Remuneration practices, and in particular the "bonus culture", at large financial institutions are a hot topic. The Group of Twenty, the Financial Stability Board (FSB) and, in some jurisdictions, the media and politicians - urged on by taxpayers irate at footing the bill for unprecedented financial-sector bailouts - have all voiced their concerns and called for action in reforming the bonus culture in the interests of financial stability.
Generous bonus payments to employees, based on high short-term profits without adequate regard to longer-term risks, are widely regarded as one of the many factors contributing to the financial crisis that began in 2007. Remuneration practices that reward short-term revenue and profit targets effectively incentivise staff to look for higher incomes in the short run by undertaking risky activities, even though this might expose their institutions to higher potential losses over the longer term.
Something has to be done about these perverse incentives and national authorities have to take up the task. Self-discipline by the industry is unlikely to be sufficient given the competitive pressures. As the Chairman of the FSB has acknowledged, compensation is now fully in the domain of the supervisors.
Under the guidance of the G20 and the FSB, jurisdictions are working together to ensure that the remuneration practices of large financial institutions are consistent with the goal of sound risk management and that there is a level-playing field among institutions and jurisdictions as far as remuneration standards are concerned. The consensus is that changes in remuneration practices will not work unless they are implemented and enforced internationally. Talented people can, and will, migrate to less strictly regulated jurisdictions, resulting in what has been described as "pay cheque" arbitrage.
To foster international co-operation and co-ordination, the FSB produced a set of Principles for Sound Compensation Practices in April and a set of Implementation Standards in September last year. All members of the FSB (including Hong Kong) are expected to adopt these Principles and Standards. Regulators around the world, including Australia, the UK, Switzerland, the Netherlands and the US have issued rules, standards or guidance on remuneration practices. Here in Hong Kong, the HKMA has issued its Guideline on a Sound Remuneration System, following consultation with the banking industry.
Recognising the link between remuneration systems and effective risk management, the HKMA's Guideline does not attempt to limit or cap individual remuneration packages. Instead, it focuses on risk issues and whether institutions' systems are conducive to promoting safety and soundness.
The HKMA's Guideline follows the FSB's Principles and Standards in covering specifically:
- Governance structure of remuneration systems: including board-level oversight; the involvement of risk-control units in the design and implementation of remuneration systems; and the need to focus on staff whose activities involve the assumption or taking of material risk on behalf of an institution as well as senior management.
- Structure of remuneration packages: including the balance between fixed and variable remuneration with a bias towards substantial variable remuneration for senior management and staff who can have a material impact on risk exposure; apportioning variable remuneration between cash and shares / share-linked instruments and the use of a share-retention policy.
- Performance measurement: including non-financial factors, risk adjustments and the time horizons for the outcome of business activities to be reliably measured;
- Deferral and claw-back arrangements: including the deferral of part of an award of variable remuneration and the introduction of a claw-back mechanism in the event of the subsequent negative performance of the institution, business unit or the relevant employee.
- Disclosure: covering the most important design characteristics of the system, such as performance measurement, risk adjustment, and deferral policy, together with specified aggregate quantitative information.
Our aim is for institutions to comply with the Guideline within 2010.
As the FSB has observed, "one size does not fit all" when it comes to remuneration systems. The HKMA is mindful that remuneration systems may vary among institutions, depending on factors such as size and business mix. The HKMA will therefore focus on the goals to be achieved and consider likely outcomes when assessing the potential risks arising from individual remuneration systems as part of its risk-based supervision.
Financial institutions' remuneration systems are likely to continue to evolve, particularly in areas such as performance measurement and risk adjustment. We will continue to refine our guidance in the light of the changing circumstances both in Hong Kong and overseas.
Arthur Yuen
Deputy Chief Executive
19 March 2010
