Weekend Reading: The Price of Culture — Supporting Financial Stability Through Compensation

By: Ratidzo Starkey , Member of the Secretariat at the Financial Stability Board (FSB)

This piece first appeared in Starling Insights' newsletter on February 2, 2025. If you are interested in receiving our thrice-weekly newsletter, among many other benefits, please consider signing up as a Member of Starling Insights.

The Financial Stability Board (FSB) has long been at the forefront of fostering sound compensation practices within the financial sector to ensure stability and mitigate misconduct. The?FSB Principles for Sound Compensation Practices (April 2009) and their?Implementation Standards (September 2009) — collectively, the “Principles and Standards” — were developed to align compensation with prudent risk-taking, particularly at significant financial institutions.

The FSB Principles and Standards provide a framework for aligning compensation with prudent risk-taking, which is crucial in mitigating the risk of future financial crises. In addition to promoting prudent risk-taking, compensation tools such as in-year adjustments, malus and clawback, 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 that ensure appropriate accountability.

The FSB monitors and reviews the effective implementation of the FSB Principles and Standards.* In 2024, the FSB conducted a survey of its member jurisdictions to take stock of relevant recent developments and industry practices and hosted a workshop to explore related topics (e.g. compensation, reward, performance and human resources). The workshop brought together senior executives of major banks, insurance companies, asset management firms, and compensation and business consultancy firms, as well as academics. This article summarises the FSB’s recent report on Legal and Regulatory Challenges to the Use of Compensation Tools and the key learnings achieved.

The Role of Compensation in Financial Stability

The 2023 banking turmoil highlighted the critical importance of integrating robust risk culture and governance into compensation frameworks in order to mitigate financial misconduct and to ensure sustainable business practices. Among other things, the banking turmoil revealed shortcomings in compensation practices, including the use of compensation tools. For example, a report by the Basel Committee on Banking Supervision (BCBS) noted that compensation structures at Silicon Valley Bank encouraged a focus on short-term gains at the expense of sound risk management practice.**

Legal and Regulatory Challenges

The FSB's report on Legal and Regulatory Challenges to the Use of Compensation Tools highlights the continued progress made by FSB member jurisdictions in implementing compensation tools. However, the implementation of uniform compensation practices globally is complicated by the diverse legal and regulatory landscape across jurisdictions. For instance, the FSB report notes that clawback provisions are particularly challenging to enforce, especially in the United States and Europe, where cultural and legal impediments complicate their application.

In some jurisdictions, restrictive labour laws prevent the effective implementation of clawback provisions, making it difficult to reclaim distributed compensation. Participants at the FSB workshop noted that malus and clawback have limited effectiveness as deterrents, as individuals often find ways to circumvent these measures. One such example of this is an employee agreeing to a higher sign-on bonus instead of a buyout (deferred remuneration pending and paid by the incoming firm). The workshop discussion underscored the need for greater awareness and understanding of compensation tools among courts and regulatory bodies, as well as the importance of transparency in compensation structures to drive accountability and long-term corporate sustainability.

Link Between Compensation and Culture

The importance of culture was another key theme stemming from the workshop discussion.

Compensation practices are deeply intertwined with an organisation’s culture. They are pivotal in shaping employee behaviour and aligning employees’ actions with the long-term goals of financial institutions. Conversely, compensation schemes that prioritise short-term gains can incentivise excessive risk-taking, potentially leading to financial instability or misconduct.

Compensation is not merely a financial mechanism; it also serves as a significant cultural signal within an organisation. The way employees are rewarded sends strong messages about what behaviours are valued and encouraged. Establishing and maintaining a sound risk culture, with a clear tone set from the top, is fundamental. Incentive schemes are an important element of any such “tone.”

The bank failures of 2023 underscored the role of Boards and Senior Management in linking incentive structures to prudent risk metrics. Several postmortem reports have identified fundamental failures in risk management and oversight, including a lack of robust and prudent risk metrics, as root causes of the 2023 bank failures. Compensation at these banks was often tied to short-term financial profits and returns, exacerbating vulnerabilities, leading to misconduct and issues in managing non-financial risks.

Key Learnings for Organisational Culture

Some key learnings can be drawn for designing appropriate compensation schemes:

1. Alignment with Long-Term Goals: Compensation schemes should be aligned with the long-term objectives of the organisation. This includes incorporating deferred compensation and clawback provisions that hold employees accountable for their actions over an extended period. The FSB report emphasises the need for compensation outcomes to be symmetric with risk outcomes, ensuring that rewards are aligned with long-term performance rather than short-term gains.
2. Risk Awareness and Management: Financial institutions should integrate risk management into their compensation frameworks. By linking compensation to risk-adjusted performance metrics, organisations can promote a culture of risk awareness and prudent decision-making. Participants of the FSB workshop highlighted the importance of risk scorecards reviewed by the Chief Risk Officer (CRO) and the Risk Oversight Board to ensure that compensation reflects the risk profile of the institution.
3. Transparency and Communication: Clear communication about compensation policies and their rationale is essential. Transparency fosters trust and ensures that employees understand how their actions impact their rewards. The FSB report notes that transparency in compensation frameworks and outcomes is crucial for fostering employee accountability and for winning stakeholder confidence, especially during times of crisis.
4. Cultural Consistency: Compensation practices should be consistent with the broader culture of the organisation. If an institution values integrity and ethical behaviour, its compensation structures should reflect and reinforce these values. Participants at the FSB workshop emphasised the importance of embedding a sound performance management system throughout the organisation to promote positive behaviours and a sound risk culture.

Challenges in Implementing Compensation Tools

Despite the clear benefits of well-designed compensation tools, their implementation remains challenging. The FSB report identifies several key obstacles:

1. Legal and Cultural Hurdles: As already mentioned, clawback provisions are particularly challenging to enforce due to legal and cultural hurdles. For example, in some Latin American countries, compensation tools such as clawback and malus are seen as offensive, complicating their application. One participant at the FSB workshop noted their experience of prolonged legal challenges with clawback, even when the case for negligence and misconduct was clear.
2. Administrative Burden: Implementing compensation tools such as malus and clawback involves significant administrative effort. Participants at the FSB workshop noted that these tools require considerable time and resources, making their application burdensome for firms.
3. Complexity of Compensation Structures: Compensation structures are becoming increasingly complex, challenging to implement, and difficult to communicate effectively. This complexity can result in unintended consequences; workshop participants noted, as examples, the establishment of a culture of fear within the organisation and the need to increase fixed remuneration to offset variable compensation subject to adjustment.
4. Impact on Talent Attraction and Retention: Compensation tools can impact the ability of financial firms to attract and retain talent. Workshop participants highlighted that regulatory requirements in remuneration are not fully aligned across jurisdictions, creating an uneven playing-field and potentially disincentivising employees from joining firms with stringent compensation frameworks. The effectiveness of compensation tools also hinges on their integration into the broader risk culture of the institution, with proportional application being crucial to maintain a balance between attracting talent and ensuring robust risk management. Participants noted that firms must balance the use of compensation tools against the competition for talent between financial institutions and other sectors. For example, the Fintech sector often lacks bonus caps, deferrals, malus, and clawbacks.

Next steps

Though significant, the challenges to implementing compensation tools are not insurmountable. The FSB report provides several practical steps that firms and regulatory bodies should consider to address such challenges:

1. Strengthen Board and Remuneration Committee Roles: The Board, including the Remuneration Committee, plays a crucial role in establishing compensation frameworks that drive the desired risk culture. Boards must be willing to discharge their responsibilities to apply compensation tools where risk incidents occur, based on appropriate risk reporting from sources such as the CRO and Risk Committee. Firms should ensure that their Boards and Remuneration Committee members have the necessary skills and independence to oversee and apply compensation tools effectively. Further, they should seek to enhance governance frameworks to support their Boards in making informed and balanced decisions regarding compensation adjustments.
2. Foster a Strong Risk Culture: Compensation practices should be deeply intertwined with organisational culture. A culture of accountability and strong risk management is essential. Leadership must therefore seek to embed a risk-aware culture throughout the organization, starting from the top, they must ensure that compensation practices reinforce this culture, and that they promote relevant accountability at all levels. Lastly, firms should utilise risk scorecards and other tools to integrate non-financial risk metrics into their compensation frameworks.
3. Enhance Transparency and Simplification: Clear communication regarding compensation frameworks is crucial, as is clear discussion of how compensation outcomes link directly to firm performance and its prudent risk management. The FSB report highlights the importance of transparency in fostering employee accountability and gaining stakeholder confidence. With this in view, management should simplify compensation structures to make them easier to understand and implement. They should focus on clear, straightforward tools like in-year adjustments and malus provisions. And they should increase transparency in compensation practices and outcomes, helping to ensure clear communication with both internal and external stakeholders.
4. Regulatory and Supervisory Roles: Regulators and supervisors play an important role by setting expectations and monitoring the use of compensation tools through the guidance they offer, the standards they establish, and the supervisory activities they conduct. Continuous development of regulatory expectations is important to evolve and uplift minimum standards. Collaboration with legal and compliance teams to address the complexities of implementing malus and clawback provisions is also important. To ensure that compensation tools are legally sound and aligned with regulatory expectations, firms must engage with regulatory bodies to develop clear guidelines and support for the effective use of compensation tools.

Conclusion

The FSB's recent report on the legal and regulatory challenges to the use of compensation tools provides key insights into the intricate relationship between compensation practices and organisational culture. By aligning compensation with long-term goals, integrating risk management into compensation frameworks, ensuring transparency, maintaining cultural consistency, and adhering to regulatory requirements, financial institutions can foster a culture that supports stability and ethical behaviour.

The lessons from the 2023 banking failures underscore the importance of sound compensation practices in promoting prudent risk-taking and accountability. While challenges in implementing compensation tools remain, the practical solutions provided by the FSB offer a roadmap for financial institutions to overcome these obstacles and to build a resilient and responsible industry. As the financial landscape continues to evolve, these learnings will be instrumental in shaping a robust risk culture and ensuring the long-term health of financial institutions.

*See: https://www.fsb.org/work-of-the-fsb/implementation-monitoring/monitoring-of-priority-areas/compensation-practices/.

**BCBS (2023), Report on the 2023 banking turmoil, October.

Ratidzo Starkey?joined the Financial Stability Board as a member of the Secretariat in February 2021. She supports the FSB’s Compensation Monitoring Contact Group, which provides a forum for supervisory authorities, central banks and practitioners to share information on developments in compensation practices of financial institutions.