APRA should take a look at the latest Bank of England staff blog as it casts doubt on claims that the Bank Executive Accountability Regime's remuneration policies will have the desired effect.
The research shows, the BoE bloggers argue, that sophisticated banks can game clawback regulations by altering pay contracts to incentivise bankers to take risks that benefit shareholders but are excessive for society.
“The entire pay package matters, so understanding how it shapes risk-taking incentives is as important as monitoring compliance with any deferment or clawback rules.”
The BEAR regime is modelled on a similar existing regime in the UK which the BoE bloggers reckon has massive loopholes when it comes to pay contracts for top executives.
The new Aussie regime, which begins next July, will ensure that up to 40 per cent of senior bank executives' remuneration is deferred for a minimum of four years.
Bonuses to outpace clawbacks
Under the new rules, bank executives will be directly answerable to the prudential regulator who also has the power to clawback bonuses.
And, it is these clawbacks that BoE staff are convinced can be gamed by the big banks.
Their research claims that there is a case for regulating pay by mandating a greater level of clawback than shareholders would themselves choose when there is a clear divergence between the interests of the banks’ shareholders and those of society.
“Implicit expectations that a bank is too-big-to-fail and mis-priced depositor guarantees create such a divergence. As they keep the interest rates on bank debt low, they create an incentive for shareholders to encourage bank management to select excessively risky projects to boost returns in a flat market.”
For example, they argued, not offering any rewards for mediocre results - while lavishing sufficiently high rewards for strong results - can be enough to encourage bankers to choose risky projects even when their rewards are at risk of clawback.
“It is easy to design a contract that rewards the chief executive to select the risky project preferred by shareholders even in the presence of a clawback rule by ensuring that the chief executive’s expected pay rises more rapidly in shareholder value generated than the potential clawback amount."
The BoE research showed that measures such as pay deferral or linking pay to the cost of debt don’t particularly help, either.
"Pay deferral still maintains the link between the chief executive’s choice and the shareholders’ preference; and too-big-to-fail distorts the cost of debt in any case."
The blog concluded that regulators need to monitor how bank executives’ entire pay packages are structured and how they shape risk-taking incentives.
"Regulators therefore need to be alert to the possibility that banks may use the tools at their disposal to undo the intended effect of clawback rules.
"And that banks also have significant discretion over who gets promoted, and who is shown the door, although regulators could use its powers to block senior appointments if deemed inappropriate."
Anyone with an interest or involvement in the BEAR - especially on the remuneration side - will find this a fascinating read,according to KPMG’s risk partner, Michael Cunningham.
But the risk specialist was quick to point out that BoE staff have not fully considered or weighted, institutions’ social licence.
Increasingly, he added, banks are viewing major projects and new product/service delivery through the lens of their social licence - it’s not just the dollars but impact on the broader community and societal expectations.”
“Deferral of remuneration is only one component of the BEAR, other aspects such as the civil penalties, disqualification for accountability persons, etc. remain powerful incentives for compliance and doing the right thing.”