunderland later stated that a reduction in an individual's salary from one year to the next would be a "dramatic shift, and a very new concept"[1396] and an "interesting concept".[1397]

833. The current Chairman of Barclays, Sir David Walker, declined to criticise his RemCo Chairman on either count,[1398] because Sir David was "not interested in disinterring what might have happened in the past".[1399] He said that base salaries at Barclays were not considered an incentive, but were "set by reference to standards internationally".[1400] Responding to criticism of Barclays' decision to pay 428 employees more than £1 million in 2012,[1401] Sir David said that remuneration levels were "about right now" at his bank.[1402]

834. Antony Jenkins told us that Barclays have now adopted the policy of not "paying in the top quartile in aggregate as an organisation", although they would do so for "certain roles".[1403] PwC expressed "surprise that investment bank pay has not fallen faster given the high starting point" and the wider environment in which the industry operated. They partly attributed this stickiness in remuneration to a "survivor strategy" aimed at "retaining key talent" to take advantage of a subsequent economic upswing with fewer competitors.[1404] Carol Arrowsmith acknowledged that it could be difficult for remuneration committees to recommend bottom-quartile pay, because "it is always nice—it is a bit like everything in life—to hand out prizes".[1405]

835. Alison Carnwath told us that investment banking has been characterised by what she described as a "sense of entitlement [resulting in] obscene levels of award in a minority of cases and excessive reward in many cases".[1406] The Salz Review of Barclays explored this concept:

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In their written evidence, PwC suggested that the "psychological difficulty of cutting pay" was an important factor in the failure of rewards in investment banking to fall to levels commensurate with profitability.[1408]

Conclusions

836. Remuneration lies at the heart of some of banks' biggest problems. Risk and reward are misaligned, incentivising poor behaviour. The core function of banks should be to manage and price the risk inherent in the taking of loans and deposits and in holding other financial products over different time periods. One effect of limited liability is to enable individuals to extract high rewards predicated on disproportionate risks, sheltered from exposure to commensurate potential losses. This misalignment has been further reinforced by the implicit taxpayer guarantee and by the practice of making pay awards over a relatively short period. This has included remuneration for the creation and marketing of products, to retail and wholesale customers, for which the full costs and benefits may not be clear for many years. The risk inherent in complex derivatives is particularly hard to assess.

837. Aggregate remuneration continues to consume a high share of returns relative to shareholder dividends and capital. From this share, a relatively small proportion of senior management and supposedly irreplaceable key staff have received very large rewards. Banks should be free to compete in the global market: the use of remuneration to retain the most productive staff is a legitimate management tool. However, the financial crisis and its aftermath have exposed the extent to which many of the highest rewards were unjustified. Senior bankers have also benefited from a remuneration consultancy industry whose advice may itself have been distorted by conflicts of interest and by board Remuneration Committees trapped into ever higher awards by allegiance to colleagues and the ratchet effect of industry competitors. A culture of entitlement to high pay developed which has yet fully to be dispelled.

838. Over time, increased capital ratios, lower levels of leverage and structural changes to reduce the scale of the implicit taxpayer guarantee through ring-fencing will help to redress the misaligned incentives. However, these measures will not address all the problems that remain. Further public policy intervention is required.

839. The purpose of the Commission's proposals is, as far as possible, to address the misalignment of risk and reward, and in doing so, reduce the extent to which remuneration increases the likelihood of misconduct and of taxpayer bailout. The Commission's intention is not to prevent rewards when merited—and still less to exert retribution on a group or industry—but to ensure that the rewards of banking flow only in accordance with the full long-term costs and benefits of the risks taken.

The current policy framework

840. The remuneration of bankers, and director and executive pay in general, has been subject to substantial public policy change in recent years, much of which continues. The developments include:

· the international Financial Stability Board Principles for Sound Compensation Practices and their Implementation Standards, introduced in 2009;

· the FSA Remuneration Code, which intends to align bank remuneration with risk, introduced in August 2009 and updated in January 2011 to implement the provisions of the Third Capital Requirements Directive (CRD III);

· the Fourth Capital Requirements Directive (CRD IV), likely to be implemented in 2014, which includes provisions for a cap on bonuses paid to certain bankers as a multiple of fixed remuneration and increased pay transparency requirements; and

· amendments to the Companies Act 2006 requirements of quoted companies, made in the Enterprise and Regulatory Reform Act 2013, including a binding shareholder vote on the remuneration of directors.

The current public policy framework is set out in more detail in Annex 6.

Fixed and variable remuneration

Introduction

841. For much of the public, the excesses of banking in recent years are epitomised by enormous bonuses. Chapter 3 described how, though the level of cash bonuses has fallen in recent years, overall remuneration in major banks has largely been sustained through a shift towards more fixed remuneration. This section examines the relationship between fixed and variable remuneration and its policy implications.

Why banks pay bonuses

842. PwC set out three major benefits to banks of paying a high proportion of remuneration in variable form:

· it enables cost flexibility in face of variations in firm performance;

· it enables strong differentiation in pay between low and high performing areas; and

· it enables rapid cost reductions for business areas or individual employees being exited by the firm.[1409]

Nomura told the Treasury Committee that "the cyclical nature of investment banking revenues required firms to manage their staff costs carefully through economic cycles" and that paying variable bonuses meant that investment banks could "keep down their variable costs in lean times, while continuing to pay for performance".[1410]

843. PwC emphasised that investment bank bonuses were considered, by both banks and their employees, a normal part of compensation for satisfactory performance:

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844. Andrew Bailey warned that fixed remuneration is "essentially cash out of the door" and that it was much harder to recoup pay "once it has been paid [...] rather than when it is deferred and unvested".[1412] Douglas Flint identified the "paradox [that] there is quite a lot of public support for clawback, which can only happen with deferral and deferral can only happen with bonus. You cannot defer someone's salary".[1413] Erkki Liikanen concurred that "if you limit [variability] it takes away the flexibility [...] so that if the minimum salary is low there can be a high variable, then if the bank goes badly they just go down". However, Mr Liikanen went on to say that the ratio of variable to fixed remuneration had "grown too wide and has a negative impact on the long-term commitments":

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The EU bonus cap

845. In May 2013, the European Union agreed to cap the variable pay of particular bank staff at a maximum of 100 per cent of fixed pay, increasing to 200 per cent of fixed pay with the explicit agreement of shareholders. Bonus payments could account for, at the very most, two thirds of a European banker's annual remuneration. These provisions are enshrined in CRD IV and must be implemented by Member States by 1 January 2014. Previously, it had been thought that the bonus cap would only apply to employees classed as "material risk-takers". However, Europe's banking regulator, the European Banking Authority, has now broadened its definition to cover more financial services staff with the criteria widened to include staff earning more than €500,000 (currently approximately £420,000) per annum.[1415]

846. The economic case for a bonus cap was well put by The Financial Times:

Incentives work. People respond to them. Remuneration skewed towards short-term performance encourages risk-seeking behaviour in the short term. This is close to a verity; in the short term, all you need to do to make more money for a bank is take more risk.

Bonuses are asymmetric; they are not so variable that traders can be required to hand money back to shareholders in years when their trades come unstuck. This asymmetry will continue under the proposal, but at least it will be limited.

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847. Andrew Bailey warned that the bonus cap would "push up fixed remuneration" rather than act to reduce overall pay.[1417] Sir David Walker told us that the cap had already had this effect in some institutions.[1418] PwC cautioned that a reduction of flexibility in remuneration could result in volatility:

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Several witnesses argued that increases in fixed pay to compensate for reductions in variable remuneration could have undesirable behavioural effects. Sir Mervyn King argued that "to give banks an incentive to raise the fixed remuneration at present, which is what the proposed rules would do, is to go in the wrong direction".[1420] Jon Terry, remuneration partner at PricewaterhouseCoopers, argued that "introducing bonus caps runs the material risk of increasing risk, rather than reducing it".[1421]

848. Lord Turner noted that the cap could reduce the potential for recouping deferred awards:

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Lord Turner concluded that, while he was "sympathetic to the objectives of many people who are in favour" of the cap, further reform to the structure of variable remuneration would be more effective than limits on levels:

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849. Jon Terry, a partner in the reward and compensation practice at PwC, argued that the bonus cap "could seriously undermine the competitiveness of EU banks outside the EU" and would encourage banks "to build new capabilities in New York, Hong Kong or Singapore instead of Europe". This, he said, would "harm employment, not just of bankers but in the wider economy".[1424] Sir Mervyn King cautioned that banks would find a way around the cap:

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Sir Mervyn told us that the debate on the bonus cap was actually a "bit of a distraction" characterised by "a great deal of sound and fury about the proposals".[1426] He argued that it was:

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The Commission's proposals for reform to variable remuneration are set out in subsequent sections of this chapter.

Conclusions

850. The scale and forms of variable remuneration as they have been paid to staff at senior levels in banks, and investment banking in particular, have encouraged the pursuit of high risks for short-term gain, at times seemingly heedless of the long-term effects. The high levels of variable remuneration that persisted in the sector even after 2008 are difficult to justify.

851. There are distinct advantages to a significant proportion of banking remuneration being in variable rather than fixed form. It is easier to adjust variable remuneration to reflect the health of an individual bank. The use of variable remuneration also allows for deferral and the recouping of rewards in ways which better align remuneration with the longer term interests of a bank. There are signs already that the fall in bonuses in recent years has been offset by an increase in fixed remuneration. We note that Andrew Bailey considered that the EU bonus cap would "push up fixed remuneration" rather than act to reduce overall pay. We are not convinced that a crude bonus cap is the right instrument for controlling pay, but we have concluded that variable remuneration needs reform.

Yardsticks for variable remuneration

COMPANY FINANCIAL PERFORMANCE

852. In Chapter 3, we noted that the use of return on equity (RoE) in calculating variable remuneration has incentivised short-termism, risk-taking and high leverage. The November 2012 Financial Stability Report noted that, while "there is evidence to suggest that a number of banks have reduced somewhat their reliance" on measures such as RoE, "there is further to go and there is a risk that this progress could be easily reversed in future, particularly when external conditions improve".[1428]

853. Tim Bush, Head of Financial Analysis at PIRC, but writing to the Commission in a personal capacity, was in favour of use of return on assets (RoA) as an alternative to RoE, arguing that it "not only avoids the moral hazard that return on equity gives, it may also serve to incentivise bringing more assets back on balance sheet".[1429] Andy Haldane, who was also in favour of greater use of RoA, told us that it "covers the whole balance sheet and, because it is not flattered by leverage, does a better job of adjusting for risk".[1430]

854. Measures such as RoA are attractive because they discourage leverage. However, the use of RoA might incentivise management to underwrite high risk assets. This is because these are likely to bring in a higher return in the short term than a portfolio of the same volume of high quality, lower risk assets. This point was emphasised by the Financial Reporting Council:

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The point was also stressed by HSBC, who told us that "a return on assets is not risk sensitive so a return on risk weighted assets may be considered more useful".[1432]

855. The calculation of returns for remuneration purposes depends on the accounting practices used. These returns can be subject to considerable uncertainty, not least because many assets and liabilities on bank balance sheets are long term in nature. There can be a considerable time gap between profits being booked and being realised. This is particularly the case under IFRS accounting, whereby assets are classified as held for trading and therefore marked-to-market values through the profit and loss account. Martin Taylor told us that:

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856. Assets used for the calculation of profits for remuneration purposes may also be illiquid, with consequently volatile and uncertain values. Andy Haldane explained that:

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Professor Stella Fearnley argued that banks should not be able to use "profits out of financial instruments that are not marked to deep and liquid markets […] for […] any form of distribution or bonus payment".[1435] We consider the case for separate accounts for regulatory purposes in Chapter 9.

INCENTIVES FOR RETAIL SALES

857. Chapter 3 discussed the effect of sales-based incentives on the conduct of retail bank employees, concluding that incentive schemes were a significant factor in mis-selling.[1436] The FSA's September 2012 review of sales incentives found that:

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The FSA also found that firms did not understand their own incentive schemes and had inadequate control procedures to monitor their effects.[1438] The FSA published revised guidance in January 2013,[1439] noting that "it remains largely unchanged" but that it had "clarified the wording in some areas and provided more examples of good and bad practice".[1440]

858. Peter Vicary-Smith called for "an end to the sales-focused culture and the focusing of remuneration on selling rather than providing what customers need."[1441] During the course of our evidence-taking, several banks have announced that they no longer use sales based incentive schemes to motivate staff in retail branches and call centres.For example, Barclays have adopted a system based on "a measure of customer satisfaction and the extent to which customers would recommend Barclays to others".[1442] Lloyds has abandoned quarterly sales targets and now pays quarterly bonuses based on customer feedback.[1443]

859. The Remuneration Code requires that "non-financial performance metrics should form a significant part of the performance assessment process"[1444] and advocates the use of a "balanced scorecard".[1445] RBS outlined its retail scheme:

1446

Eric Daniels told us that he had introduced a balanced scorecard to Lloyds TSB in 2001, but this was not effective in preventing widespread mis-selling of PPI by Lloyds.[1447]

860. Some witnesses told us that, even where formal sales-based incentives have ceased to apply, a culture that values sales appears to have remained. For example, Stuart Davies of the Unite union told us:

Our concern sits around a very, very aggressive sales [and] performance-management culture that exists in the banks, to the extent of e-mail trails that go round and round individual performance on performance targets and whiteboards that contain information on individual performance. That feeds into increased pressure on staff, which feeds into, perhaps, some dysfunctional selling to customers, because they are concerned for their jobs.

The Salz review of Barclays echoed the same issues:

1448

CONCLUSIONS

861. Many of the so-called profits reported by banks in the boom years turned to dust when markets went into reverse. However, for some individual bankers, they had served their purpose, having been used in calculations leading to huge bonuses which could not be recouped. The means by which profits are calculated for remuneration purposes needs to change, even if there is no change in the accounting standards which underpin reported profits and losses. Unless they change, incentive structures will continue to encourage imprudent banking. In Chapter 9 we consider the case for the introduction of regulatory accounts. Alongside any change in this area, the Commission recommends that regulators set out, within the new Remuneration Code, criteria for the determination of profits for remuneration purposes, at company level and from business units. We would expect that unrealised profits from thinly traded or illiquid markets would usually not be appropriate for this purpose.

862. Banks and regulators should avoid relying unquestioningly on narrow measures of bank profitability in setting remuneration. One measure which has commonly been used—return on equity—creates perverse incentives, including the incentive to use debt rather than equity to finance bank activity, thus increasing leverage. Using return on assets as an alternative measure would remove the incentive towards leverage, but carries its own problems, including an incentive to hold riskier assets. While a measure based on risk-weighted return could help address this, we have noted the severe limitations of risk-weighting in the context of the Basel II and Basel III framework.

863. The Commission recommends that bank remuneration committees disclose, in the annual report, the range of measures used to determine remuneration, including an explanation of how measures of risk have been taken into account and how these have affected remuneration. The regulators should assess whether banks are striking an appropriate balance between risk and reward. They should be particularly sceptical about reliance on return on equity in calculating remuneration. The regulators should also assess whether the financial measures that are used cover adequately the performance of the entire bank as well as specific business areas. The former serves to create a collective interest in the long-term success of the institution. Where it is not satisfied, the regulator may need to intervene. It is for banks to set remuneration levels, but it is for regulators to ensure that the costs and benefits of risks in the long term are properly aligned with remuneration. This is what judgement-based regulation should mean.

864. Misaligned remuneration incentives have also contributed to conduct failure, including scandals such as PPI. The Commission welcomes announcements by some banks that retail staff will no longer be rewarded based on their sales, but notes the widespread warnings that sales-based rewards may persist informally even where their explicit inclusion in incentive schemes is removed. The Commission recommends that the new Remuneration Code include a provision to limit the use and scale of sales-based incentives at individual or business unit level, and for the regulator to have the ability to limit or even prohibit such incentives.

Reforming variable remuneration

DEFERRAL

865. The interim Financial Policy Committee has sought to ensure that inappropriately structured remuneration contracts do not increase risks in the banking sector. It noted at its 21 November 2012 meeting how:

1449

866. The PRA and FCA's Remuneration Code already states that at least 40 per cent of any variable remuneration must be deferred over a period of not less than three to five years, and that the length of the deferral must be established in accordance with the business cycle, the nature of the business, its risks and the activities of the employee in question.[1450] Michael Cohrs, a former member of the interim FPC, speaking with respect to the length of deferrals, said that:

1451

However, Mr Cohrs wanted to "go a bit further", and argued that there was a case for deferral to last seven to ten years to ensure that "we have gone through a business cycle before people are paid out".[1452] Andy Haldane made a similar point:

1453

Others favoured a deferral period shorter than seven to ten years, but which nevertheless went beyond the minimum three to five years specified in the Remuneration Code. Fidelity Worldwide Investment told us that it had recently changed its proxy voting guidelines so that there was a minimum of five years (up from the previous three years) between the date of grant of an award and the sale of any shares.[1454]

867. Andrew Bailey saw the deferral as a way of achieving some of the advantages of a partnership structure for banks:

1455

The FSA drew our attention to another argument for longer rather than shorter deferral periods:

1456

RECOUPING VARIABLE REMUNERATION

868. Although the terms 'clawback' and 'malus' are often used interchangeably, they are different forms of ex-post risk adjustment with potentially different legal and tax consequences. Many bank remuneration schemes give considerable discretion to the relevant remuneration committees to exercise their judgement to reduce outstanding unvested remuneration, including to zero, in the light of subsequent events.

869. 'Clawback' is the compulsory repayment of all or some of the cash, shares or other securities previously received by an employee under an incentive arrangement, either because the performance of the business is later found to be worse than initially reported, or because the recipient has committed misconduct which is uncovered after the award is made. As the term strictly refers to the recovery of compensation that has already been received, there are legal and practical obstacles to clawback and limits on when it can be applied. The High Pay Centre has warned that "clawing back money already paid to individuals will be inherently difficult, and may cost as much in legal fees as would be gained from doing it". Instead, it advocated "smaller variable rewards that would not be paid out until the impact of the action for which the reward was being offered was clearly evident".[1457]

870. 'Malus' refers to making reductions to deferred performance-related pay in the event of a company's performance or inappropriate conduct by the employee. Malus arrangements therefore adjust pay or share awards before the employee is entitled to receive the pay or before the share award has vested. The Remuneration Code states that a firm should reduce unvested deferred variable remuneration when as a minimum:

There is reasonable evidence of employee misbehaviour or material error;

The firm or the relevant business unit suffers a material downturn in performance; or

1458

Lord Turner felt that the UK had made "considerable progress" in ensuring that a significant proportion of variable remuneration is deferred and available to be recouped.[1459] Andrew Bailey told us that:

1460

871. There are signs that deferred remuneration is being recouped by banks. Lloyds Banking Group has recovered approximately £2 million from 13 senior executives as a result of their role in PPI mis-selling, with the bonus cuts made by reducing the amounts already awarded in deferred shares.[1461] JP Morgan has signalled its intention to recoup bonuses from the individuals deemed responsible for losses of $5.8bn (£3.7bn) from trading in complex financial derivatives. This would amount to about two years'' worth of pay for each individual.[1462] These amounts clawed back are tiny in relation to the losses to the banks as a result of the actions of those involved.

872. Nicholas Dorn of Erasmus Law School told us that a better "collective self-discipline" was required which would encourage "those working in the industry to more closely scrutinise and discipline each other":

Vertical clawbacks, extended to those who hold line supervisory or management responsibilities, are clearly merited. If superiors claim not to have known, then either they neglected their duties, tactically turned a blind eye or strategically ensured that they were never formally informed. [...]

1463

873. We noted earlier in this chapter that the practice by which firms buy out the bonus of an employee leaving another firm to join them creates problems for clawing back remuneration based on subsequent financial performance at the employee's former firm. PwC explained:

1464

THE INSTRUMENTS OF VARIABLE REMUNERATION

874. The variable remuneration of senior executives in the banking sector typically involves being rewarded through shares or share options in the organisation. The growth of share-based variable remuneration was based on the premise that this would serve to align the interests of senior executives with those of shareholders. It has on occasion also had the perverse incentive of encouraging excessive risk-taking and leverage in order to increase the short-term share price, often at the expense of the stability of the firm. The financial crisis has also provided examples of firms, such as Lehman Brothers, where senior executives held large amounts of stock, but where this did not prevent excessive risk-taking or firm failure. Similarly, in the UK, Andy Hornby had invested his entire cash bonus for his final last eight years in HBOS shares.[1465]

875. Professor Charles Goodhart drew our attention to some alternative instruments of remuneration, including payment in debt instruments and in equity shares subject to additional liability in the event of default.[1466] On the former, the FPC has noted that:

1467

Andy Haldane, a member of the FPC, added:

1468

Paul Sharma of the Bank of England told us that the use of bail-in debt would help in "aligning the incentives and solving the principal agency problem not just between the employees and the shareholders, but between the employees and all the stakeholders in the bank".[1469]

876. Some witnesses warned, however, that rewarding individuals in debt rather than equity might encourage more risk taking. Fidelity Worldwide Investment argued that:

1470

The Squam Lake Group, a non-partisan group of US-based academics who offer guidance on the reform of financial regulation, have proposed using "holdback" of a significant proportion of senior managers' remuneration with the aim of preventing the catastrophic consequences of a bank declaring bankruptcy or receiving a government bailout:

we suggest that financial institutions should be forced to withhold a significant share—perhaps one fifth—of each senior manager's total annual compensation for a significant period—perhaps five years. The deferred compensation would be a fixed 'dollar' amount. [...] this compensation would be forfeited if the firm fails or needs government assistance during the holdback period. The holdback is intended to move the incentives of employees who can have a meaningful impact on the survival of the firm closer to those of taxpayers. Because payment is forfeited if the firm stumbles, and does not increase when the firm does well, management would be less inclined to take excessive risk or leverage, and more inclined to recapitalize a distressed firm. Of course, holdbacks only reduce management's incentives to take excessive risk if management cannot hedge its deferred compensation. Any hedging of deferred compensation should therefore be prohibited.

1471

CONCLUSIONS AND RECOMMENDATIONS

Application

877. Variable remuneration does not form a large proportion of total pay for the vast majority of bank staff. However, the use of very high bonuses, both in absolute terms and relative to salaries, is more prevalent in banking than in other sectors. As we have already noted, there are advantages to variable rather than fixed remuneration, but it is essential that the use of variable remuneration is far better aligned with the longer term interests of the bank. The Commission's proposals which follow do not relate simply to investment bankers or directors, but should apply to all those whose actions or behaviour could seriously harm the bank, its reputation or its customers. They should apply not only to all Senior Persons but also to all licensed staff receiving variable remuneration in accordance with the proposals in Chapter 6.

Deferred compensation for all senior executive staff

878. The remuneration of senior bankers has tended to suffer from the fundamental flaw that annual rewards were not sufficiently aligned with the long-term interests of the firm. Bankers often had something akin to "skin in the game" through payment of part of bonuses and long term incentive plans in equity. But this provided unlimited upside but with the limited liability that comes with equity putting a floor under the downside. The Commission recommends that there should be a presumption that all executive staff to whom the new Remuneration Code applies receive variable remuneration and that a significant proportion of their variable remuneration be in deferred form and deferred for longer than has been customary to date. In some cases, there is a danger that individuals will be penalised for the poor performance of their colleagues or successors. However, such concerns are outweighed by the advantages of ensuring that these staff have a bigger personal interest in, and responsibility for, the long-term future of the bank. This will change behaviour for the better. It is particularly important for some of the team-based functions where members have often felt a greater loyalty to the small team than to the wider bank interest. By linking rewards much more closely to long term risks, deferral can recreate some of the features of remuneration structures characteristic of unlimited liability partnerships.

879. For the most senior and highest rewarded it is even more crucial that their remuneration reflects the higher degree of individual responsibility expected of them. Flexibility on the part of firms, and judgement on the part of regulators, is essential to take account of wide variations of risk and time horizons of its maturity in different areas of banking. Poorly designed schemes may increase the risk of gaming or circumvention of regulations and will have adverse or perverse affects on behaviour.

The form of deferred remuneration

880. Too high a proportion of variable remuneration in the banking sector is often paid in the form of equity or instruments related to future prospects for equity in the bank concerned. The path of share prices after remuneration has been awarded is unlikely to reflect accurately the quality of decisions made and actions taken in the period to which the award relates. Too much reliance on equity value creates perverse incentives for leverage and for short-termism. There are merits in the greater use of instruments such as bail-in bonds in deferred compensation. If senior staff are liable to lose their deferred pay if the bank goes bust, it will concentrate minds. In the event of capital inadequacy, such instruments would convert into capital available to absorb losses. However, there is no package of instruments which necessarily best matches risks and rewards in each case. Flexibility in the choice of instruments is vital. Banks should make this choice, dependent on particular circumstances. It is equally important that the supervisor assesses whether these choices are consistent with the appropriate balance of risks and rewards.

Length of deferral

881. The ability to defer a proportion of an individual's bonus is an important feature of remuneration schemes for those in senior decision-making and risk-taking roles in banks. This is because bonuses are typically awarded annually, while profits or losses from banking transactions may not be realised for many years. Similarly, misconduct may be identified only some time after the misbehaviour has occurred. Deferral for two or three years is likely to be insufficient to take account of the timescale over which many problems come home to roost in banking, whether in the form of high risk assets turning bad or misconduct at individual or wider level coming to light. Deferral should be over a longer period than currently is the case. However, no single longer period is appropriate and flexibility in approach is required to align risk and rewards. This is the job of the bank, but the supervisor should monitor decisions closely, particularly where the individuals concerned pose the greatest potential risks. The Commission recommends that the new Remuneration Code include a new power for the regulators to require that a substantial part of remuneration be deferred for up to 10 years, where it is necessary for effective long-term risk management.

Recouping deferred remuneration

882. The deferral of variable remuneration for longer periods is so important because it allows that remuneration to be recouped in appropriate circumstances. Clawback or similar recovery is also an appropriate course of action in cases where fines are levied on the firm, such as for misconduct in relation to LIBOR. However, what matters more is the development of legal and contractual arrangements whereby deferred remuneration comes to be seen as contingent, so that it can be recouped in a wider range of circumstances. These might include not only enforcement action, but also a fall in bank profitability resulting from acts of omission or commission in the period for which the variable remuneration was initially paid.

883. In the most egregious cases of misconduct, recovery of vested remuneration may be justified. The Commission recommends that the regulator examines whether there is merit in further powers, in the cases of individuals who have been the subject of successful enforcement action, to recover remuneration received or awarded in the period to which the enforcement action applied.

Provision in the event of taxpayer bailout

884. One of the fundamental weaknesses of bank remuneration in recent years has been that it lacked down-side incentives in the worst case scenarios that were remotely comparable to the upside incentives when things seemed to be going well. This disparity was laid bare by taxpayers bailing out failed banks while those responsible for failure continued to enjoy the fruits of their excess. We believe that the alignment of the financial interests of the most crucial bank staff with those of the bank is an important factor in addressing this imbalance. The Commission recommends accordingly that legislation be introduced to provide that, in the event that a bank is in receipt of direct taxpayer support in the form of new capital provision or new equity support, or a guarantee resulting in a contingent liability being placed on to the public sector balance sheet, the regulators have an explicit discretionary power to render void or cancel all deferred compensation, all entitlements for payments for loss of office or change of control and all unvested pension rights in respect of Senior Persons and other licensed staff.

Provisions for change of employment

885. Our recommendations in this section are aimed at incentivising bank management and staff to prioritise appropriate conduct, and the safety and soundness of their organisation, by enabling some or all of the deferred remuneration to be recouped in the event of conduct or prudential failures emerging. Such deferral structures as the industry had prior to the financial crisis were intended as staff retention schemes, rather than to incentivise appropriate behaviour. Consequently, these awards are generally forfeited if an employee resigns from the firm during the vesting period. As a result, it is common practice for banks hiring staff from competitors to compensate recruits for the value they have forfeited, by awarding them equivalent rights in their own deferred compensation scheme. This is tantamount to wiping the slate clean and, if it continued, would blunt the intended effect of our recommendations. International agreement on this issue, while desirable, is unlikely. The Commission recommends that the regulators come forward with proposals for domestic reform in this area as a matter of urgency. Among possible proposals, they should consider whether banks could be required to leave in place any deferred compensation due to an individual when they leave the firm. The regulators should also examine the merits of a new discretionary regulatory power, in cases where a former employee would have suffered deductions from deferred remuneration, but does not do so as a result of having moved to another bank, to recover from the new employer the amount that would have been deducted. This would be on the understanding that the cost is likely to be passed on to the employee. The use of this power might be initiated by the former employer, or by the regulator, in specific instances such as company fines for misconduct.

Obstacles

886. The adoption of the proposals set out in this section would amount to a substantial realignment of the risks and rewards facing senior bankers. Even with legislative backing and Parliamentary support, there are considerable obstacles to their rapid and successful implementation. This area is subject to considerable international regulatory interest and there is a danger that further interventions could change the wider framework within which our recommendations would operate. The regulators should ensure that new employment contracts are consistent with effective deferral schemes and should be aware of the potential for gaming over-prescriptive rules, or encouraging the arbitrage of entitlements. In fulfilling these roles, the regulators should exercise judgement in determining whether banks are operating within the spirit of the Commission's recommendations as implemented.

Board remuneration

887. The role of the bank board was discussed in Chapter 7. The important responsibilities of bank non-executive directors, particularly the Chairman and the Senior Independent Director (SID) were noted. The Commission recommended that the Chairman of a bank board should be full-time and that both the Chairman and the Senior Independent Director should be given specific assigned responsibilities under the Senior Persons Regime. The Commission recognises that these increased responsibilities and time commitments may be reflected in increased remuneration.

888. Customarily, the remuneration of non-executives, including the Chairman, has been fixed and entirely in cash, though many companies set shareholder guidelines e.g. building to a holding equal to annual value of the basic fee.[1472] This approach is widely supported by investors. HBOS was a notable exception to this model. Lord Stevenson, the former Chairman of HBOS, was awarded an additional incentive payment equivalent to 100% of his annual fee. The award vested after three years, but was dependent on relative outperformance by the shares over the period, and the ultimate value of the award was also linked to relative and absolute share price performance. HBOS said that it was appropriate for him to have a performance-related long term incentive because he played an "active role in influencing the strategic direction of the Group and ensuring overall performance delivery".[1473]

889. The Walker Review favoured "a very cautious approach to remuneration for NEDs and for the chairman".[1474] It opposed any form of variable remuneration for Chairmen:

1475

890. The Commission regards it as inappropriate for non-executives to receive some of their compensation in the form of shares or other instruments the aggregate amount of which could be influenced by leverage. A bank board should act as a bulwark against excessive risk-taking driven by individual rewards. The challenge and scrutiny responsibilities of non-executive directors are not consistent with the pursuit of additional awards based on financial performance. The Commission recommends that the new Remuneration Code prohibit variable, performance-related remuneration of non-executive directors of banks.

The international dimension

891. Measures taken to reform remuneration in the sector, if taken in isolation by the UK, could result in banks or bankers choosing to locate elsewhere. This implied threat has been a feature of the debate on banking reform in the UK since the financial crisis, and has taken two principal forms. First, that banks themselves might relocate abroad or choose other financial centres when looking to expand their business operations. Second, that bankers themselves might relocate, depriving the UK industry of the talents and the tax revenues of such individuals. These arguments were put forward when the ICB first mooted introducing some form of structural separation, when a bankers' bonus tax was introduced, and most recently following EU proposals for a bonus tax. We have discussed the first of these threats—that institutions might choose to move or expand their business operations outside the UK—in Chapter 4. In this section we consider the possible behaviour of individuals.

892. Sir David Walker told us that "many of the most senior people we [Barclays] have are marketable internationally—that includes the chief executive—and have opportunities elsewhere". He argued for reforms to remuneration "set by reference to standards internationally".[1476] Andy Haldane thought that changes were best made at European level:

1477

Michael Cohrs supported practices being set at an international level to avoid regulatory arbitrage:

1478

893. The risk of a 'brain-drain' of skilled labour if the UK acted alone on remuneration was raised by a number of organisations. The BBA expressed concern that the "UK is becoming an unattractive place in which an individual would choose to spend part of their career".[1479] In response to revisions to the FSA Remuneration Code in 2011, the PA Consulting Group referred to the "clear expectation that the Code will make it more difficult to attract and retain talent in the UK and that this could lead to a loss of competitiveness for the City".[1480] The personal tax regime also been cited as a disincentive to work in the UK. Mark Giddens of UHY Chartered Accountants said that, despite the recent reduction in the top rate of income tax, "a high personal tax burden makes it difficult for the UK to attract and retain the most experienced and skilled workers".[1481]

894. Individual bankers choosing to leave would need somewhere to go. We argued in Chapter 4 that a mass migration of banking activity from the UK was highly unlikely, and a banker is, of course, nothing without a bank. Many of the factors we identified in that chapter which should continue to make London attractive as a location for banks should also make it attractive to bank employees. There are also more personal factors. A recent report about the quality of life in financial centres for the City of London Corporation said that:

1482

Michael Cohrs put it more succinctly:

1483

895. Andy Haldane stressed the importance of ensuring that the UK had the flexibility under CRD IV to introduce specific remuneration requirements that it deemed necessary to promote financial stability. He noted the scope for "national discretion" in implementing proposals and argued that the UK would be permitted to adopt a more stringent approach to reducing the scope for basing remuneration on non-risk adjusted measures and extending minimum deferral periods beyond three years:

1484

However, he was less confident about the scope for going further than the Directive in terms of the scope for paying bonuses in debt-like instruments as "binding technical standards will be developed that will determine which instruments can be used".[1485]

896. Remuneration requirements should, ideally, be mandated internationally in order to reduce arbitrage. The Commission expects the UK authorities to strive to secure international agreement on changes which are focused on the deferral, conditionality and form of variable remuneration, and the measures for its determination, rather than simply the quantitative relationship to fixed remuneration, because it is changes of this kind that will most improve the behaviour of bankers in the longer term. In particular, we expect the Government and the Bank of England to ensure that the technical standards under CRD IV contain sufficient flexibility for national regulators to impose requirements in relation to instruments in which deferred bonuses can be paid which are compatible with our recommendations.

897. It must be recognised, however, that international agreement on some of the changes we envisage may be neither fast not complete. This may lead some to advance the argument that the UK will be placed at a competitive disadvantage. The extent to which this is true has been overstated. The UK has great strengths as a financial centre, but, partly because of those strengths, it also faces substantial risks. The PRA must adopt a common sense and flexible approach to handling these issues. However, its overriding objective of financial stability should not be compromised and, in fulfilling this objective, the risk of an exodus should be disregarded.

Getting it done

A NEW REMUNERATION CODE

898. In this chapter we have we have set out a series of reforms to remuneration in the banking sector. Our proposals are designed to ensure that bank staff are aware that there will be financial penalties for failure but, even more importantly, that appropriate behaviour will be rewarded. Remuneration needs to be aligned with the long term interests of the bank and its customers. This means that it must:

· incentivise the company's financial stability as well as its growth;

· incorporate measures of risk, rather than short term revenue and profit;

· particularly in retail and SME markets, where the asymmetry of information is greatest, encourage the marketing of products that are genuinely in customers' long term interests rather than the bank's; and

· allow for clawback or 'malus' in the event of risk or conduct failings.

Overall remuneration structures should also reflect the long term nature of banking.

899. The current terms of the Remuneration Code do not provide a clear basis for full implementation of our proposals. The Commission recommends that a new Remuneration Code be introduced on the basis of a new statutory provision, which should provide expressly for the regulators to prescribe such measures in the new Code as they consider necessary to secure their regulatory objectives.

900. Our recommendations place undue additional burdens on neither banks nor regulators. The proposals require banks to identify which staff are associated with high prudential or conduct risks and assess how the structures and timings of incentive schemes may affect the behaviour of employees. This should be tantamount to routine risk management in a well-run bank and banks should already be doing it as part of their internal controls. The regulator will need to check that the bank has identified the key risk-takers and decision-makers and confirm that deferred rewards will flow only when the full, long-term consequences of their decisions have become evident. The proposals require the careful examination of the remuneration of the highest risk Senior Persons Regime staff and spot checks on other licensed employees. Incentives are fundamental to the behaviour of individual bankers. Regulators should already be undertaking these checks.

TRANSPARENCY AND REPORTING REQUIREMENTS

901. There has been a trend for banking sector remuneration to increase in complexity, particularly for senior executives. Senior executives of major banks now typically receive four elements of remuneration: base salary; benefits, including pension rights, health insurance etc; annual incentives; and Long Term Incentive Plan (LTIP). The annual incentives and LTIP are in turn linked to a range of measures, some of individual performance and some of business units and/or the organisation as a whole. Some of these measures are formulaic, some involve the judgement of the Remuneration Committee.

902. As a result of their complexity, it is often difficult to judge the full value of remuneration packages. The NAPF said in written evidence that "complexity has built up which is now a barrier to understanding and motivation creating perverse behaviour".[1486] Complexity and consequent lack of understanding also limits the ability of shareholders to discipline remuneration. Companies disclose details of how remuneration packages are structured, but not what they believe those packages are worth.

903. This complexity can make it extremely difficult for shareholders, even where they do wish to monitor remuneration arrangements in the banks they have invested in, to do so effectively. This was noted by Virgin Money:

1487

Sir David Walker was supportive in principle of greater transparency:

1488

However, others warned that transparency could have the unintended consequence of further ratcheting up pay. Carol Arrowsmith said:

1489

904. Several witnesses encouraged the disclosure of the number of individuals earning over a threshold figure. They argued that the present requirement only for board member remuneration to be disclosed was perverse, as banks frequently had more highly remunerated staff below board level. Sir David Walker told us:

1490

Barclays disclosed the number of employees earning £1m to £2.5m, £2.5m to £5m and over £5m in its 2012 Annual Report.[1491] Requirements for reporting remuneration under CRD IV are outlined in Annex 6.

905. There is a risk that increased regulatory oversight could lead to banks outsourcing their remuneration policies to the PRA, in the same way they outsourced risk management before the financial crisis. However, we anticipate that other changes will, over time, have the effect of imposing more effective market discipline on remuneration. The PRA should monitor remuneration carefully and report on it as part of the regular reporting of its activities.

906. The Commission recommends that banks' statutory remuneration reports be required to include a disclosure of expected levels of remuneration in the coming year by division, assuming a central planning scenario and, in the following year, the differences from the expected levels of remuneration and the reasons for those differences. The disclosure should include all elements of compensation and the methodology underlying the decisions on remuneration. The individual remuneration packages for executive directors and all those above a threshold determined by the regulator should normally be disclosed, unless the supervisor has been satisfied that there is a good reason for not doing so. The Commission further recommends that the remuneration report should be required to include a summary of the risk factors that were taken into account in reaching decisions and how these have changed since the last report.

THE ROLE OF BANKS AND THEIR OWNERS

907. The question of whether the Government or the regulatory authorities should be involved in regulating or intervening, not just with respect to the structure of remuneration in the banking sector, but also with respect to levels of pay, was raised during our inquiry. The Chancellor, while critical of the level of pay in the sector, argued that it was not the role of Government to address it:

1492

908. We do not recommend the setting of levels of remuneration by Government or regulatory authorities. However, banks should understand that many consider the levels of reward in recent years to have grown to grotesque levels at the most senior ranks and that such reward often bears little relation to any special talent shown. This also needs to be seen in the context of the fact that many people have seen little or no increase in pay over the same period. We would encourage shareholders to take a more active interest in levels of senior remuneration. Individual rewards should be primarily a matter for banks and their owners. Nonetheless, we recognise that the measures we propose will radically alter the structure of bank remuneration. They will also provide far greater information to shareholders in carrying out their role.

1321 Ev 1423 Back

1322 US Bureau of Labor Statistics, CPI inflation calculator, www.bls.gov Back

1323 US Senate Committee on Banking and Currency, The Pecora Investigation: Stock Exchange Practices and the Causes of the 1929 Wall Street Crash (Cosimo, 2010, originally published 1934), p 208 Back

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1327 "The Company File: Goldman Sachs will float", BBC News, 8 March 1999, www.bbc.co.uk/news Back

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1329 Q 4563 Back

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