The regulatory framework for bank executive remuneration: general principles

Reform impetus in the area of bank executive remuneration began with the Walker Review which recommended that remuneration committees’ oversight be extended to cover remuneration policy at the group level and approving the compensation of all high-end employees. The report also recommended that half of an officer’s variable remuneration be in the form of a long-term scheme, whereby half vests in no less than three years and half in five years. Bonus awards, meanwhile, should be paid over a three-year period. Moreover, it was recommended that high-end employees and executive directors retain a shareholding in the company in proportion to their overall remuneration. In terms of statutory reforms, FSMA 2000 section 139A, which was inserted by the Financial Services Act 2010 section 6, vested the PRA with new responsibilities on executive remuneration, including the duty to require regulated firms to adopt a remuneration policy consistent with the effective management of risks and, most importantly, the power to prohibit relevant persons from being remunerated in a way that contravenes the above standards.

Significant reforms in the area were also introduced by CRD IV. The Directive clearly states that its policy is to prevent financial incentives for excessive risk-taking which are perceived as one of the main causes of bank failures and financial instability. Indeed, the preamble to the Directive emphasises that ‘Weaknesses in corporate governance in a number of institutions have contributed to excessive and imprudent risk-taking in the banking sector which has led to the failure of individual institutions and systemic problems in Member States and globally’. To that effect, the Directive introduced a detailed set of rules on executive remuneration in banks falling within its scope. In the UK, many of these rules were already in place before coming into force of the Directive. Regarding the range of senior managers covered, the scope of CRD IV remuneration rules is broad and covers all material risk takers including ‘senior management, risk takers, staff engaged in control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management’.

CRD IV requires banks to have a remuneration committee comprising NEDs.[1] The provision of guaranteed variable remuneration is prohibited other than to new staff and for the first year of their employment. The fixed component of remuneration must be high enough to enable firms to not pay any variable remuneration at all when performance is poor. Furthermore, the rules require that at least 50% of variable remuneration be paid in shares, share-linked instruments or capital instruments rather than cash. The rules also require banks to defer at least 60% of variable remuneration for at least seven years, for persons performing a senior management function, which includes executive directors. The deferred element must vest no faster than on a pro rata basis, i.e. equally on each anniversary of the grant, with no vesting taking place until three years after the award. Most crucially, banks are required to reduce any unvested deferred variable remuneration (malus) and to take reasonable steps to recover any vested variable remuneration (clawback) in case an individual senior manager is found guilty of misconduct, or failed to meet standards of fitness and propriety, or there is a significant failure of risk management.

Another important aspect of the regulatory framework concerns the metrics used to measure senior managerial performance. Consistent with its overall emphasis on sound risk management, the PRA demands banks to risk-adjust any profit-related metrics used to assess financial performance. As a result, all major UK banks currently use a variety of non-profit-related metrics alongside profit-related ones to determine the vesting of bonuses and performance share awards. Non-profit-related criteria include the following: capital strength, liquidity, minimisation of bad loans, customer satisfaction, compliance, risk management, corporate reputation and strategy development. In parallel, financial performance is no longer exclusively assessed by relative total shareholder return (TSR) and earnings per share (EPS), but rather some major UK banks use return on risk-weighted assets (RoRWA). The latter metric does not depend on a bank’s leverage and therefore does not create any perverse incentive for senior managers to increase a bank’s leverage in order to maximise the variable remuneration they receive.

  • [1] CRD IV, art 95 implemented by PRA Rulebook, CRR Firms, Remuneration 7.4. 2 CRD IV, art 94(l)(d) and (e) implemented by PRA Rulebook, CRR Firms, Remuneration 15.7. 3 CRD IV, art 94(l)(f) implemented by PRA Rulebook, CRR Firms, Remuneration 15.9 (2). 4 CRD IV, art 94(1)(1) implemented by PRA Rulebook, CRR Firms, Remuneration 15.15. 5 PRA Rulebook, CRR Firms, Remuneration 15.17 and 15.18. All CRD IV regulated firms are expected to deter 40% of variable remuneration of all material risk takers. However, in the case of payments in excess of 500,000 euros and payments to directors of significant firms, 60% of remuneration must be deferred. The monetary limit was introduced by CRD IV, article 94 (1) (m). A discussion of the policy behind the seven year deferral period can be found in PRA, ‘Strengthening the Alignment of Risk and Reward: New Remuneration Rules’ (PRA PS12/15, 2015) 7-8 (accessed 19 May 2020). 6 CRD IV, art 94(l)(n) implemented by PRA Rulebook, CRR Firms, Remuneration 15.22 and 15.23, respectively. 7 PRA Rulebook, CRR Firms, Remuneration 11.2-11.6 which also implement CRD IV, art 94(l)(a).
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