Reforming Executive Compensation: A Clear Purpose and a Blank Canvass (Part 2)

We are discussing the recent decision by the the Financial Services Authority (FSA) in the United Kingdom to regulate executive compensation in the wake of the current financial crisis.  In its August Policy Statement, the FSA identified that reforming the current system of unchecked executive compensation was a necessary step in establishing and maintaining economic stability.  Despite its clear purpose, it remains uncertain how the FSA will enforce its recently proposed regulations.      

The FSA has mostly relied on principal-based regulations that stops far short of any defined or formulaic limits on executive compensation.  In the introduction of Section 2 of the Policy Statement, “Remuneration policies and risk,” the FSA further explained the purpose of its decision:

• If remuneration consists predominantly of cash bonuses that are paid out immediately without any deferral or claw back mechanism, and are based on a formula that links bonuses to current year revenues rather than risk-adjusted profit, there are strong incentives for managers to shy away from conservative valuation policies, strong incentives to ignore concentration risks, strong incentives to rig the internal transfer pricing system in their favour and strong incentives to ignore risk factors, such as liquidity risk and concentration risk, that could place the institution under stress at some point in the future. These strong incentives could undermine effective risk management. (¶2.1)

The Policy Statement also concluded that the compensation schemes implemented in the banking and financial services industries had “allowed management to introduce compensation policies that in effect subordinate the interests of shareholders to those of employees.” (¶2.2). 

The presence of the new code, however, leaves several important questions unresolved. First, to what extent will the FSA pursue an agenda of aggressive enforcement?  Given the FSA’s laissez-faire track record and ambiguous principle-based philosophy, how prepared will the agency be to take the steps necessary to curb the defined dangers of excessive executive compensation?  Secondly, what will enforcement look like?  As enforcement of the new regulations begins, the FSA will be applying principles with which it has little experience and for which no precedential authority exists to provide guidance.