News analysis: FSA puts rein on rewards for risk-taking

Revisions to the FSA’s remuneration code will have a significant impact on how financial institutions reward their employees, says Tynan Barton

The Financial Services Authority’s revised remuneration code, which comes into force on 1 January 2011, will bring critical changes to the remuneration practices of nearly 2,500 financial institutions.

The proposed revision, which will extend the code to include all banks, building societies, asset managers and hedge fund managers, seeks to tighten the rules on bankers’ pay and bonuses to discourage short-term risk-taking. The existing code states that companies must apply remuneration policies, practice and procedures that are consistent with, and promote, effective risk management.

The revisions to the code, which seek to meet the Capital Requirements Directive (CRD 3) enacted by the European Union in July, mean more firms are now covered. Janet Cooper, partner at law firm Linklaters, said: “The key message is that all financial services firms which are [covered] need to look at the remuneration regulations. They do apply to them, and they have to decide the extent to which they need to comply.”

Affected employers must ensure they have identified the employees (known as code staff) who will be affected by the revised rules. These include individuals who have a material impact on the risk of the organisation, for example senior managers and traders, as well as heads of control functions, such as audit, risk and compliance.

When the FSA issued details of its consultation in July, it said that as the scope of the code was expanded, it would apply a proportional approach to implementation, ensuring that “institutions shall comply with the principles in a way and to an extent appropriate to their size, internal organisation and the nature, scope and complexity of their activities”.

One of the principles is that at least 40% of a bonus must be deferred over a period of at least three years for all code staff, but at least 60% must be deferred when the bonus is over £500,000.

Principle of proportionality

However, firms that are newly covered by the code will be able to apply the principle of proportionality and could reduce the amount deferred, taking into account the size and complexity of the business. Jon Terry, head of reward at PricewaterhouseCoopers, said because the rules were self-policing, “organisations need to decide themselves and then justify to the FSA, how they are going to apply proportionality to these key clauses around deferral, the percentage of shares and claw-back provisions”.

Problems are also presented by the principle that at least 50% of any variable remuneration must be made in shares, share-linked instruments or other equivalent non-cash instruments, because employers need to consider whether they have such vehicles available. Listed companies with a share plan may easily adhere to this rule, but other financial organisations, for example a building society or an institution that cannot issue shares, will have to consider how to address this rule.

Until the FSA’s policy statement is published in December, the 50% rule remains unclear, says Irving Henry, director, prudential capital and risk at the British Bankers’ Association. “The complication is that a lot of firms are not listed, or do not have a lot of shares to give to their staff,” he said. “It is not yet clear how banks that do not issue shares will be able to get around the rules.”

The code will also address the processes involved in making pay, bonus and share award decisions. Although most organisations have good appraisal systems in place, they are disconnected from remuneration decisions. Terry said individuals’ performance was important because employers had to show the regulator they had a robust, objective process in place.

“Looking at those processes to show the connection between what someone does and what someone gets paid is crucial by 1 January,” he added. “That can be, in some organisations, a very significant piece of work.”

Read more news