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

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday March 31, 2011 at 9:02 am
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Editor’s Note: The following post comes to us from Guido Ferrarini, Professor of Business Law and Director of the Centre for Law and Finance at the University of Genoa, and Maria Cristina Ungureanu, Research Fellow at the Centre for Law and Finance.

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.

  1. On 2 April 2009, the G-20 issued the: Declaration on Strengthening the Financial System. The Declaration vested “enhanced capacity” to the former Financial Stability Forum–now re-named the Financial Stability Board. It also seems to have appointed the IMF with an enhanced role in the arena of financial regulatory reform. Several reports and articles have since been produced, many of which are quite comprehensive.
    The G-20 document references many component parts; one of which deals broadly, with compensation. This is the subject of the post by Professor Ferrarini and Ms. Ungureanu.
    However, before I turn attention to my comment, I would like to make an observation. We still live in a world which subscribes to a Westphalian system (well discussed by Padoa-Schioppa in his intellectually breathtaking Per Jacobsson Lecture). Much of the declaration reads as if it were some form of treaty by sovereign governments. As these types of issues do not garner much press or interest for that matter, and are not very well understood by legislators (empirically evident in the U.S.), the liability extant is that it will meet with opposition when finally understood by those with responsibility. Surveying several legislators, economics and business professors, bankers and business chieftains in the U.S, it is interesting to note that 99 out of 100 have never heard of the BIS–much less one of its secretariats the FSB.
    The idea of misalignment of compensation being a central cause (of the Turmoil of 2007) is a “red herring” of immense proportion. It’s tantamount to a medical doctor chasing the symptoms of a patient rather than dealing with the source of the illness.
    The turmoil and consequent damage caused globally was primarily a failure of sovereign governments and central banks to monitor and understand what was occurring under their charge. This primarily was a U.S. problem of faulty legislation and poor use of regulation; but most importantly, monitoring in an holistic fashion. Putting forth the idea that “greed” (let’s call it what it is) can be regulated is unrealistic and counter-productive–as well as counter-intuitive.
    It is a fact that Wesphalian systems are dirigistic and need to set rules and guidelines–especially in the insured banking sector. Yes leverage requirements, yes de-construction of too big to fail institutions offering too many diverse products and services, yes prudential supervision, yes reform of CRA’s, etc. But the attempt at moderating compensation from outside of the internal entity or organization by an authority that is not part of the actual Sovereign is a non-starter and will not gain traction.
    The turmoil developed over a 25 year period; very specific events occurred in the timeline which led up the collapse. It’s time to revisit those events.

    Comment by Stephen R. Ganns — April 14, 2011 @ 3:28 pm

  2. [...] by Stephen R. Ganns — April 13, 2011 @ 7:04 pm Comments [...]

    Pingback by FSB/G-20 propose compensation rules financial institutions | Stephen R. Ganns — April 14, 2011 @ 5:20 pm

  3. [...] Comment by Stephen R. Ganns — April 13, 2011 @ 7:04 pm [...]

    Pingback by Harvard Law Forum FSB Principals Compensation Practices | The Independent Fiduciary — April 18, 2011 @ 6:13 pm

 

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