Whatever you think of Kevin Rudd, it is difficult not to admire his skills as a politician. Those talents were shown last year when during the financial crisis, as fingers were being pointed at wealthy executives, Rudd made an impassioned plea to Parliament, claiming that the enveloping financial crisis had been “turbo-charged by unregulated financial markets, by obscene remuneration packages that maximised risk with no regard whatsoever to the impact of their behaviour on ordinary investors”.

To remove the spectre of such extreme capitalism, Rudd commissioned APRA (and later the Productivity Commission), the prudential body that regulates banks and insurance companies to develop a set of rules to curb employees from benefiting from risky behaviour.

At the time, it was suggested that the APRA report would do little to prevent such behaviour but serve as a political smokescreen to make it appear that the federal government was curbing runaway executive pay. Those predictions would prove prescient.

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Yesterday APRA formally released prudential standards and a practice guide for corporate governance requirements. Sadly, the “minimum foundations” stated by APRA are either obvious, already in practice or won’t have any actual effect on curbing the scourge of “extreme capitalism”.

The APRA standards specified rules on director independence and board composition, most of which are already undertaken by large banks and insurers as well as rules regarding foreign-owned corporations. The big-ticket item, however, was remuneration — especially the sky-high salaries and bonuses received by bankers, without any connection to the risks they take with shareholders’ capital. In this regard, APRA’s guidelines are about a useful as a condom vending machine being installed in the Vatican.

APRA meant well, noting that:

The Remuneration Policy must provide for the Board or, for a foreign ADI, the senior officer outside Australia, to adjust performance-based components of remuneration downwards, to zero if appropriate, in relation to persons or classes of persons, if such adjustments are necessary to … (a) protect the financial soundness of the regulated institution; or (b) respond to significant unexpected or unintended consequences that were not foreseen by the Board Remuneration Committee or, for a foreign ADI, the senior officer outside Australia.

While nice in theory, not only does APRA fail to provide a degree of guidance on what constitutes the “soundness of the regulated institution” but most pertinently, boards already have the ability to reduce bonuses to zero. For example, short-term bonuses are largely at the whim of boards (most remuneration reports provide merely vague outlines of what underlines short-term bonuses), it’s not that company directors don’t have the ability to curtail bonus payments, but rather, that they choose to pay executives millions of dollars in short-term cash payments.

APRA intentionally did nothing about quantitative measures — banks are still able to pay executives as much as they like. Not only did APRA completely avoid setting any sort of quantum limits, but it also adopted a vague description of “risk” as a means of benchmarking remuneration, specifically:

The performance-based components of remuneration must be designed to align remuneration with prudent risk-taking and must incorporate adjustments to reflect (a) the outcomes of business activities; (b) the risks related to the business activities taking account, where relevant, of the cost of the associated capital; and (c) the time necessary for the outcomes of those business activities to be reliably measured.

The statement has little real effect — how does an institution (or APRA, for the purposes of regulation or enforcement) determine risk? Does it relate to volatility of earnings? Or how those earnings are derived? (APRA’s Practice Guide notes only that “a number of techniques are available to adjust accounting profits for risk. The board would be expected to choose the techniques most appropriate to the circumstances of the regulated institution”.)

APRA makes no reference as to how such risk would actually be measured and or how it would enforce any rules. APRA also intentionally failed to define the levels of “performance-based” remuneration that should be paid. Then there is the practical problem of linking risk taking with specific employees, especially in very large financial institutions.

Ultimately, the guidelines are a load of well meaning puffery, which, most likely, would have little or no actual effect on how much (or even the manner in which) banking executives are paid. The entire episode appears to be an expensive way for the federal government to appear to be doing something to prevent runaway remuneration.

(In fairness, the guidelines weren’t a complete waste of time, APRA did manage to come up with a few worthwhile recommendations. Specifically, APRA determined that remuneration committees must consist of only non-executive directors (many instances of high remunerations, such as Babcock & Brown, Leighton and Village Roadshow involved the CEO sitting on the remuneration committee). In addition, APRA also stated that external advisers (presumably remuneration consultants) are not to be employed if they are currently or have recently acted on behalf of management.)

For what it’s worth, the new standards will apply to banks and insurers from  April 1, 2010.

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Peter Fray
Peter Fray
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