Australia’s financial prudential regulator, APRA, has revealed its approach to the review of executive pay it is about to release for banks and other financial groups it oversees. The news will strike fear into the hearts of executives and boards.

The outline (“positioning”) was detailed in this speech by John Trowbridge, an executive member of APRA and one of the most experienced insurance industry executives and advisers in the country.

Banks, insurance companies and all other groups in APRA’s regulatory purview will be affected by the new policies.

“The purpose of this presentation is not to put on the table APRA’s proposed approach to executive remuneration, which will be explained in depth in a discussion paper to be issued in the next few weeks, but rather to explain the context of the executive remuneration debate generally and to position APRA’s approach within the wider debate, ” Mr Trowbridge said.

But from what he outlined, it’s clear Australian financial institutions of all sizes and complexities, from the biggest bank, to the smallest fund manager, will have to contend with stricter rules, more responsibility for boards and a tougher approach to risk.

In fact the approach on risk may very well rule out some of the riskier forms of investment activity, if executive remuneration is seen as encouraging it. It has implications for the likes of Macquarie Group and other financial groups regulated by APRA.

While it would not have captured some of the rorts at Allco and Babcock and Brown, from what Mr Trowbridge said, a new approach from ASIC and the ASX would cover the payment policies at listed financial engineers, including property.

But you can see why the Federal Government has used APRA (or encouraged it) to kick off the attack on overpaid executives. It can enforce its new rules, once decided on by simply getting boards of regulated companies and groups to take responsibility for their actions. Where there are breaches, the board will pay the price.

Mr Trowbridge revealed APRA’s hand in discussing the components of executive pay:

“Remuneration can usually be subdivided into three elements, namely fixed pay, short term incentive payments (STI) and long term incentive payments (LTI). APRA will be taking an interest in all three.

“APRA will be requiring incentive payments to be adjusted for risk. Such adjustments have not generally been required by regulators or other agencies in the past. Indeed rarely has there been any guidance on, let alone obligation for, risk adjustments.

The absence of risk adjustments, especially for some of the more extreme examples of high remuneration in the US and UK in recent times, is often seen to be both a failing of the remuneration structure and a direct contribution to the global financial crisis.

Extending the calculation of incentive payments over multi-year periods, and deferring bonus payments and the vesting of bonuses for several years, is usually a sound and transparent technique for making risk adjustments. APRA will generally be expecting eligibility for and assessment of bonus payments to go beyond one year.

“Performance measurement refers to the form and the metrics of incentive or bonus calculations. APRA will be offering some guidance around such matters as rewards in the form of cash, shares, share options and the like. We will also be offering some guidance on calculation methods, which can range from simple percentages of fixed pay to complicated formulae based on various measures of profitability and economic value added or economic capital models.”

That’s all well and good, but APRA is a regulator, so how can it enforce these changes? Answer, through the use of the prudential regulatory rules.

“The first distinguishing feature of prudential regimes is their opportunity to go beyond the disclosure approach and to use their supervisory powers to hold company boards directly accountable for executive remuneration,” Mr Trowbridge said.

“The second distinguishing feature is that their application is limited to regulated financial institutions. Given, however, the accountability inherent in APRA’s approach, we can expect quite some community and corporate interest in how influential this regime might be on boards of Australian companies that are not prudentially regulated.”

The key phrase in that paragraph is “the accountability inherent in APRA’s approach”. That simply means APRA has the ability to enforce its actions and get changes to executive pay. And when that is seen to be working, the pressure will be on ASIC and the ASX and other regulators to follow suit.