The Financial Crisis and Compensation Practices In association with: 24 June 2009.

The Financial Crisis and Compensation Practices

In association with:

24 June 2009

Agenda

• Review of the Global Financial Crisis– Contributing factors

• The response of governments and regulators– Multilateral– Countries

• How financial companies can address this– Understanding risk & reward

• Immediate actions


Financial Crisis - Contributory factors

• Low interest rates• Sub-prime and predatory lending • Deregulation• Financial Innovation and Complex Products• Over-leveraging • Shadow banking


…. which resulted in:

Company Bailouts

• AIG• Citigroup • Bank of America • GM • Chrysler• Northern Rock• Royal Bank of Scotland

Company Failures

• Lehman Brothers • Washington Mutual • Icesave • Fortis• Merrill Lynch• HBOS• Bear Stearns


“This financial crisis had many significant causes, but executive compensation practices were a contributing factor. Incentives for short term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.”

“By outlining these principles now, we begin the process of bringing compensation practices more tightly in line with the interests of shareholders and reinforcing the stability of firms and the financial system”

US Treasury Secretary, Timothy Geithner,10 June 2009 The Financial Crisis and Compensation Practices

Compensation - a contributory factor

• Low interest rates

• Sub-prime and predatory lending • Deregulation

• Financial Innovation and Complex Products• Over-leveraging • Shadow banking


The Global Response

• G20 meeting in April 2009 to address global economic crisis• Meeting endorsed the “Principles for Sound Compensation Practices”

developed by the Financial Stability Forum(FSF) • Principles to ensure compensation structures are consistent with

financial firms’ long-term goals and prudent risk taking. • The principles are detailed and include specific requirements.• The direction given is for implementation in 2009. • Expectation that financial regulators will actively enforce compliance.• Requirement for “firms' boards of directors to play an active role in

the design, operation, and evaluation of compensation schemes”.


FSF Principles – Key Points

a) Directors must actively oversee compensation system’s design and operation; not primarily controlled by the CEO/ management.

b) The practical operation of the system should be regularly reviewed for compliance with design policies and procedures.

c) Staff engaged in financial and risk control must be independent and have appropriate authority.

d) Compensation must be adjusted for all types of risk :– symmetric with risk outcomes. – link the size of the bonus pool to the overall performance of the firm– payout schedules must be sensitive to the time horizon of risks– compensation mix of must be consistent with risk alignment.

e) Supervisors (Regulators) should include compensation practices in their risk assessment of firms.

f) Comprehensive and timely disclosure of compensation practices. The firm should be able to explain the rationale for its compensation mix.


Australian Response

• APRA provides oversight of Australian financial services sector

• Regulates through a combination of:o Legislationo Prudential Standards

the Board must have a Remuneration Policy that aligns remuneration and risk management;

a Board Remuneration Committee must be established;

o Prudential Practice Guideso Inspection


“APRA’s proposals on remuneration are designed to endorse and implement the FSF’s tough new principles on pay and compensation”

PPG 551 - Governance

• Remuneration Committee (RC) to periodically review Remuneration Policy to identify:– Material deviations between outcomes and intent– Undesirable outcomes that flow from policy limitations e.g.

imprecise risk or profit measures

• Review to extend to persons at all levels.• Advice to RC be commissioned and provided directly –

independent of management.


PPG 551 – Remuneration Policy

• Remuneration Policy must cover all employees and agents “whose actions could put the institution’s financial soundness at risk.”a) Directors, Executives and Senior Managers whose decisions

affect the whole or a substantial part of the institution

b) Risk and financial control personnel

Remuneration must be free from conflicts

c) Persons who receive a significant proportion of performance-based remuneration through commissions, bonuses etc.

“Large numbers of lower-level employees with material financial incentives can take actions that are individually insignificant but collectively can be detrimental …”


PPG 551 – Performance Measures

• Accounting standards used as starting point for financial measures:– Adjustments documented and substantiated

• Comparative measures (e.g. company Total Shareholder Return v. Peer group TSR) need to be carefully considered in case absolute returns are low or negative

• Take into account non financial measures e.g. internal audit, CSR, compliance etc.

• Adjust profit to take into account cost of capital


PPG 551 – Payment Timing

• Performance based pay should be “at risk” until performance can be validated i.e. not paid until the consequences of the risks undertaken can be assessed.

• Defer a portion of allocated bonus which will be reduced or eliminated if outcomes adverse.

• Deferred payments should not “vest” on leaving• Reduce or eliminate performance based pay where such

actions necessary to protect financial soundness.• With equity based compensation, executives must maintain

a long view even when approaching end of contract.


PPG 551 – Miscellaneous

• Base pay should be sufficient proportion of total remuneration to allow boards to make performance based components truly discretionary

• “Golden Parachute” arrangements inconsistent with prudent practice

• Must undertake due diligence on previous remuneration of incoming executives

• Prohibit hedging of equity exposure


Compensation Control Cycle ™

Behaviours:• alignment• risk propensity• time horizon

Compensation structure:• mix – guaranteed & variable • levels & timing• projected outcomes

Risks:• measurable or unknown• short & long term• extreme events

ControlsRisk Management

RegulatorsBoard

Understand Map

Change

Attract & Retain

Strategy Risk Culture


Mapping Compensation & Risks

Compensation StructuresLOW VARIABILITY• Base Salary• Guaranteed Bonus/ Deferred

Payments• Golden Handshake / Parachute• Pensions & other benefits

MEDIUM VARIABILITY• Annual Performance Bonus• Restricted Stock Grants

HIGH VARIABILITY• Options• Performance Shares

Risks in Financial FirmsSTRATEGIC RISKS• Aggregate Portfolio / Industry• Political• Currency

FINANCIAL RISKS• Specific Investment• Market• Credit• Funding/ Liquidity

OPERATIONAL RISKS• People• Process & Systems (Business

Disruption)• Legal & Regulatory• Reputation


Amounts

Performance Measures

Timing

Authorities

Conflicts

Disclosures

Immediate Challenges for Remuneration Committees

• Gaining a comprehensive understanding of current remuneration practices throughout the firm (i.e. not just the senior executives) including a comparison of how these compare with the FSF principles

• Mapping of risk in the firm and how such risks can be influenced by pay structures

• Reviewing existing governance processes and how information and advice are received by the RC

• Assess current disclosure of remuneration including pay levels and compensation structures

• RC’s may also wish to consider their own remit and whether they have the right balance of skills and experience


Freshwater Advisers Pte Ltd3 Pickering Street

#03-06 China Square CentralSingapore, 048660

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The Financial Crisis and Compensation Practices In association with: 24 June 2009.

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