Remuneration Policies

One of the factors leading to the financial tsunami was "moral hazard" - investment bankers were motivated to take excessive risks in order to bet for a huge amount of bonuses without bearing the consequential losses. While the banks have been "nationalized", the remuneration policies would be expected to undergo a significant reform.

UK FSA recently published a draft code of practice on remuneration policies relevant to all FSA regulated firms. The aim of the code is to ensure that firms have remuneration policies which are consistent with sound risk management, and which do not expose them to excessive risk. However, It is not concerned with setting levels of remuneration, which are a matter for the boards of companies and their shareholders.

The specific principles of this code are highlighted as follows:

A. Governance

1. Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm's financial situation and future prospects. Their members should have the skills and experience to reach an independent judgement on the suitability of the remuneration policies, including the implications for risk and risk management.

2. The procedures for setting compensation within the firm should be clear and documented, and they should include measures to avoid conflicts of interest. Risk and compliance functions (in consultation with the firm's HR function as may be deemed appropriate) should have significant input into setting compensation for business areas.

3. Compensation for staff in the risk and compliance functions should be determined independently of the business areas. They should have different performance metrics, with greater emphasis on the achievement of their own objectives.

B. Measurement of performance for the calculation of bonuses

4. Assessments of financial performance to calculate bonus pools should be principally based on profits. The bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.

5. Firms should not assess performance solely on the results of the current financial year.

6. Non-financial performance metrics, including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment process

C. Measurement of performance for long-term incentive plans

7. The measurement of performance for long term incentive plans, including those based on the performance of shares, should also be risk-adjusted.

D. Composition of remuneration

8. The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.

9. The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.

10. It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.