The carrot and the stick: changes to remuneration rules

In recent years, after what first was known as "the credit crunch" and which then became "the crisis", the UK's relevant regulatory authorities, now the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (the FCA), have been working to impose rules to encourage staff in financial institutions to be rewarded appropriately for their efforts without placing the institutions that employ them, and the public's money, at risk.

Many of these rules are to be found in the various remuneration codes. The latest instalment has now been issued in the form of a joint policy statement on new remuneration rules, designed to further align long-term risk and reward. The changes follow on from a joint consultation in July 2014, snappily entitled, 'Strengthening the alignment of risk and reward: new remuneration rules' and are designed to implement the recommendation in this regard made by the Parliamentary Commission on Banking Standards. With one exception, these new rules are those which formed the subject of the recent consultation.

Which organisations, and which roles within them, will be affected by the changes to the remuneration rules?

The changes to the PRA Rulebook and FCA Handbook will apply to banks, building societies and PRA-designated investment firms, including branches of non-EEA headquartered firms.

All material risk takers at these firms will be covered, including senior managers designated under the Senior Managers Regime from 2016.

What's new?

Extended deferral periods

Deferral periods (the period during which variable remuneration is withheld following the end of the accrual period) will be as follows:

• Senior managers (as defined under the forthcoming Senior Managers' Regime) will be subject to a deferral period of no less than seven years, as these individuals are judged as having the greatest influence over the strategic direction of their business. There will be no vesting prior to the third anniversary of the award, and vesting will have to be no faster than on a pro rata basis;

Risk managers at PRA-regulated firms (excluding those covered by the Senior Managers' Regime) who have senior, managerial or supervisory roles, will be subject to a deferral period of no less than five years, with vesting no faster than pro rata from year one; and

All other material risk takers (staff whose actions could have a material impact on a firm but who are subject to a greater degree of management oversight) will remain subject to the Capital Requirements Directive minimum deferral periods of three to five years, with vesting no faster than pro rata from year one. This will include individuals exposing the firm to credit risk and trading book/market risk, individuals approving the introduction of new products, individuals on local risk committees and material risk takers identified solely under quantitative criteria, if subject to managerial oversight.

Under the original proposals which were the subject of the consultation, all material risk takers save for Senior Managers would have been subject to a deferral period of five years. The PRA and FCA were persuaded that this was disproportionate, particularly for those with relatively junior roles and limited authority to commit the firm to risk.

The regulators have suggested that firms should not increase fixed pay in response to longer deferral periods.

Clawback

In January 2015, the PRA introduced a rule requiring firms to apply clawback to awards of variable remuneration which have already vested up to seven years from the date of the award. Clawback applies where there has been either misconduct or failures in risk management.

The FCA has confirmed it will introduce a comparable rule, meaning that there will be a minimum clawback period for all material risk takers of seven years from the date of the award, where there has been misconduct or failures in risk management.

In addition, the FCA and PRA will introduce a new rule extending the clawback period by up to a further three years, for PRA-designated senior managers only, where there are outstanding internal or regulatory investigations at the end of the normal seven-year clawback period.

Non-executive directors

A new rule will prohibit non-executive directors from receiving variable remuneration in respect of any activities carried out in their non-executive role.

Buy-outs

In their consultation, the PRA and FCA considered a number of options to address the issue of buy-outs, where a firm compensates a new employee for any unvested remuneration which is cancelled when they leave their previous firm. The options it considered were: 

• banning buy-outs altogether;

requiring firms to maintain unvested awards if an employee leaves;

requiring buy-outs to be held in a form, such as an escrow account, which permits them to be subject to malus (downward adjustment) by the previous employer; and

relying on clawback rules.

The majority of those who responded to the consultation considered that the practical difficulties associated with the first three options meant that option four (clawback) was the best option. However, since there was some support for further exploring the third option, the PRA and FCA have confirmed that they will consider whether or not more detailed proposals should be made around that third option. At the same time, they will seek to ensure that clawback arrangements at firms are robust.

Bailed out banks

The PRA and FCA will build on existing rules in this area. Current rules provide that no variable remuneration should be paid to the management body of a firm in receipt of exceptional government intervention, unless this is justified. New rules will explicitly state that the presumption against payment or vesting extends to all discretionary payments for loss of office and discretionary pension benefits.

The rule will apply to any firm which receives exceptional government intervention, whether in the form of direct support or a guarantee, but will not apply to firms which are already in receipt of such support. It will also not apply to any firm which avails itself of emergency liquidity assistance.

Risk adjustment and performance metrics (PRA regulated firms only)

New PRA rules will place additional focus on risk adjustment for variable remuneration, including: 

• adjusting fair value accounting profit by the incremental change in prudent valuation adjustment (or a comparable method); and

a formal requirement that simple revenue or profit-based measures may not be relied upon to determine variable remuneration at aggregate or individual level, except as part of a balanced and risk-adjustment scorecard.

Timing

The changes on clawback and deferral will apply to variable remuneration awarded for performance periods beginning on or after January 1, 2016. The rest of the changes apply from July 1, 2015.

Will the plot thicken?

It is worth noting that, for now, no changes are proposed to the rules on proportionality, though both the FCA and PRA have issued updated guidance. This is unlikely to be the end of the story, however. The European Banking Authority will publish its updated remuneration guidelines later this year and this may mean that the UK regulators will have to revisit their own guidelines at that stage.

This article, written by Jessica Corsi, was originally published on Thomson Reuters Accelus at http://www.complinet.com/hr/news/article.html?ref=179817.