Flexibility of the FSB Principles for Sound Compensation Practices at Financial Institutions

The Principles for Sound Compensation Practices at financial institutions and their Implementation Standards issued in 2009 by the Financial Stability Board (FSB) are only the first step in a complex global reform process that is currently underway at both regional and national levels. This process is the outcome of an intense political debate conducted against the backdrop of the international crisis and popular resentment, within countries and across the international arena. When the G20 head of governments and the FSB considered the relevant issues, some of the political conflicts were no doubt diluted by the international and diversified membership of these institutions, and solutions were found at a sufficient level of generality to allow for adaptations and exceptions. However, when the implementation of the Principles is discussed at regional and national level, many of the underlying conflicts inevitably resurface, depending not only on the relative weight of the interest groups involved and the role of banks in the economy, but also on national culture and ethical values.

No reform could be successful unless adopted by the majority of jurisdictions. One-sided reforms (adopted only by some countries) do not prevent contagion from other countries choosing not to regulate compensation at financial institutions. Assuming that flawed remuneration structures were allowed in a given country and led to the failure of a large institution as a result of excessive risk taking, the negative externalities from such a failure would easily impact on other countries, including those that have outlawed similar remuneration structures for their own institutions. In addition, one-sided reforms could jeopardize a country’s competitive position as a financial centre, by determining a flow of financial firms’ headquarters and top managers to other countries adopting a more liberal stance relative to executive compensation.

To a great extent, legislative and regulatory responses depend on the type of equilibrium found in each country between the different interests at stake. The ‘level playing field’ argument will likely be used to resist regulatory reform and protect rents from hefty compensation packages. Senior staff will threaten to move to other countries or to less regulated financial firms, such as hedge funds. Moreover, financial institutions will use their influence on politicians and the media to dilute reform efforts and protect their freedom to fix remuneration structures. Their shareholders will join in these efforts, as variable pay is the main tool to put pressure on managers and induce them to maximize shareholder wealth through increased risk taking. Regulators, on the contrary, will require incentive pay to reflect not only shareholders’ interests, but also those of creditors and of financial stability in general. They welcome post-crisis reforms as a unique opportunity to expand their supervisory reach to areas previously reserved to bank boards and shareholders. At the same time, they are prone to capture by their regulated industry and may be willing to accept the ‘level playing field’ and similar arguments in order to protect the same. Where public criticism of bankers and hostility to their remuneration practices are strong, the risk of regulatory capture is lower and a tougher regime for executive pay may emerge. Culture may contribute to similar outcomes, given that high levels of executive pay are less tolerated in some countries.

International fora, such as the G20 and the FSB, necessarily dilute the conflicts of interest concerning issues like bankers’ pay. First, not all governments involved have the same political agenda. While compensation at financial firms came on top of the EU and US governments’ agenda immediately after the crisis, this did not occur in other countries (including Brazil, India and China) which were less affected by the financial turmoil and did not perceive executive pay as a serious problem. Secondly, interest groups, including large financial institutions, are relatively weaker in the international arena, given that they face large coalitions of governments. Thirdly, the types of financial firms and their problems differ according to the economic circumstances of the regions concerned. Fourthly, the international financial standards are usually formulated at a sufficient level of abstraction, which allows for smoothing of conflicts between the various interests at stake and introduce some flexibility in the implementation of the standards.

The Principles represent an acceptable political compromise between the various interests at stake in the area of compensation, incorporating traditional criteria and adapting these to new circumstances. But they are being implemented along different models. In many jurisdictions, the model includes a mix of regulation and supervisory oversight, with new regulations often supported by supervisory guidance that illustrates how the rules can be met. Other jurisdictions follow a primarily supervisory approach to implementation, involving principles and guidance and the associated supervisory reviews. It may be difficult, therefore, to compare one system with another without analysing the compensation practices of the relevant financial institutions, particularly with regard to jurisdictions following a supervisory approach.

The EU adopted the former of the two models described. The recently modified Capital Requirements Directive (CRD III) includes rather detailed provisions for banks, to some extent incorporating the Principles, at the same time asking the Committee of European Banking Supervisors (CEBS) to issue guidelines in this area. As a practical consequence, the Principles will become generally binding for European banks, with very few exceptions. Moreover, the flexibility of the Principles will be lost, to a large extent, given the more prescriptive character of the European provisions and guidelines. The US initially followed the supervisory model. The Interagency Guidance on Sound Incentive Compensation Policies, applicable to all banks closely tracks the Principles, keeping however a remarkable level of flexibility and generality. However, Section 956 of the Dodd-Frank Act requires federal regulators to jointly prescribe rules for compensation disclosure and prohibit certain incentive-based payment arrangements that encourage ‘inappropriate’ risk-taking by financial institutions. Already the FDIC and other US agencies have jointly approved a “Notice of Proposed Rulemaking on Incentive-Based Compensation Arrangements”, which takes an interesting approach to the subject and could have an impact on the convergence of the US and EU systems.

Rigidity in implementation may determine unintended consequences by increasing the total costs of remuneration and/or making incentives less effective. Any final assessment should however be suspended whilst waiting for the full implementation of the Dodd-Frank Act.

The full paper is available for download here.