Supervisors on Supervision

“The 2023 banking turmoil highlighted the critical importance of integrating robust risk culture and governance into compensation frameworks in order to mitigate financial misconduct and to ensure sustainable business practices. Among other things, the banking turmoil revealed shortcomings in compensation practices, including the use of compensation tools. 

The bank failures of 2023 underscored the role of Boards and Senior Management in linking incentive structures to prudent risk metrics. Several postmortem reports have identified fundamental failures in risk management and oversight, including a lack of robust and prudent risk metrics, as root causes of the 2023 bank failures. 

Compensation at these banks was often tied to short-term financial profits and returns, exacerbating vulnerabilities, leading to misconduct and issues in managing non-financial risks.”

“Compensation practices are deeply intertwined with an organisation’s culture. They are pivotal in shaping employee behaviour and aligning employees’ actions with the long-term goals of financial institutions. Conversely, compensation schemes that prioritise short-term gains can incentivise excessive risk-taking, potentially leading to financial instability or misconduct.

Compensation is not merely a financial mechanism; it also serves as a significant cultural signal within an organisation. The way employees are rewarded sends strong messages about what behaviours are valued and encouraged. Establishing and maintaining a sound risk culture, with a clear tone set from the top, is fundamental. Incentive schemes are an important element of any such ‘tone.’

Some key learnings can be drawn for designing appropriate compensation schemes:

1. Compensation schemes should be aligned with the long-term objectives of the organisation.
2. Financial institutions should integrate risk management into their compensation frameworks.
3. Clear communication about compensation policies and their rationale is essential.
4. Compensation practices should be consistent with the broader culture of the organisation.

Despite the clear benefits of well-designed compensation tools, their implementation remains challenging.

1. Clawback provisions are particularly challenging to enforce due to legal and cultural hurdles.
2. Implementing compensation tools such as malus and clawback involves significant administrative effort.
3. Compensation structures are becoming increasingly complex, challenging to implement, and difficult to communicate effectively. This complexity can result in unintended consequences.
4. Compensation tools can impact the ability of financial firms to attract and retain talent. Regulatory requirements in remuneration are not fully aligned across jurisdictions, creating an uneven playing-field and potentially disincentivising employees from joining firms with stringent compensation frameworks.

The effectiveness of compensation tools also hinges on their integration into the broader risk culture of the institution, with proportional application being crucial to maintain a balance between attracting talent and ensuring robust risk management.

1. Strengthen the Board and Remuneration Committee Rules: Firms should ensure that their Boards and Remuneration Committee members have the necessary skills and independence to oversee and apply compensation tools effectively. Further, they should seek to enhance governance frameworks to support their Boards in making informed and balanced decisions regarding compensation adjustments.
2. Foster a Strong Risk Culture: Compensation practices should be deeply intertwined with organisational culture. A culture of accountability and strong risk management is essential.
3. Enhance Transparency and Simplification: Clear communication regarding compensation frameworks is crucial, as is clear discussion of how compensation outcomes link directly to firm performance and its prudent risk management.
4. Regulatory and Supervisory Roles: Regulators and supervisors play an important role by setting expectations and monitoring the use of compensation tools through the guidance they offer, the standards they establish, and the supervisory activities they conduct. To ensure that compensation tools are legally sound and aligned with regulatory expectations, firms must engage with regulatory bodies to develop clear guidelines and support for the effective use of compensation tools.”