APRA proposes stronger rules on remuneration

The Australian Prudential Regulation Authority (APRA) has released a draft prudential standard to strengthen remuneration requirements, a move which takes a major step into the traditional territory of the board.

APRA says the package of measures has a strong focus on risk management which is more prescriptive than its existing remuneration requirements and places Australia in line with better international remuneration practice. The standard will be finalised in late 2019 or early 2020 and it is expected that it will come into effect on 1 July 2021.

Among the key reforms for APRA-regulated entities, APRA is proposing:

• An expanded role for the board, including approving and actively overseeing an organisation’s remuneration policy and approving remuneration outcomes for an expanded number of roles
• Financial performance measures must not comprise more than 50 per cent of performance criteria for variable remuneration outcomes
• Minimum deferral periods for variable remuneration of up to seven years for CEOs in larger, more complex entities
• Boards will also have scope to claw back remuneration for up to four years after vesting
• Annual compliance reviews and triennial effectiveness reviews of the remuneration framework.
• APRA will intensify its supervision of remuneration practices under the new standard, with a focus on design, implementation and outcomes.

Long-term incentives

APRA Deputy Chair John Lonsdale says, “APRA will not be determining how much employees get paid. Rather, we want to empower boards to more effectively incentivise behaviour that supports the long-term interests of their entities. By reducing the risk of misconduct, we hope to see better outcomes for customers and higher returns for shareholders in the long-term.”

He says it is clear that existing remuneration arrangements in many entities are not incentivising the right behaviours. “Remuneration and accountability frameworks play an important role in driving employee behaviour. Where policies are poorly designed, or not followed in practice, companies may incentivise conduct that is contrary to the long-term interests of the company and its customers."

“In the financial sector, APRA has observed an over-emphasis on short-term financial performance and a lack of accountability when failures occur, especially among senior management. This has contributed to a series of damaging incidents that have undermined trust in both individual institutions and the financial industry more broadly. Crucially from APRA’s perspective, these incidents have damaged not only institutions’ reputations, but also their financial positions,” Mr Lonsdale said.

APRA proposes to shift the remuneration requirements from the governance standards in CPS 510 and SPS 510 into a stand-alone prudential standard covering ADIs, general insurers, life insurers, private insurers and RSE licensees with a view to reinforcing the need for industry to improve current remuneration practices. Draft prudential standard CPS 511 Remuneration introduces heightened requirements on entities’ remuneration and addresses recommendations 5.1 to 5.3 from the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

Role of the board

APRA underscores the need to address key conclusions of recent governance self-assessments and the Financial Services Royal Commission. The draft standard would require the board to have an expanded role in oversight of organisation-wide remuneration. In particular, it mandates:

• Board responsibility for the overall remuneration framework (including consideration of factors such as how it promotes effective risk management);
• Board involvement in remuneration arrangements for persons in “special roles” categories; and
• that the Board establish a clear link between remuneration arrangements and prudent risk management of the entity to ensure risk outcomes are reflected in remuneration outcomes for persons in special role categories

As foreshadowed by APRA Chair Wayne Byres, the new standard aims to limit the use of financial performance metrics (share-based and profit -based) and promote the use of non-financial performance criteria in designing incentives.

APRA flagged its intention to strengthen prudential requirements on remuneration in April last year following its Review of Remuneration Practices at Large Financial Institutions. The need for a strengthened approach was further underlined by the findings of last year’s Prudential Inquiry into the Commonwealth Bank of Australia, as well as the recent industry self-assessments examining issues on governance, accountability and culture.

Mr Lonsdale said CPS 511 would complement the Banking Executive Accountability Regime to lift industry standards of accountability and reduce the likelihood of misconduct. “Limiting the influence of financial performance metrics in determining variable remuneration will encourage executives to put greater focus on non-financial risks, such as culture and governance. As our recent response to the industry self-assessments made clear, this remains a weak spot in many financial institutions."

“Introducing the minimum holding periods for variable remuneration ensures executives have ‘skin in the game’ for longer, and allows boards to adjust remuneration downwards if problems emerge over an extended horizon. We recognise that some aspects of this proposal are far-reaching and will require major changes to industry practices.”

AICD perspective

The APRA draft standard represents a significant step by an Australian regulator, away from a principles-based approach and towards more prescriptive regulation. Given the recommendations of the Financial Services Royal Commission this was always likely.

While recognizing the need for reform, the AICD believes that boards must ultimately remain responsible, and accountable, for setting remuneration policies that align with the company’s needs, strategy and desired standing in the community.

Any additional regulatory overlay must be workable and recognize that the board’s role is one of oversight, and that there are competing tensions from different sets of stakeholders – investors, proxy advisers, regulators and customers.

The AICD looks forward to being an active participant during the consultation process.

If you have any insights to share, please contact Christian Gergis, Head of Policy, or Sally Linwood, Senior Policy Adviser via policy@aicd.com.au.

Further information

A three-month consultation period will close on 23 October.

The AICD’s summary of the key governance issues raised by APRA’s consultation is available here.