Legal opinion: bankers’ bonuses – will we learn from past mistakes?

Bankers’ remuneration has been at the front of people’s minds when examining why financial institutions took the excessive risks that dragged the global economy into a recession. It is an issue that still leaves many people angry and disillusioned with the banking system.

A global response?

Besides the domestic response, the prime minister will no doubt be asking the G20 members at their meeting this week to support a package of principles for financial institutions to curb incentive pay structures which focus on the short term, at the expense of long-term company sustainability.

Mindful, as ever, of the significance to the UK economy of a successful, global financial services industry, the government is also making clear that it will look at what other countries are doing to improve remuneration policies before deciding whether to go ahead with these plans. In other words, leading from the front is fine, but we are not going to lead if no-one follows.

While it makes sense for the FSA to simply regulate the operation of UK financial firms, the government has the ability to lead a macro movement for international amendment on this topic. As the Turner Review specifically says, the capital markets are global in nature and the agreement of standards – whether remuneration policies in banks or their liquidity ratios – is critical both to repair the system and as a pre-emptive measure.

From the US to Europe, countries have already proposed amendments to or enacted legislation or codes governing executive pay. Most countries have implemented changes to complement specific rescue packages aimed at financial institutions. In the UK, the changes as outlined in the Turner Review have generally been aimed at the UK-based financial sector. Additionally, the EU is formulating legislation with similar scope, to be passed during the summer of 2009.

The UK position

The FSA has put its marker down in its consultation paper on reforming remuneration practices in financial services. At the heart of its response is the principle that certain financial institutions (essentially FSA-regulated banks, building societies and the larger broker dealers) should have to establish and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management.

The FSA believes that the principles that it set out in its draft code on executive remuneration (in February 2009) could then be used as evidence of the promotion of effective risk management. It is not seeking to curb levels of remuneration. Indeed, Lord Turner himself points out in his report that the proposed major increases in capital requirements are more likely to affect future remuneration than any policies designed directly to influence it.

The UK government has yet to propose legislation regarding remuneration, but has proposed a general umbrella requirement, with supporting principles, rather than a change in legislation or prescriptive regulation.

If a consensus is to be reached at the forthcoming summit, to prevent another collapse, three fundamental pillars must be reinforced – scope, disclosure and enforcement.

Scope: The FSA has amended the scope of its policies so that, rather than applying to all FSA-authorised firms, it will only apply to the top-tier banks, building societies and broker-dealers. However, it has made clear that it wants its proposals to apply to all employees of such firms – in particular, it wants to see something done about the possible conflict of interest between those who judge risks and those who take them.

Disclosure: In the draft code, the FSA alluded to the possibility of firms disclosing remuneration policies and how they adhere to the published code, but only on request. There is no annual disclosure statement, but firms need to ensure that they would have evidence of compliance. It is unfortunate that implicated firms do not have a more definitive answer on disclosure, but just a constant threat of audit. It is highly possible that historic opaqueness in this area contributed to the build-up of the credit bubble. What is needed is more clarity, and less of a ‘roulette wheel’ approach to disclosure of remuneration policy.

Enforcement: First, the FSA will need to police its application. Unfortunately, the draft code is not clear about enforcement measures, and it will need to be to avoid undermining the concepts behind it. However, once it becomes a rule in the handbook, various existing legal redresses will apply, such as civil penalties.

Second, the draft code proposes the quantification of risk, to measure compliance. It incorporates remuneration risk into capital adequacy and risk assessment processes applicable to all authorised firms. The draft code supports firms having the flexibility to choose techniques to adjust performance criteria for risk, so long as the full range of risks is covered. Provided there is clear disclosure on this topic, it could introduce flexibility and counter any ‘brain drain’ concerns that rigid prescription could cause. Letting banks decide how to remunerate, but with a new ‘cost’ associated with such decisions, for example through capital or liquidity ratios, should be a good thing.

Where next?

The Turner Review was honest about its heightened supervisory approach, which is a change from the light touch of the last decade. In theory, a principles-based approach combined with clear definition of scope, disclosure and enforcement could go far in repairing the system.

If regulation is too prescriptive, then there is a risk of the law of unintended consequences coming back to haunt the system, as the US saw with the Sarbanes-Oxley Act. Already we are seeing reactionary legislation in the US, in the form of a proposed 90% tax on ‘banker bonuses’. But does this kind of taxation provide a future model, as the Turner Review is attempting to, or just widely punish a narrow sort of behaviour?

Executive pay is a moving target in the current economic market, and the next step will be to see whether synchronised measures introduced by governments and regulatory bodies across the globe can provide a better model for the future.

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