1.1 Background

1.1.1Responses to the GFC

As the report of the Australian Prudential Regulation Authority (APRA) Prudential Inquiry into CBA noted, ‘remuneration practices at financial institutions globally came under a harsh spotlight during the Global Financial Crisis’.[1] The report said that remuneration practices ‘were exposed as promoting behaviours and outcomes that were inconsistent with sound risk management and the best interests of customers’.[2]

In 2009, in response to this exposure, the Financial Stability Board (FSB),[3] an international body that monitors and makes recommendations about the global financial system, released its Principles for Sound Compensation Practices (the Principles) and accompanying Implementation Standards. As the panel inquiring into CBA recorded, the Principles ‘sought to realign executive remuneration systems with prudent risk management and longterm financial sustainability’.[4] They were not explicitly directed to issues about the interests of customers, but instead aimed to ensure that:

  • the boards of financial institutions would have adequate oversight of the institution’s compensation arrangements;
  • compensation would be adjusted to take account of the risks to which employees exposed the financial institution; and
  • there would be effective supervisory oversight of compensation practices.

Although the Principles stated that compensation should be adjusted to account for all types of risk, including difficult to measure risks, they appear to have been understood as being directed to promoting financial soundness and stability, rather than addressing misconduct. Mr Wayne Byres, Chairman of APRA, described the Principles as having been ‘strongly focused on financial soundness’ and accepted that, in this respect, the Principles may have been ‘too narrowly focused’.[5]

This narrow focus was reflected in the way that APRA incorporated the Principles into its prudential guidance and prudential standards.[6]

In 2009, APRA issued a Prudential Practice Guide, PPG 511, about remuneration.[7] The guide was directed to all institutions regulated by APRA including authorised deposit-taking institutions (ADIs), general insurers and life companies. The guide said that ‘APRA’s remuneration requirements and guidance relate to managing or limiting risk incentives associated with remuneration’.[8] The guide did not identify the kinds of risk, or risk incentives, to which it was directed. In particular, it said nothing about conduct risk, compliance or regulatory risk and nothing about reputational risk.

In 2010, APRA amended its Prudential Standard about governance, CPS 510, to include requirements about remuneration. Among other things, these amendments introduced requirements for ADIs, general insurers and life companies to:

  • maintain a documented remuneration policy;
  • design performance-based components of remuneration to encourage behaviour that supports:
  • the institution’s long-term financial soundness; and
  • the risk management framework of the institution;
  • design performance-based components of remuneration to align remuneration with prudent risk-taking; and
  • provide for the board to adjust performance-based components of remuneration downwards, including to zero, if such adjustments are necessary to:
  • protect the financial soundness of the institution; or
  • respond to significant unexpected or unintended consequences.

Like the guide issued in the previous year, the standard did not identify the kinds of risk to which it was directed. But coming, as they did, in the immediate wake of the GFC, it seems probable that the guide and the standard would have been understood by those to whom they were addressed as being directed primarily, even exclusively, to the management of financial risks. Mr Byres accepted that both documents focused on the financial safety and soundness of financial institutions.[9]

Although APRA’s guide and standards did not deal expressly with the relationship between remuneration arrangements and misconduct, other developments in Australia in the wake of the GFC prompted legislators to consider that issue.

As I have explained in the chapter dealing with financial advice, several financial product and financial services providers in Australia collapsed during or after the GFC. In particular, in late 2008 and early 2009, many clients of Storm Financial sustained significant losses.[10] And many clients of Commonwealth Financial Planning Limited, many of whom were nearing retirement or had already retired, lost millions of dollars because they had followed bad financial advice. In response to these and other events, the Future of Financial Advice (FoFA) reforms were proposed.

The FoFA reforms, which were enacted in 2012, drew an explicit connection between remuneration and poor customer outcomes. The legislation did that in the provisions made about conflicted remuneration, defined as: benefits (monetary and nonmonetary) given to a financial services licensee, or a representative of a licensee, who gives financial product advice to persons as retail clients that ‘because of the nature of the benefit or the circumstances in which it is given’ could reasonably be expected to influence the choice of product recommended or product advice given to the client.[11]

To the extent to which banks or their subsidiaries participated in the personal financial advice market, these provisions applied directly. But no wider application of the guiding premise of these FoFA amendments (that remuneration affects conduct) to general remuneration arrangements within the banks seems to have been identified or considered by APRA, the Australian Securities and Investments Commission (ASIC), Treasury, or the banks themselves until several years after the FoFA reforms came into effect.

1.1.2International developments

By 2015, instances of serious misconduct associated with financial institutions in the United States, the United Kingdom and elsewhere had attracted much publicity. For example, in June 2012, Barclays plc, one of the world’s largest and most important banks, had admitted that it had manipulated LIBOR (a benchmark rate fundamental to the operation of financial markets and the basis of trillions of dollars of financial transactions).[12] Between 2012 and 2015, other banks admitted their parts in similar conduct.

These and other scandals prompted prudential concerns about effective governance, risk management, controls, and incentive-based compensation in Europe and North America.[13] Over $320 billion in fines and restitution imposed in the United Kingdom, the United States and the European Union were thought to have affected banks’ prudential standing and significantly reduced the value of their issued capital.[14] Banks and regulatory authorities began to consider how to address misconduct.

In 2015, the FSB launched a work plan to reduce the risk of misconduct at financial institutions around the world. The work plan had a number of elements. It looked at:

  • the relationship between governance frameworks and the risk of misconduct, including the ways in which ‘responsibility mapping’ could be used to strengthen the governance of conduct risk in financial institutions;[15]
  • the relationship between organisational culture and the risk of misconduct, and the work that supervisors can do to form a view about the culture of financial institutions;[16] and
  • the relationship between remuneration and misconduct.[17]

In 2016, as part of its work on the relationship between remuneration and misconduct, the FSB agreed to develop guidance on better practice in applying the Principles to manage the risk of misconduct. In March 2018, the FSB published the product of that work – the ‘Supplementary Guidance to the FSB Principles and Standards on Sound Compensation Practices’ (the Supplementary Guidance). The Supplementary Guidance was directed specifically to the use of compensation tools to address misconduct. It recognised that:[18]

Inappropriately structured compensation arrangements can provide individuals with incentives to take imprudent risks … Costs may be imposed on firms and their customers not only by inappropriate risk-taking but also by misconduct that can result in harm to institutions, and their customers and other stakeholders, and impair trust in the financial system more generally. Compensation tools, along with other measures, can play an important role in addressing misconduct risk by providing both ex ante incentives for good conduct and ex post adjustment mechanisms for appropriate accountability when misconduct occurs.

The Supplementary Guidance did not alter the Principles, or establish additional principles. It explained how the Principles should be applied to address misconduct. The Supplementary Guidance emphasised that the compensation systems of financial services entities should be designed to promote ethical behaviour and compliance with laws and standards, and that they should be implemented so as to manage the risk of misconduct.[19] Among other things, the Supplementary Guidance said that compensation systems should include:[20]

  • ‘ex ante processes that embed non-financial assessment criteria such as the quality of risk management, degree of compliance with laws and regulations and the broader conduct objectives of the firm including the fair treatment of customers, into individual performance management and compensation plans at all levels of the organisation’; and
  • ‘mechanisms to adjust variable compensation, including … through in-year adjustment, and malus or clawback arrangements, which can reduce variable compensation after it is awarded or paid’.

Importantly, the Supplementary Guidance also said that prudential supervisors should ‘monitor and assess the effectiveness of firms’ compensation policies and procedures, including the application of compensation tools in addressing misconduct risk and related misconduct outcomes’.[21] That is, the Supplementary Guidance proposed that supervisors, like APRA, should play a central part in monitoring the way that remuneration systems are designed and implemented to address misconduct. FSB is continuing to work in this area. In November 2018, it published ‘Recommendations for National Supervisors: Reporting on the Use of Compensation Tools to Address Potential Misconduct Risk’ (the Recommendations).

1.1.3Australian developments

While the work of the FSB progressed overseas, further attention was given to the relationship between remuneration and misconduct in Australia.

In 2016, the Australian Bankers’ Association (ABA) launched its ‘Banking Reform Program’. As part of that program, the ABA appointed Mr Stephen Sedgwick AO to conduct an independent review into remuneration practices in retail banking. The review began in July 2016 and Mr Sedgwick provided his final report in April 2017. The report said that:[22]

[S]ome current [remuneration] practices carry an unacceptable risk of promoting behaviour that is inconsistent with the interests of customers and should be changed. Some of these relate to management practices that may reduce the effectiveness of the bank’s risk mitigation strategies. Other practices relate to the way incentives and remuneration are structured. The need for change is true of both direct (ie staff) and some third party channels …

New approaches to retail bank remuneration are by no means a panacea. But the Issues Paper (issued by Mr Sedgwick in January 2017) has documented instances in retail banking and across the financial services sector more broadly, both in Australia and abroad, in which incentives have at least appeared to drive behaviour that was not in the best interests of customers and, on occasion, scandalously so.

Mr Sedgwick made 21 recommendations. He summarised the effect of the recommendations he made about retail bank staff (as distinct from introducers, referrers, franchisees and mortgage brokers) as being that:[23]

  • incentives will no longer be paid to any retail staff based directly or solely on sales performance (see Recommendations 2 and 7);
  • eligibility to receive any personal incentive payments will instead be based on an assessment of that individual’s contribution across a range of measures, of which sales (if included at all) will not be the dominant component (Recommendations 3, 4, 5 and 6), and the maximum available payments will be scaled back significantly for some roles (Recommendation 8);
  • retail bank culture will be demonstrably ethically and customer oriented (Recommendation 9);
  • a significant investment will be undertaken, as necessary, to ensure that performance is managed consistently with such a philosophy, and supported by proactive steps to develop leadership and management skills at all levels so that management practices match the intent of the recommendations (Recommendations 10,11 and 12); and
  • the board and the most senior managers of the bank will show clear and consistent leadership (Recommendations 13 and 14).

Each of the major banks told the Commission that it is committed to implementing the recommendations made by Mr Sedgwick.[24]

In 2017, APRA reviewed remuneration policies and practices across a sample of large financial institutions. One of the purposes of the review, focusing on APRA-regulated institutions, was to gauge how their stated remuneration frameworks and policies were translated into outcomes for senior executives’.[25] In April 2018, APRA published an information paper based on the review.

The paper noted that ‘other financial regulators and industry bodies’ had conducted reviews focused on remuneration ‘largely from the perspective of limiting the potential for misconduct’.[26] It went on to say that the link between remuneration and misconduct ‘is also of interest to APRA as a prudential supervisor’ but explained that this was ‘because conduct issues can provide additional insights into an organisation’s attitudes towards risk more generally’.[27] Unlike the FSB and other international bodies, however, APRA appears not to have considered dealing with the risk of misconduct as being an end in itself. Instead, for APRA, understanding an entity’s attitude to the risk of misconduct was a means to understanding the entity’s attitude to risk more generally.[28]

In the Interim Report, I expressed the view that it would be surprising, and a cause for concern, if APRA’s approach to prudential governance of remuneration remained as narrowly focused as its information paper suggested.[29] When he gave evidence in the seventh round of hearings, Mr Byres explained that the narrow focus of the information paper reflected the narrow focus of the prudential standards in their current form.[30] He acknowledged that the standards need to ‘evolve and improve’,[31] and said that APRA was in the process of changing its prudential standards and guidance to deal expressly with the potential for poorly designed and implemented remuneration systems to increase the risk of misconduct.[32]

APRA must revise its prudential standards and guidance about remuneration. Mr Byres said that work is already underway at APRA to identify ‘what … good look[s] like’,[33] and that he expects a revised standard will be made available for consultation next year.[34] I encourage APRA to continue that work as expeditiously as possible.

I make some specific recommendations in relation to the content of the revised standards below, but those recommendations should not be taken to exhaust the changes that will be required. In preparing the revised standards and guidance, APRA must bear steadily in mind that entities can and should use both the design and the implementation of remuneration and incentive systems to reduce the risk of misconduct. Misconduct can have significant consequences for financial soundness and stability. It undermines trust in the financial system. The use of remuneration systems to reduce the risk of misconduct is a legitimate – and necessary – subject of concern for a prudential regulator. Prudential regulation and supervision of remuneration arrangements must have, as one of its aims, the reduction of misconduct at financial institutions.

1.1.4Further observations

Poorly designed and implemented remuneration arrangements can increase the risk of misconduct. Well designed and implemented remuneration arrangements can play an important role in reducing that risk.

What I have said about local and international efforts to improve remuneration practices since the GFC shows that, until recently, the regulator with the power to create binding standards in relation to remuneration arrangements for ADIs, insurers and superannuation entities was focused on the potential for remuneration arrangements to affect the financial soundness of those entities. It had not focused, or not focused sufficiently directly, on the potential for remuneration arrangements to affect misconduct and compliance and, as a result, to diminish trust in and the reputation of individual entities and the Australian financial system generally.

In the sections that follow, I consider some of the failings that have been identified in relation to the remuneration practices of financial services entities, and the ways in which those failings can be addressed. In doing so, I will deal with the remuneration of executives separately from the remuneration of front line staff. While there are common features of the remuneration of both, there are important differences.

Like most international work in this area, APRA’s prudential standards and guidance are directed to the remuneration of senior employees: the entities’ executives.[35] Accordingly, I begin by considering those employees.


[1]CBA Prudential Inquiry, Final Report, 65.

[2]CBA Prudential Inquiry, Final Report, 65.

[3]Established in 2009 as the successor to the Financial Stability Forum that had been founded in 1999 by the G7 Finance Ministers and Central Bank Governors as a mechanism (among other things) for developing and implementing strong regulatory, supervisory and other policies in the interest of financial stability. See FSB, Our History (2018) FSB <www.fsb.org/about/history/>.

[4]CBA Prudential Inquiry, Final Report, 65.

[5]Transcript, Wayne Byres, 29 November 2018, 7397; FSB, Principles, 2.

[6]Transcript, Wayne Byres, 29 November 2018, 7394–5.

[7]APRA, Prudential Practice Guide PPG 511, 30 November 2009.

[8]APRA, Prudential Practice Guide PPG 511, 30 November 2009, 5 [2].

[9]Transcript, Wayne Byres, 29 November 2018, 7395–6.

[10]ASIC, Media Release 18-081MR, 22March 2018.

[11]Corporations Act s 963A.

[12]Clayton S Rose and Aldo Sesia, ‘Barclays and the LIBOR Scandal’, Harvard Business School Case 313-075, January 2013, revised October 2014 <www.hbs.edu/faculty/Pages/item.aspx?num=43888>.

[13]FSB, Supplementary Guidance, 3.

[14]FSB, Supplementary Guidance, 3–4.

[15]FSB, Reducing Misconduct Risks in the Financial Sector: Progress Report to G20 Leaders, 4 July 2017, 1–2.

[16]FSB, Reducing Misconduct Risks in the Financial Sector: Progress Report to G20 Leaders, 4 July 2017, 3.

[17]FSB, Reducing Misconduct Risks in the Financial Sector: Progress Report to G20 Leaders, 4 July 2017, 3–4.

[18]FSB, Supplementary Guidance, 1.

[19]FSB, Supplementary Guidance, 6.

[20]FSB, Supplementary Guidance, 6–7.

[21]FSB, Supplementary Guidance, 7.

[22]Sedgwick Review, Report, i.

[23]Sedgwick Review, Report, 7.

[24]Transcript, Matthew Comyn, 19 November 2018, 6587; Transcript, Andrew Thorburn, 26 November 2018, 7040; Transcript, Shayne Elliott, 28 November 2018, 7318; Exhibit 7.48, Statement of Brett Tollmann, 6 November 2018, 1718 [46], 20 [53].

[25]CBA Prudential Inquiry, Final Report, 65.

[26]APRA, Information Paper, Remuneration Practices at Large Financial Institutions, April 2018, 6.

[27]APRA, Information Paper, Remuneration Practices at Large Financial Institutions, April 2018, 6.

[28]APRA, Information Paper, Remuneration Practices at Large Financial Institutions, April 2018, 6.

[29]FSRC, Interim Report, vol 1, 320.

[30]Transcript, Wayne Byres, 29 November 2018, 7401.

[31]Transcript, Wayne Byres, 29 November 2018, 7401.

[32]Transcript, Wayne Byres, 29 November 2018, 7402.

[33]Transcript, Wayne Byres, 29 November 2018, 7405.

[34]Transcript, Wayne Byres, 29 November 2018, 7405–6.

[35]APRA, Prudential Standard CPS 510, July 2017, [57]. I note that the requirements do encompass the remuneration arrangements for more junior staff, where their collective activities may affect the financial soundness of the institution.