Most banks now have compensation policies in place that reduce the potential for inappropriate risk-taking, but the challenge now is to develop frameworks for assessing their effectiveness.
The FSB (Financial Stability Board) has published its sixth progress report on financial institutions’ implementation of its Principles and Standards for sound compensation practices.
The Principles for Sound Compensation Practices and Implementation Standards were published in 2009 in the aftermath of the global financial crisis to promote sound compensation practices, reduce incentives towards excessive risk-taking, and ensure compensation frameworks are supported by sound governance and risk management practices.
The latest report confirms (as did the July 2017 report) that all FSB jurisdictions have implemented the Principles and Standards for sound compensation for all banks considered significant for the purposes of the Principles and Standards (banks listed by jurisdiction in Annex B of the report).
While most banks have put in place practices and procedures which reduce the potential for inappropriate risk-taking, their effectiveness is still being tested. Further work is required to validate that practices and procedures operate effectively and cover all compensation-related risks, the report says.
International supervisory dialogue has facilitated increased attention to compensation design and implementation, contributing to better practice, the FSB notes. Many authorities are now incorporating assessment of compensation practice as part of ongoing supervisory review processes.
The report highlights a number of changes have taken place for significant banks:
- Boards appear more active and engaged and compensation processes are now conducted with greater oversight
- Risk, compliance and other control functions now providing more significant input
- Areas of attention have expanded to all types of risk, i.e. financial as well as non-financial
- Monitoring practices have become more robust, including initial efforts to back test and validate relationships among measures of financial performance, risks taken, risk outcomes, and payouts
- Compensation arrangements now have longer time horizons, include mechanisms that better align them with effective risk management practices and include a wider range of financial and non-financial risk assessment criteria
- Compensation and risk governance frameworks are applying a baseline set of expectations to all employees, not just senior executives and material risk takers
- Focus on compensation as a tool to address conduct risk is increasing, alongside and a greater emphasis on how results are achieved
According to the FSB, the challenge now is to develop frameworks for assessing the effectiveness of compensation policies and practices in balancing risk and reward.
Compensation systems should be monitored and reviewed to ensure that they operate as intended. As supervisors continue to monitor compensation practices, they will need to ensure that compensation remains aligned with prudent risk-taking, and fully reflects evolving risks and new areas of vulnerabilities as they emerge, the report says.
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The Principles and Standards are also intended to apply to insurers and asset managers, but fewer jurisdictions have implemented the requirements for these sectors as they have not been deemed significant.
However, in many cases the asset management businesses within banking groups that are deemed significant are subject to consolidated application of standards and supervision and hence also subject to the national implementation of the Principles and Standards at the entity-wide level, the FSB notes.
“It is important that jurisdictions consider compensation practices for significant firms in all financial sectors to ensure these support prudent risk-taking and good conduct,” it said.
The full report is available here.
Additionally, the FSB has released a list of FSB member jurisdictions’ national regulation and supervisory guidance on compensation, available here.