The UK’s House of Commons Treasury Committee, which scrutinises government, regulators, central banks and financiers, has published its report on the reform of corporate governance and pay in the City.

The UK’s House of Commons Treasury Committee, which scrutinises government, regulators, central banks and financiers, has published its report on the reform of corporate governance and pay in the City. This article outlines the committee’s findings and considers the implications of what it said.

Remuneration practices in financial services companies are cited as a clear factor in the crisis and blame is apportioned widely, including among remuneration committees, institutional shareholders and the regulators.

The Committee falls short, however, of recommending the regulation of actual levels or amounts of executive remuneration but a number of proposals made to ensure City pay is more effectively overseen in the future.

Executive Remuneration

From the evidence received, the Committee concluded that the design of reward structures in the banks, particularly in investment banking, led to reckless and excessive risk-taking.

The design of bonus schemes was flawed and not aligned with the interests of shareholders and the long-term sustainability of the banks, it said. The Committee criticised the Financial Services Authority for being complacent on this issue and the FSA’s Turner review for downplaying the role of remuneration structures in the banking crisis. It is concerned lest, as soon as the fuss dies down, banks simply carry on with their now-discredited remuneration practices. Although the Committee does not propose the regulation of the overall level of remuneration paid in the private sector, it does urge the FSA to make tackling remuneration structures in the banking sector a higher priority. Self-regulation or a light touch approach to regulating remuneration in the banking sector is said to be unacceptable.

The FSA's new code of practice on remuneration policies, meanwhile, is broadly welcomed. The committee endorsed the FSA's intention to impose higher capital requirements on banks and other financial services firms whose remuneration practices do not comply with the code of practice. However, it also urges the FSA not to back away from using its powers to sanction firms whose activities fall short of good practice. The FSA is also asked to provide regular reports on what action it has taken on remuneration policy in the banks. The committee recommended that the use of mechanisms to defer or claw back bonus payments for senior and board level staff should be encouraged to align the interests of senior staff more closely with those of shareholders.

The committee heard that shareholders are often in a weak position when seeking to engage on remuneration issues with firms in which they are investors. In particular, many of the highest paid individuals, particularly in investment banks, are below board level and, therefore, their remuneration does not need to be disclosed in the annual report.

The committee recommended reform so that banks and other financial services companies must disclose remuneration of senior managers at sub-board level. Remuneration structures within particular pay bands should be disclosed together with what deferral or clawback mechanisms apply.

Remuneration committees at firms are criticised for too often operating as "cosy cartels", with non-executive directors being all too willing to sanction the ratcheting up of remuneration levels for senior managers whilst setting relatively undemanding performance targets. The committee said there is a pressing need for increased expertise on remuneration committees as well as increased transparency and independence of mind.

The report recommended that the links between the remuneration, risk and audit committees should be strengthened and that the remuneration committee should also have greater input from interested stakeholders such as employees and shareholders.

The committee is also concerned about the evidence it received that remuneration consultants are responsible for the upward ratcheting of executive remuneration in the banking sector and that they have potential conflicts of interest when they advise both the company management and the remuneration committee.

Corporate Governance

The report also addresses corporate governance issues more widely than just executive pay and considered whether more effective corporate governance could have prevented the banking crisis.

For example, the committee said many non-executive directors failed to act as an effective check on, and challenge to, executive managers. This can be attributed, firstly, to the lack of time they devote to their role. The committee suggested that a "comply or explain" approach should be adopted whereby an individual who holds more than a certain number of posts would have to provide an explicit defence of how they would be able to fulfil this role in addition to their other duties.

Secondly, the lack of relevant banking or financial experience is also seen as a cause of the failure of non-executives to provide adequate checks on executive managers.

The committee says that serious consideration should be given to whether all, or a some of, non-executive directors sitting on bank boards should hold professional qualifications relating to banking or other areas of relevance such as accountancy.

The committee heard that institutional investors were not sufficiently engaged with the banks prior to the crisis and the committee concluded that some institutional investors accorded only a low priority to governance issues.

Future Regulation of Executive Pay

A number of issues raised in the Treasury committee report are referred to the Walker Review of corporate governance within the UK banking industry. This is expected to publish its recommendations in autumn 2009.

There are a number of other initiatives under way both in the UK and within the EU looking at how corporate governance and, in particular, executive remuneration, should be better regulated, both within the financial services sector and among listed companies generally.

In particular, on 30 April 2009, the European Union Commission published two Recommendations on remuneration policies, one relating to the financial services sector and the other relating to listed companies generally.

In both cases, the EU Commission decided against introducing a legally binding directive on executive remuneration as such, although it will assess the application of the recommendations at the end of the year.

However, in the case of the financial sector, the EU Commission is proposing to introduce legislation to amend the Capital Requirements Directive to ensure that regulatory capital adequately covers the risks inherent in (among other things) remuneration policies.

The recommendations contain a number of principles and member states are asked to take the necessary measures to promote these. They are designed to ensure, for example, that significant variable pay is linked to performance targets, is deferred for between three and five years and may be clawed back if data is proved to be misstated.

There currently appears to be no appetite for imposing an actual cap on executive remuneration and the advantages of variable pay in incentivising senior employees are recognised.

However, we can expect enhanced disclosure requirements and (either direct or indirect) sanctions for failing to take account of risk in designing executive pay structures, at least within the financial services sector.