Yesterday, the Financial Stability Board (FSB) published its latest report into the efforts of its member jurisdictions to reform compensation regimes to address misconduct and improve culture across the industry.
"In addition to promoting prudent risk taking, compensation tools such as in-year adjustments, malus and clawback, along with other measures, can play an important role in addressing misconduct risk by providing both ex-ante incentives for good conduct and ex-post adjustment mechanisms that ensure appropriate accountability," the report reads.
The report is part of the FSB's long-time work on improving compensation practices in the financial sector. In 2018, the FSB published supplementary guidance laying out how regulators can use compensation tools to address misconduct. Following this, in 2021, it issued a progress report on how compensation practices had evolved following the Global Financial Crisis. And, this past July, the FSB hosted a workshop for industry executives to discuss the implementation of compensation tools with a particular focus on potential unintended consequences.
The so-called "banking turmoil" of 2023 brought the impact of poorly-designed compensation regimes into sharp relief, the report argues. "The root causes of the 2023 bank failures included poor risk management and Board oversight, with compensation often linked to short-term profits, leading to poor alignment between compensation and risk," the FSB writes. “Firms need a sound risk culture, a compensation framework which has a balance of financial and non-financial measures, and transparency in the communication of compensation outcomes.”
The FSB also explains that culture and compensation and culture are intrinsically intertwined. "A compensation framework aligned with firm culture will incentivise appropriate employee behaviour and performance to achieve the firm's goals," the report reads. "Workshop participants discussed the interconnectedness and the importance of a culture-based compensation framework, where the Board plays a crucial role in establishing a framework that drives the desired risk culture and fosters acceptance of compensation tools."
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