A resilient financial system is based on alignment between the interests of financial institutions and those of stakeholders including shareholders, customers and beneficiaries, regulators and the broader community. The design and implementation of remuneration arrangements play an important role in better aligning these interests. As highlighted by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission), there have been numerous examples where this alignment has been missing. In particular, financial institution executives have received substantial incentive based pay following years with strong financial performance, while instances of significant customer harm or reputational damage to the institution have emerged.
Remuneration practices, that is, how executives and other employees are rewarded financially for the outcomes they achieve, can play an important role in promoting effective management of all risks (both financial and non-financial), sustainable performance and long-term soundness. Remuneration design and implementation that does not properly consider the incentives it creates, including an over-emphasis on short-term financial performance, can drive poor customer and beneficiary outcomes and jeopardise financial soundness.
APRA is proposing to strengthen prudential requirements for remuneration across all APRAregulated entities in the banking, insurance and superannuation industries by issuing a new prudential standard on remuneration (CPS 511). APRA’s proposals aim to ensure that an entity’s remuneration arrangements produce appropriate incentives and outcomes.
The new standard is a key milestone in APRA's broader agenda to lift industry practices in governance, culture and remuneration. The new standard will support APRA's supervision program in these areas by providing clear expectations against which supervisors will assess regulated entities.
While certain components of the package may present challenges for different stakeholders, the impact of the reform should be considered as a whole. The core elements are to:
- strengthen governance of remuneration frameworks and outcomes, in particular through an expanded Board role, where the Board needs to be active and have direct oversight;
- set overarching remuneration objectives that inform design of all remuneration arrangements and influence remuneration outcomes;
- limit the use of financial performance metrics (share price and profit-based); and
- set minimum deferral periods (up to seven years) for senior executives to provide more 'skin-in-the-game' through better alignment to the time horizon of risk and performance outcomes.
These core elements are materially more prescriptive than APRA's existing remuneration requirements. Recent evidence, as highlighted by the Royal Commission, is that the current approach to regulation in this area is not delivering satisfactory outcomes. Considering these deficiencies, APRA has looked to regulation in overseas jurisdiction and as such better international practice has strongly formed the basis of APRA’s approach to developing the new standard.
APRA has relied on its principles-based philosophy where possible and has not sought to undermine accountability within regulated entities by constraining the overall amount of remuneration. In particular, APRA is not proposing to cap the amount of variable remuneration either in absolute terms or in relation to fixed salary (as has been the case in some other countries), or prescribing specific types or forms of variable remuneration. APRA has not seen evidence that these more prescriptive approaches are effective in promoting better outcomes; indeed there is some suggestion that a strict rules-based approach is open to circumvention given the fluid nature of labour market dynamics.
A key feature of APRA's new standard is to promote the use of non-financial performance criteria in designing variable remuneration incentives. Many investors have traditionally supported a heavier weight for financial targets, whereas consumer advocates prefer customer-centric measures such as customer service and loyalty. Executives favour a remuneration arrangement reflecting their skill and expertise. No approach will satisfy all stakeholders, but in APRA's view financial targets have had too prominent a place in executive remuneration in some sectors of the financial industry.