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A full review on new Hector Sants Remuneration policies, UK Financial Services Authority

By Amarendra Bhushan for CEOWORLD Magazine Updated:October 13, 2008

The following is Hector Sants’s statement from the Financial Services Authority on executive pay after the UK government attached conditions to its 37 billion pounds ($64 billion) bailout of British banks. Hector Sants was appointed FSA Chief Executive in July 2007. He joined the FSA in May 2004 as Managing Director, Wholesale and Institutional Markets at the Financial Services Authority. Hector had responsibility for all regulated markets, the related infrastructure such as clearing and settlement, the operation of the UK Listing rules and regulation of firms or groups which conduct primarily wholesale or institutional market business between professionals.

Dear CEO

Remuneration policies

Introduction

1. There is widespread concern that inappropriate remuneration schemes, particularly but not exclusively in the areas of investment banking and trading, may have contributed to the present market crisis. In the private sector, bodies such as the Counterparty Risk Management Group (CRMPG) have identified remuneration structures as one of the possible driving forces behind current problems.1 The International Institute of Finance (IIF) reached a similar conclusion and has issued Principles of Conduct which they think should be adopted by firms.

2. The FSA shares these concerns. It would appear that in many cases the remuneration structures of firms may have been inconsistent with sound risk management. It is possible that they frequently gave incentives to staff to pursue risky policies, undermining the impact of systems designed to control risk, to the detriment of shareholders and other stakeholders, including depositors, creditors and ultimately taxpayers.

3. The FSA has no wish to become involved in setting remuneration levels: that is a matter for Boards, which should ensure that they have effective structures in place to set remuneration policies and monitor remuneration levels throughout the firm. However we want to ensure that firms follow remuneration policies which are aligned with sound risk management systems and controls, and with the firm’s stated risk appetite.

4. Note that our interest in this area (and the scope of this letter) does not extend to the remuneration of Board non-executive directors. Their remuneration (as well as their role, eg in overseeing employee remuneration) has been covered in the 2003 Higgs Review and earlier reviews.

Criteria for ‘good’ and ‘bad’ remuneration policies

5. It is difficult to be prescriptive about remuneration policies. They will vary widely between firms, and within firms between different levels of staff. They will also need to reflect many factors including the nature of the business undertaken and the culture of each institution. Nevertheless we believe that it is possible to set out some high level criteria against which policies can be assessed. An illustration of our current thinking is set out in the attached annex.

Action for firms

6. Many firms have a remuneration process with a year end review. Planning for that review may already be underway. I urge all firms, whatever the timing of their remuneration reviews, to consider carefully their remuneration policies, especially in light of recent market developments. If the policies are not aligned with sound risk management, that is unacceptable. Immediate action will be required to change the policies.

7. The criteria set out in the annex provide a benchmark for this exercise. We would expect firms to avoid (or to be implementing plans to eliminate) bad or poor practices concerning the measurement of performance, the composition of the remuneration and governance arrangements.

8. We would further expect firms to be moving towards good practice. We recognise that performance-adjusted, deferred compensation arrangements are complex to design: nevertheless, if they are not already in place we expect firms to be considering actively how they might be incorporated into remuneration structures within a specified time period.

Action by the FSA.

9. During September the FSA held a number of high level discussions with London-based firms about remuneration policies. Between now and the end of the year we will arrange a further round of visits to all recipients of this letter. Our aim will be to gather more specific information about remuneration practices in your firm to assure that bad practices are not present and to seek further input on what would constitute good practice.

10. In the early part of next year we will communicate our findings regarding good practice to you, and have a further discussion with you about them, if appropriate. We will also publish our general findings about remuneration structures in the London market, on a no-names basis.

11. We believe that given the events of the past year firms recognise the need to review their remuneration policies and to take steps to change them if necessary. We believe that in working with the industry we can assist and encourage this process.

12. Changes to remuneration policies formed part of the recommendations of the report of the Financial Stability Forum4, and the subject remains under active discussion internationally. The FSA is taking a prominent part in those discussions. We are mindful that to be effective action on this subject needs to be taken internationally. We hope to be able to report on the international work in our published report early next year.

Conclusion

13. This letter does not constitute formal Guidance from the FSA but is intended to update you in regard to our work on remuneration policies and to inform you as soon as possible of our initial thinking in this area. We would encourage firms to review compensation policies throughout the firm (not just in trading and investment banking areas) to be sure that they are consistent with sound risk management. We will update firms early in the new year on the result of our further work as well as progress in international forums, such as the FSF.

Criteria for good and bad remuneration policies

a) Measurement of performance for the calculation of bonuses

Bad or poor practice (firm view):

Calculated on the basis of revenues, without any counterbalancing risk controls
Does not take risk or capital cost into account
Performance assessed entirely on the results for the current financial year
Employee bonuses calculated solely on the basis of financial performance

Good practice (initial thoughts)

Calculated on profits, and by reference to other business goals if appropriate
Uses a measure of risk-adjusted return. Measure likely to be based upon economic capital calculation, and should take proper account of a range of risks including liquidity risk.
Performance assessed on a moving average of results
Bonuses awarded take into account appraisal of other performance measures, including risk management skills, adherence to company values and other behaviours

b) Composition of the remuneration

Bad or poor practice (firm view)

Remuneration which has little or no fixed component.
Paid wholly in cash
No deferral in the bonus element

Good practice (initial thoughts)

Fixed component of the remuneration package to be large enough to meet the essential financial commitments of the employee.
Appropriate mix of cash and components which are designed to encourage corporate citizenship and alignment of interests between those of the employee and those of the firm.
A major proportion of the bonus element is deferred so that the impact of the performance in one year on the firm/unit’s long term profits can be established

Sincerely,

Hector Sants
Chief Executive
Financial Services Authority

Hector Sants bio (Profile)

Chief Executive Officer, the FSA

Hector Sants was appointed FSA Chief Executive in July 2007. He joined the FSA in May 2004 as Managing Director, Wholesale and Institutional Markets at the Financial Services Authority. Hector had responsibility for all regulated markets, the related infrastructure such as clearing and settlement, the operation of the UK Listing rules and regulation of firms or groups which conduct primarily wholesale or institutional market business between professionals.

Hector joined the FSA from Credit Suisse First Boston where he was Chief Executive Officer of Europe, Middle East and Africa and has extensive experience of the wholesale markets both in the UK and internationally. He joined CSFB in 2000 when the firm merged with Donaldson, Lufkin & Jenrette and was a member of CSFB’s Executive Board. He was a member of the Financial Services Practitioner Panel and was previously a Board member of, among other bodies, the SFA and the London Stock Exchange.

Hector Sants, 51, joined the FSA in May 2004 from Credit Suisse First Boston where he was chief executive of Europe, Middle East and Africa. He joined CSFB in 2000 when the firm merged with Donaldson, Lufkin & Jenrette and was a member of CSFB’s Executive Board. He was a member of the Financial Services Practitioner Panel and was previously a Board member of, among other bodies, the SFA and the London Stock Exchange. He is married with three children and lives in Oxford.

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