In brief - on 23 July 2019, APRA released a discussion paper for consultation relating to the introduction of a new prudential standard on remuneration (CPS 511) which is aimed at strengthening the prudential requirements for remuneration across all APRA-regulated entities in the banking, insurance and superannuation industries
The new standard is a key milestone in APRA's broader agenda to prudentially regulate industry practices in governance, culture, remuneration and accountability (GCRA).
Also importantly, on 19 November 2019 APRA released an Information Paper 'Transforming governance, culture, remuneration and accountability' which reveals that the introduction of CPS 511 is part of APRA's broader plan to scale up significantly its efforts to lift standards of GCRA matters across the industries it regulates in line with a key commitment made in APRA’s 2019-2023 Corporate Plan.
APRA’s GCRA agenda
In its Information Paper, APRA has pre-empted a more intensive regulatory approach to GCRA, with a view to transforming GCRA practices across the financial system.
The key attributes of APRA’s new approach to GCRA are:
(i) strengthening the prudential framework in areas such as remuneration and risk management and incorporating the wider use of GCRA risk governance declarations and self-assessment
(ii) sharpening APRA's supervisory focus by increasing internal resourcing and capabilities for GCRA supervision, adopting new tools to assess GCRA practices and holding entities more forcefully to account when deficiencies are identified, and
(iii) sharing APRA's insights to better inform industry and the public about APRA’s work, promote better GCRA practices, and drive greater accountability among boards and management.
Remuneration framework under CPS 511
Amongst other things, the prudential reforms under CPS 511 seek to better align remuneration frameworks with the long-term interests of APRA regulated entities and their stakeholders, including customers and shareholders.
APRA's underlying concern is founded on evidence from the banking royal commission that existing remuneration arrangements have been a factor in driving poor consumer outcomes and that the use of non-financial metrics to assess performance in the financial services sector has been typically limited to STI scorecard design only, rather than incorporating in long-term interests.
Accordingly, a key feature of APRA's new standard is:
(i) to promote the use of non-financial performance criteria in designing variable remuneration incentives; and
(ii) that performance based components of remuneration must be designed to encourage behaviour that supports the regulated entity’s long-term financial soundness and risk management.
The core elements of CPS 511 are to:
(i) strengthen governance of remuneration frameworks and outcomes via:
- an expanded Board role with active and direct oversight of the remuneration framework including approval of the remuneration policy, the remuneration of senior executives and other roles for compliance with remuneration outcomes
(ii) set overarching remuneration objectives that inform the design of all remuneration arrangements and influence remuneration outcomes
(iii) limit the use of financial performance metrics (share price and profit-based):
- to establish purposeful non-financial measures together with financial measures limited to 50 per cent and individually capped at 25 per cent.
(iv) set minimum deferral periods (up to seven years) for senior executives to provide more 'skin-in-the-game' through better alignment to the time horizon of risk and performance outcomes:
- restrictions on deferral and vesting set for significant financial institutions (SFIs) and remuneration clawback arrangements for senior roles in SFIs.
APRA intends that the new stand-alone prudential standard will ultimately apply to ADIs, general insurers, life insurers, private health insurers and RSE licensees and replace remuneration requirements in current governance standards CPS 510 and SPS 510 (CPS/SPS 510).
CPS 511 remuneration thresholds
APRA’s proposed starting point is to identify entities according to asset size and to first apply CPS 511 only to large, complex entities classified as significant financial institutions (SFIs) and to certain SFI senior executives and other special roles.
The thresholds are designed generally to capture the publicly listed entities, foreign owned banks, larger RSE funds with more complex in-house operations and other prudentially regulated entities of a similar size and character.
The prudential standard defines a new category of APRA-regulated entities categorised as significant financial institutions (SFIs) based on the following asset size:
- authorised deposit-taking institutions (ADIs) - more than $15 billion in total assets
- general and life insurers - more than $10 billion in total assets
- registrable superannuation entities (RSE) licensees - more than $30 billion in funds under management.
Specified personnel - organisational role based on risk
CPS 511 imposes a range of review obligations for remuneration arrangements and variable remuneration outcomes for persons in special role categories:
- individually for senior managers and highly-paid material risk-takers
- collectively for material risk-takers who do not fall in the category of highly-paid material risk-takers; and
- collectively for risk and financial control personnel
The revised scope aims to align with ‘Accountable Persons' under the Banking Executive Accountability Regime (BEAR), to capture material risk takers other than those individuals with a high share of performance-based pay and to apply to all other persons whose activities have a material potential impact on the an entity's overall soundness (rather than being limited to financial soundness).
The banking royal commission recommended that APRA require entities to design their remuneration arrangements to encourage the sound management of non-financial risks, reduce the risk of misconduct and limit the use of financial metrics in connection with long-term variable remuneration.
APRA is not proposing to impose a cap on variable remuneration, or to prescribe the proportion of variable and fixed remuneration.
However CPS 511:
(i) imposes minimum standards relating to measures used to assess performance, as well as the time period over which variable remuneration must be deferred
(ii) limits the use of financial performance measures
(iii) promotes a broader suite of measures of performance, including non-financial and risk-based measures.
The proposed reforms focus on a balanced scorecard as the mechanism to improve the inclusion of non-financial risks in remuneration performance measures.
Financial performance measures must make up no more than 50 per cent of the weighting of total performance criteria used to determine variable remuneration.
Any individual financial performance measure must comprise no more than 25 per cent of the total measures used.
For entities designated as SFIs, APRA is proposing more extensive provisions.
For senior managers and highly paid material risk takers in these entities, a substantial portion of variable remuneration is to be deferred. Specifically, where the variable remuneration is $50,000 or more, APRA proposes to prescribe the minimum number of years it is to be held, vesting conditions and the minimum deferral periods.
APRA is proposing that SFIs implement clawback mechanisms to adjust variable remuneration outcomes for persons in special role categories.
The table below from APRA's discussion paper, 'Strengthening prudential requirements for remuneration (23 July 2019) summarises the holding requirements for variable remuneration in SFIs.
|Special role category
Substantial portion to be held
|Deferral period without vesting
||Deferral period with pro-rata vesting
||60% of total variable remuneration.
||Four years from the inception of the variable remuneration arrangement.
||Three years thereafter.
|Senior manager other than the CEO and highly paid material risk taker
||40% of total variable remuneration.
||Four years from the inception of the variable remuneration arrangement.
||Two years thereafter.
APRA has taken a conservative approach whereby SFIs must allow for variable remuneration to be recoverable for at least two years after the end of the deferral period, and a further two years where an individual’s circumstances are under investigation.
The table below from APRA's discussion paper (23 July 2019), summarises the variable remuneration design practices of Australian banks, international banks and under APRA's proposals.
||Current industry practice in Australia
||Better international practice
|Deferral of a portion
(4 years under the BEAR).
|7 years deferral for senior managers with pro-rata vesting after 3 years.
7 years deferral for the CEO with pro-rata vesting after 4 years.
||STI – 50% weighting for financial metrics.
LTI – 100% weighting for financial metrics.
|50% - 75% weighting for financial metrics.
||Maximum 50% weighting for financial metrics.
||Moderate use of malus and clawback not widely used.
||Malus used and clawback can be applied up to 10 years after the award.
||Require entities to have malus and clawback in place and use these when appropriate.
Banking Executive Accountability Regime (BEAR)
The BEAR is currently limited to ADIs. The BEAR imposes strengthened obligations on both ADIs and their 'accountable persons'. The obligations under the BEAR covers conduct that is systemic and prudential in nature.
The new prudential standard will operate in addition to the BEAR and APRA has already considered the BEAR provisions in developing the proposals regarding deferral of variable remuneration.
APRA has indicated that it recognises that the interaction of draft CPS 511 with the BEAR requirements could cause some difficulty and is proceeding to consult on its preferred approach to deferral and other matters.
APRA can apply to a court for the imposition of a civil penalty when there is evidence of a failure to comply with the BEAR relating to 'prudential matters' which is defined in the Banking Act 1959 (Cth).
In this regard, the accountability obligations of an 'accountable person' relates to conduct or behaviour that is systemic and prudential in nature and their obligations being a function of their role, the systemic nature of reasonable steps, and relating to prudential matters.
In its submission to the banking royal commission dated 13 July 2018, Treasury foreshadowed the extension of the BEAR would be consistent with evidence to the commission that indicates that governance and accountability issues extend beyond the banking sector into areas such as general and life insurance, financial advice and wealth management.
Treasury also raised the possibility of an extension of the scope of behaviour that is covered by the BEAR, along the lines of the regulatory approach in the UK, to cover conduct or behaviour that is of a systemic nature beyond those that impact the prudential reputation or standing. Such an extension could also require that both APRA and ASIC jointly administer the regime – similar to the approach in the UK.
Even if the BEAR doesn’t apply to a prudentially regulated entity in all likelihood the new stand-alone prudential standard in CPS 511 will ultimately apply to regulate remuneration frameworks of ADIs, general insurers, life insurers, private health insurers and RSE licensees.
Commencement of CPS 511
APRA intends to finalise the new prudential standard in late 2019 or early 2020. APRA expects that the requirements will come into force from 1 July 2021, although it will consider the feedback from consultation on implementation challenges in determining the appropriate start date. For the private health insurance industry, APRA expects that the new requirements will not apply until 2022.
Upon commencement of new standard, APRA will repeal the remuneration related requirements in CPS/SPS 510.
Private Health Insurance
APRA is proposing not to include private health insurers (PHI) in the SFI categorisation at this time.
APRA is in the process of modernising the PHI prudential framework more broadly, and will reassess the need to include PHIs as SFIs at a later date.
Impact of GCRA on all APRA regulated entities
Co-regulation, New Risk Culture Benchmark and GCRA Self-Assessment
Overall the APRA Information Paper signals the following headline changes which support the implementation of the GCRA regulatory framework:
- APRA and ASIC will cooperate on GCRA issues and work with ASIC and Treasury to design, implement and jointly administer an expanded accountability regime for regulated entities
- the introduction of a new regulatory tool to benchmark and assess trends in risk culture across regulated entities, similar in method to the work undertaken by the UK Banking Standards Board
- establishment of a risk culture benchmark in respect of which APRA will use its data analytics capabilities to interrogate the responses from self- assessment and reporting frameworks to provide evidence of the extent to which positive changes are (or are not) occurring
- scaling the self-assessment process to apply to all regulated entities to incorporate GCRA declarations and self-assessments into the supervision framework, building on the existing process of risk management declarations under CPS 220
- more formal supervisory actions applied to entities that fail to make sufficient progress in rectifying deficiencies in compliance with benchmarks and GCRA standards
- potential introduction of a full scale 'Prudential Inquiry' process for addressing GCRA issues in circumstances which are serious, complex and potentially indicative of systemic GCRA problems within the regulated entity or could, diminish the prudential standing of the entity including use of APRA’s formal investigation powers to undertake such reviews
- in the future, a dedicated GCRA team within APRA which will undertake a range of GCRA-related thematic reviews and deep-dives, as well as utilise entity self-assessments and industry-wide surveys
In strengthening its approach to GCRA compliance and risk culture benchmarks, APRA will have regard to international practice in the regulation and supervision of GCRA.
In its Information Paper, APRA has specifically identified a leading international governance practice which encompasses explicit powers for regulatory supervisors to veto board and senior management appointments and to observe board meetings. APRA has confirmed that is "considering the benefits associated with observing board meetings".
The strengthening of regulatory policy in respect of GCRA prudential governance, signals an intensification of APRA resolve to assess an entity's long term overall prudential and risk soundness (rather than being limited to financial soundness) and the outcomes for its customers.
The supervisory framework will be supported by periodic GCRA self-assessments and targeted GCRA deep dives as part of ongoing supervision.
Risk culture and an entity’s attitude to risk management will be fundamental to GCRA reviews and likely regulatory action will endeavour to 'root out' poor risk culture and related deficiencies or departures from benchmarks in governance, remuneration structures and accountability mechanisms.
This will necessitate deeper engagement with APRA by directors and senior managers of regulated entities set against a changing liability landscape for those directors and senior executives who are responsible and accountable for GCRA governance and compliance.
As foreshadowed in the Information Paper, this more intensive approach to GCRA responds to banking royal commission recommendations and will involve enhanced cooperation with ASIC and be enabled by additional government resourcing and a heightened regulatory appetite to intervene more forcefully where necessary.