FSA starts to fight back

The Turner Review

“In the future the FSA’s supervisors will seek to make judgments on the judgments of senior management and take action if in their view those actions will lead to risks to the FSA’s statutory objectives.” Lord Adair Turner, Chairman of the FSA in the Turner Review

At the beginning of the banking crisis the Chancellor of the Exchequer asked the chairman of the FSA (Lord Adair Turner) to review the events that led to the crisis and to recommend reforms.

The consultation on the Turner Review closed in June 2009 and the proposals in the Review are now being gradually implemented by the FSA. The proposals include:

changes to bank capital and liquidity regulations, including tighter regulation of liquidity;

banks being required to hold more and higher quality capital, with several times as much capital now being required to support risky trading activity;

counter-cyclical capital buffers with banks being required to build up capital in good economic times so that the capital can be drawn on in downturns;

regulation of “shadow banking” activities on the basis of economic substance and legal form, with increased obligations for firms which are not authorised as banks but which carry out bank-like activity;

regulation of credit rating agencies to limit conflicts of interest and inappropriate application of rating techniques;

major changes in the FSA’s supervisory approach, with a focus on business strategies and system-wide risks rather than internal processes and structures; and

proposals to reform the regulation of the European banking market, including a new European banking regulator and increased powers for the FSA to constrain risky cross-border activity by firms.

One recent example of the FSA’s change in approach is how it has been dealing with applications for individuals at banks and other large firms to hold “significant influence functions” (which includes directors, non-executive directors, chief executive officers, heads of compliance, and anti-money laundering officers). Such individuals are now being required to attend an interview with FSA staff prior to being approved to hold their role. Some individuals are having their applications rejected by the FSA purely on the basis that they do not have enough relevant experience.

Code of Practice on Remuneration Policies

“Boards must set an appropriate risk appetite and, together with their remuneration committees, must ensure the distribution of profits is made in a way that is consistent with that philosophy.” Hector Sants, Chief Executive of the FSA in an article in the Financial Times, 11 August 2009

Another area that the Turner Review considered was remuneration structures and incentives. The Review concluded that some remuneration structures encouraged excessive risk taking at FSA authorised banks.

In order to address this the FSA has recently published a Code of Practice on Remuneration Policies (the “Code”).

FSA-authorised firms which meet large size criteria will have to provide a remuneration policy statement to the FSA by the end of October 2009. It is thought that the Code will initially only catch 26 groups in the United Kingdom, but it is possible that, over time, the Code may be extended by the FSA to apply to more firms.

The Code contains eight principles which relate to:

Role of bodies responsible for remuneration policies and their members (Principle 1): Remuneration committees should exercise independent judgment and demonstrate that the decisions made by the committee are consistent with the firm’s financial situation and prospects. Remuneration committees should also be responsible for approval and periodic review of remuneration policies.

Procedures and input of the risk and compliance functions (Principle 2): Procedures for setting remuneration should be clear and documented, and should include appropriate measures to manage conflicts of interest. Independent functions such as risk management, HR and compliance functions should have appropriate input into setting remuneration for other business areas, which will help firms to avoid conflicts of interest.

Risk and compliance function remuneration (Principle 3): Remuneration for employees in risk management and compliance should be determined independently of other business areas, and the performance metrics for those employees should be principally based on the achievement of the objectives of those functions rather than on the profits made by the firm as a whole. The FSA expects employees in risk management and compliance to have remuneration packages which have a smaller bonus component and a larger fixed component.

Profit-based measurement and risk adjustment (Principle 4): Assessments of financial performance used to calculate bonus pools should be based principally on risk-adjusted profits, which the FSA considers to be a better measure of financial performance than revenue or turnover. Bonus pool calculation should include an adjustment for current and future risk, and take into account capital employed and liquidity.

Long-term performance measurement (Principle 5):

The assessment process for the performance-related component of an employee’s remuneration should be designed to ensure that assessment is based on longer-term performance. Profits at firms can vary widely from one year to the next, resulting in volatile changes to bonuses. The FSA expects remuneration not to be assessed solely on the results of the current financial year but rather assessed over a period of time.

Non-financial performance metrics (Principle 6): Non-financial performance metrics should form a significant part of the performance assessment process. These metrics should include adherence to effective risk management and compliance with the regulatory system.

Measurement of performance for long-term incentive plans (Principle 7): The measurement of performance for long-term incentive plans, including those based on the performance of shares, should be risk-adjusted. The FSA considers that firms should be wary of attempts to increase leverage to boost “earnings per share” and “total share return”, where increases in those measures are used for the purposes of calculating employee incentives.

Remuneration structures (Principle 8): The fixed component of remuneration should be a sufficient proportion of total remuneration to allow a firm to operate a fully flexible bonus policy. Where firms perform badly the FSA expects them not to pay bonuses, and the fixed component of remuneration must be sufficient to allow firms to do this. If a bonus is a significant proportion of an employee’s remuneration package, then the majority should be deferred, with a minimum vesting period. The FSA considers that an example of good practice would be for at least two-thirds of a bonus to be deferred, with the vesting period being appropriate to the nature of the business. Any deferred element of an employee’s bonus should be linked to the future performance of the firm as well as the employee’s division or business unit. Deferred remuneration should not be paid automatically but should be subject to the firm meeting set criteria in future years.

Enforcement: credible deterrence?

“There is a view that people are not frightened of the FSA… people should be very frightened of the FSA.” Hector

Sants in a speech at the Reuters Newsmakers seminar, 12 March 2009

The FSA’s approach to enforcement has shifted from publicly stating that it is not an enforcement-led regulator to introducing a policy of “credible deterrence”.

Over the 2008-09 financial year the FSA was successful in its first ever insider dealing trial (securing two convictions and a custodial sentence) and began three insider dealing prosecutions. In addition the FSA imposed a record £27 million in financial penalties (in comparison with an average of £14 million over the previous five years).

The FSA has also made it clear that it considers that action against individuals has a greater deterrent effect than action against firms, and has imposed fines on four persons holding significant influence functions over the last year.

Pressure

The FSA is currently under intense political pressure to perform. The Conservative Party has stated that if it wins the next election it will abolish the FSA and expand the role of the Bank of England. The Turner Review, the Code of Practice on Remuneration, and changes to its approach to enforcement are three examples of how the FSA is trying to address the problems highlighted by the banking crisis and to ensure that they do not occur in the future.