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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 72-iii
House of commons
TAKEN BEFORE THE
Corporate governance and remuneration in the financial services sector
Tuesday 19 June 2012
Dick Saunders, Otto Thoresen and David Paterson
Evidence heard in Public Questions 122 - 197
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Taken before the Treasury Committee
on Tuesday 19 June 2012
Mr Andrew Tyrie (Chair)
Mr Andrew Love
Mr Pat McFadden
Mr David Ruffley
Examination of Witnesses
Witnesses: Dick Saunders, Chief Executive, Investment Management Association, Otto Thoresen, Director General, Association of British Insurers, and David Paterson, Head of Corporate Governance, National Association of Pension Funds, gave evidence.
Q122 Chair: Thank you very much for coming in to see us. Dick, you are a regular. There are varying degrees of frequency as I look across the panel. Can I begin with a question to Mr Saunders? Do you think that we need a separate or distinctive approach to systemically risky financial institutions with respect to corporate governance?
Dick Saunders: I would argue probably not in relation to corporate, but yes in other directions. Dealing with corporate governance first, clearly corporate governance is extremely important in these institutions and I think it is well known that some corporate governance failings were a contributory factor in the failure of some institutions in 2007-08. Without wishing to understate in any way the importance of good corporate governance practice and good boardroom practice in these institutions, I would suggest the issues are fundamentally very similar to those that you would find in any other large company-so BP, Vodafone and so on.
Where I think the difference arises and what differentiates systemically important financial institutions is the risk to the taxpayer. If these institutions fail then there is no option but for Government and taxpayer to step in and that, I would suggest, calls for a public policy and regulatory response, rather than a differential approach to corporate governance. Indeed, we are seeing that at the moment. In Europe, there are two major directives-the Capital Requirements Directive, CRD IV, and the Crisis Management Directive-which are both making their way through the process in Brussels at the moment, and which are aimed specifically at introducing appropriate regulatory structures that are complementing, in many ways, what is already being done in the UK following the Independent Commission on Banking.
Q123 Chair: Does anybody else want to add anything to that?
Otto Thoresen: I admit I agree with Dick-the answer would be no. I would put it in a slightly different way, but I think we arrive at the same place. Within the board structure you have a very important role for the chairman, you have a very important role for the risk committee and you have a very important role for the remuneration committee. Where you have an SIFI, I think the nature of the tools that are used by those groups within the board structure may be tuned to different things and have a different set of priorities that they are trying to address, but I think the principles that make for a well-run company and a well-run board would apply equally to SIFIs as to any other organisation.
David Paterson: I would agree with Otto and with Dick, but would add that I think investors place enormous stress on good regulation because that is a given when they invest in SIFIs, basically. If the regulatory regime is not effective, that significantly changes the investment risk profile, if you like, of these businesses.
Q124 Chair: Do you think all this corporate governance has added any economic value?
David Paterson: I am a corporate governance specialist so I am biased, I suppose. I think it does add value in the sense that it provides a framework within which boards can think about effective risk management and investors can also think about how to manage the risks of investing in businesses. I think governance does provide a very important part of the overall framework, but it has to be applied effectively. That depends, essentially, on the directors of the company taking into account the kind of business that they are overseeing and the goals and risks that apply to that business.
Q125 Chair: The Combined Code, Mr Saunders, has primarily been a private sector-driven creation. You talked about taxpayers being put at risk. Is there a much bigger role for Government here in making sure that corporate governance is in good shape with respect to those bodies?
Dick Saunders: I think that is part of the regulatory response. If you look at CRD IV, for example, there is a whole section in there about corporate governance within financial institutions. When the FSA supervises institutions, all major businesses, it places great stress on good corporate governance. I think in fact Government is already there.
Q126 Chair: Do you have confidence the EU can add value to this?
Dick Saunders: I think it is a good thing it is happening at EU level, because it is not simply a national issue. In many ways, the UK has blazed the trail here. The UK was first in Europe to recapitalise its banks in the wake of the crisis, and the recommendations of the ICB have been a very important driver of the intellectual debate here. Yes, I do think it’s good that it’s happening.
Q127 Jesse Norman: Mr Paterson, since the crisis there has been a much stronger focus on remuneration issues from the regulators. We do not seem to see much change in remuneration culture within the banks. Why do you think that is?
David Paterson: The first point I would make is that remuneration in banks has thawed over the past three years, reflecting the fact that profits are down. I agree with you that the culture has not changed completely yet and, as investors in the sector, we see a real need for the industry to focus on providing returns to those who provide the risk capital as part of the consideration of the overall division of the spoils, if you like. Why hasn’t it changed? I find that hard to answer. One can point, by way of excuse rather than explanation, to international pressures-the rise of a very strong Asian culture for investment banking that has taken people out to Asia on very high salaries; the American culture is different and a lot of these businesses are private as well as public. I think there are a number of factors that are working there and working, frankly, against the providers of capital. There are problems, which we are trying to work on with the banks at the moment.
Q128 Jesse Norman: That is very interesting. The culture of these institutions is working against the interests of the providers of capital?
David Paterson: Yes.
Q129 Jesse Norman: Has the change in the Shareholder Register so that there is a move away from pension funds and towards arbitrageurs and hedge funds and other institutions made a difference to that?
David Paterson: I would argue that we, as pension fund investors-and I take note of my colleagues alongside me here-probably have more clout than our position on the register suggests. In other words, we are the first port of call, as UK institutional investors, for banks and other companies looking to understand whether or not they are applying the Governance Code remuneration policies in the interest of shareholders. So I think that is important.
Q130 Jesse Norman: Mr Thoresen, would you agree with the comments that have been made? Do you think this has been contrary to the interests of the capital providers?
Otto Thoresen: My first comment would be that my own personal experience of this is relatively recent-from April last year until now. I think it fair to say that the level and effectiveness of the engagement up to the middle or, say, the third quarter of last year was not very good. There was engagement. There was a lot of discussion between the entities and the investors about what was expected, what was wanted or what was desirable, but there was not an awful lot of evidence of change. Some of the frustration behind that lack of change was what led to us going public in December with a letter to the five quoted banks about our views on the balance of sharing of value between shareholders through dividends, rewards to senior executives in the funds and capital retained to support the banks in their development in the future.
Q131 Jesse Norman: That was a reflection of the lack of competitiveness in the market. You were not able to exercise enough competitive pressure, as a provider of capital, to discipline these people not to pay themselves so much.
Otto Thoresen: We had views as investors, which we were making known, and we were not convinced that the response we were getting was reflecting those views or demonstrating any real change within the organisations. What happened after that was a period of very significant engagement with those banks through January, February and March. Where I would differ with David is that it is not the case that across all those banks we saw no response in terms of the beginnings of change. There was an acknowledgement of our argument, and in fact there has been public acknowledgement of our argument by some of the principals within those banks. I do believe that it is beginning to change. It is not uniform and it is not, perhaps, fast enough, but it is beginning to move.
Q132 Jesse Norman: Thank you. A final question for Mr Saunders, if I may. You might say there are three constraints on excessive remuneration. One is the market, which, it appears, is not succeeding in exercising enough control. The second is regulation, where there has not been much of a response. The third is culture. Do you share the views that we have had expressed to us that, of these three, the great unacknowledged one is culture and we need to look at a much wider-ranging response to changing the culture within these institutions?
Dick Saunders: I think culture is certainly extremely important and is the fundamental driver here. People’s expectations about earnings within the financial sector are wildly out of line with most other sectors of the economy and that is quite clearly a cultural issue. Yes, I would agree.
Q133 Mr Ruffley: A question for Mr Saunders. You have said that asset managers do not give rise to any systemic concerns. Are you inviting us to believe that the failure of a significant buy-side institution would have no effect on the UK economy?
Dick Saunders: Yes, I think that is correct. The important thing to remember about buy-side institutions is that, as institutions, they are quite small. They are nothing like the size of a bank and the reason for that is, while they may be managing hundreds of billions in the way of assets, those assets are held entirely separately from the asset manager. Were the asset manager to fail, those assets would be unaffected by that. So the only people that suffer when an asset manager fails are the employees and shareholders of that firm. It does not ripple out into the broader economy.
Q134 Mr Ruffley: A separate question: do you think there are any concerns that your industry needs to address regarding the corporate governance of and remuneration of asset managers, or is everything in the garden lovely?
Dick Saunders: On corporate governance, I am not aware of any specific issues. The corporate governance within an asset management firm is organised in the way that it is, whether it is listed or unlisted.
In terms of remuneration, the asset managers are subject to the same requirements in the Capital Requirements Directive as other financial institutions, although they are applied in a more proportionate manner. Generally speaking, when one looks at the way individual asset managers are incentivised, there is a fairly substantial performance-related element in there, which is related to the performance of the funds that they are managing. That is in order to try to align their interests with those of their clients. Those performance arrangements and incentive arrangements tend to be over up to three years, sometimes up to five years, and may be subject to clawback as well.
Q135 Mr Ruffley: Mr Thoresen, the ABI says to this Committee that we need to be clearer about the categories of institution that we are referring to when discussing the meaning of "systemically important". Can you tell us what the ABI defines as systemically important?
Otto Thoresen: I think there is extensive work already in the public domain around the categorisation of banks in that category. The discussion about how you extend beyond into other sectors-
Mr Ruffley: Yes. Going beyond banks-outwith banks or financial firms-can you give us a kind of working definition?
Otto Thoresen: Where I start from is, to a certain extent, the same territory that Dick was covering. The liabilities that exist within the organisations have assets that are in the organisations that can match those liabilities. If you take insurance companies, on the whole, insurance companies deal with long-term liabilities and hold assets long term to match those liabilities. So the existence of that kind of balance within your organisation protects the external economy from the effect of failure within the fund. But there have been, historically, insurance businesses globally-AIG is a very obvious example-who have extended their activities into territory where the principle that has underpinned how insurance businesses operate is not present, and those businesses then become SIFIs, clearly.
Q136 Mr Ruffley: Your submission says that the International Association of Insurance Supervisors has yet to determine whether or not an insurance company merits this categorisation of "systemically important financial firm". Wouldn’t you think it prudent, given the uncertainty at the moment, to say, "Let’s treat big insurers as systemically important financial firms for the purposes of inquiries of the kind we are engaged in today"? Why are you trying to exclude them? That seems to be the thrust of ABI’s position.
Otto Thoresen: I think what we are trying to do is effectively to segment the financial services industry into a number of different categories and try to approach those categories from first principles and identify where the risks are. Much of the discussion we are having at the moment has been about good governance and good practice in funds. I think, though, if you move to a point where the regulatory response is about protecting the wider economy from the effect of failure, it is important that that only be applied where it is relevant and justified. In our view, the vast majority of insurance businesses globally would not be in that category.
Q137 Mr Ruffley: The key words in your last sentence are "the vast majority of". What about the minority? Who might they be? Could you give us a description?
Otto Thoresen: The discussion that has been going on globally with the International Association is around where funds are operating in related sectors. I used the example of AIG earlier. I think that is a public domain example of an organisation that offered services and products that were outside the normal definition of insurance but were, as a result of that, exposing them and the economy to far greater consequences of failure. The discussion at the moment is about the extent to which that should be reflected in the way the overall organisation is classified, from the point of view of whether it is a SIFI or not.
Q138 John Thurso: Can I come to you first, Mr Paterson? One of the major criticisms of non-executives in the past has been that they are either unable or unwilling to take on management and criticise the executive, particularly the chief executive. Do you think that is a justified perception?
David Paterson: I think it varies enormously across the corporate sector. We have for some years now encouraged boards to be much more explicit in the way in which they describe the board evaluation process, which is now fixed into the Corporate Governance Code, so that shareholders have a proper grasp of where the strengths and weaknesses of a board lie. Boards are naturally a little resistant to giving us much detail of that sort, for reasons that I can understand and sympathise with, to a large extent, but I do think that there is scope to be a bit more open with shareholders when examining the effectiveness of a board.
Q139 John Thurso: You mentioned the board evaluation process, which is usually an interview between the board member and another appointed person, maybe even an outside expert, and then a collating of that data and a little group discussion, ending, usually, with a large pat on the back all round and, "What a wonderful job we are doing". To have a non-executive stand up and say in a board meeting, "I fundamentally disagree with this. I think we are running a vast risk doing this and I can’t see how we are going to deal with it", is very rare, is it not? It is the element that was missing-a real challenge, on many boards, in the past. How, if at all, can we import that on to a board?
David Paterson: It is an enormous challenge and I think one comes back, in a way, to the culture question, and that is derived from the top. The first time I spoke to a chairman about this was in about 2002, and he put the fear of God into his non-executive directors when it came to doing the evaluation process. I think that was probably quite effective. It does require a strong chairman to elicit the views of non-executive directors and to encourage them to speak up, either in the board meeting or privately to him, about concerns they have.
Q140 John Thurso: So if we want to make this effective, we do not want a statement from the board. We want a personal signed statement by the chairman, starting with "I have" and setting out what he or she has done to make this happen.
David Paterson: I think that is the direction of travel. We will see more statements of that kind by chairmen because that is what is now being suggested, shall we say, by the Corporate Governance Code.
Q141 John Thurso: Is that a common view?
Otto Thoresen: I have seen change. I came from within the industry before I took this role on, and I had already begun to see change. The catalyst for change was the requirement of the FSA to ensure that governance was effective from a risk management point of view: to be far clearer about the roles and responsibilities of, for example, the chair of the risk committee within the board structure and to ensure that, around the board table, you had the right balance of skills, so that you began to get a diverse set of perspectives and that the relationship between the executive directors and the non-executive directors reflected a unitary board structure, so that people adopted a style whereby they were there to look after the interests of the business and of the shareholders. It is changing and the role of the chairman is absolutely critical. The role of the chief executive is critical in accepting it; the role of the board as a whole and the executive team in supplying the right kind of information in a way that people can understand, and draw from it the trends and the evidence of what potentially the risks could be-all these elements need to be in place. But the chair of the board, in the end, is mostly the guy who is going to assess the extent to which this has proven effective or not.
Q142 John Thurso: You mentioned the chair of risk. Obviously, there is a difference between most FTSE companies and financial institutions, in that risk in most companies is a part of the management process and not the absolute central part of the process that it is in a financial institution.
Otto Thoresen: Yes.
Q143 John Thurso: Is it, therefore, the chair of risk within financial institutions who has that particular duty to be on the chairman or chief executive’s shoulders, whispering all the time?
Otto Thoresen: I think the chair of the risk committee has a couple of very important responsibilities. One is to ensure that he and the committee are being supplied with the right kind of data and information and analysis. That is critical. The other is to ensure that the board does not effectively outsource responsibility for risk management to the committee, because there is a risk, because of the technical demands on the individuals who have to serve on these committees, that those who are non-technical will say, "Well, that has been dealt with over here in that committee", and in some ways step back from the issue. The real sweet spot is hit when the chair of the committee can give people confidence that the work in the committee is thorough, that the information that has been supplied to them is reliable and it is the right measuring of the right things, but also then present what the findings are of the work that committee is doing to those who are more diverse people, who are not technical, to be able to then say, "This sounds to us like" or "The way we see this is", because that extra pair of eyes is the piece that avoids you heading off the point.
Q144 John Thurso: That leads me on to another question. In your evidence, you express some concern as to the increasing demands of the FSA and others for technically certified non-execs, as it were. To what extent does that remove the wise and savvy business person who will ask the dark and knotty question that goes to the heart of the whole thing?
Otto Thoresen: There is the risk that that could happen. If you look at a board and its evolution, it happens over years. It doesn’t happen overnight. I think there currently would be a risk that people would be less inclined to step forward for non-executive roles in financial institutions if they felt themselves not to be technically competent enough to carry out their duties well. I think there is a risk that what we would see is a concentration of non-executives who are drawn from more technical backgrounds, with the consequence that that diversity begins to be undermined.
Q145 John Thurso: Sorry to put words in your mouth, but we are short of time. What I took from your evidence was that you need the people who are specialists, so there is a strong specialist non-executive board, but not entirely at the price of people who are specialists in other areas, which brings important judgment to the board function.
Otto Thoresen: Absolutely, because, for me, we are very focused at the moment on the financial performance and financial stability of businesses, for understandable reasons, but a board is there to ensure that customer outcomes are good too and that other elements of the business’s behaviour conform to and meet the expectations of the shareholders and other stakeholders. So that diversity is critical.
Q146 Chair: Let us come back to a point you made, Mr Paterson, in response to an earlier question from John: how to avoid the situation where non-execs are wary about challenging the corporate wisdom then prevailing on a board. Let us relate it to a major transaction. After all, we had the huge transaction of RBS, but major transactions are considered quite often by boards. If non-execs feel that they are uncomfortable with it, they are expected, very often, to leave the board. Do you think we could get to a position where major transactions can go forward where a non-exec has expressed his reservations-where the deal can still carry on and the board can present the deal, and the non-exec can stay on the board afterwards?
David Paterson: I think it is possible, because any board or committee acts ultimately by a sort of consensual decision-building process. It is absolutely appropriate that members of a board should challenge the executive-that is what they are there for-but, at the end of the day, if the argument is lost, they should be free to carry on as directors, from perhaps a slightly more cynical perspective than those who are enthusiastic about the deal. That still provides a valuable check to the rest of the board as the transaction progresses.
Q147 Chair: They are not at the moment, are they, on the whole? The impression is generally created on boards, "If you really feel that strong about this deal, you had better leave".
David Paterson: If you do feel strongly about the direction the business is travelling in over the long term, then you have to leave, but I think there is room for the alternative from time to time.
Q148 Chair: Have you thought about how that room can be created? It is not there now.
David Paterson: We don’t know it is not there now because we do not really have insight into the inner workings of the board. For example, take the RBS case. There may have been directors who had significant reservations, which were expressed in the board meeting and which were not then carried through.
Q149 Chair: It is not as secret as juries. We have quite a bit of information.
David Paterson: We have. But again, the discussion around the board table, apart from that reflected in minutes-
Chair: Would you give thought to that question and come back to us, maybe in writing? I think it is a crucial question with respect to systemically risky institutions.
David Paterson: I will indeed.
Chair: I have not heard a good answer to it yet, but I thought for a moment you were going to start giving a very interesting one to John.
David Paterson: I am sorry to let you down, Chairman.
Q150 Andrea Leadsom: Following on from John Thurso’s questioning, could you just very briefly give us your thoughts on why no shareholders have vetoed board appointments between, I think, 2006 and 2010? So, in FTSE 350 companies, there has not been a vetoing by shareholders of a board appointment. Does that matter? If it does matter, why? Mr Paterson?
David Paterson: The facts are self-evident. I think shareholders are reluctant to use the vote against directors because they are nervous about destabilising the board, perhaps. I think they will use it more and should use it more. We have seen this year, in fact, evidence of a number of instances where there have been quite significant votes against the re-election of directors, normally tied into the remuneration discussion. I think that shows a willingness to identify individuals who are perceived as being part of the problem, as it were, rather than simply to look at the problem itself. There is movement there. I do think that investors should use these powers more than they have done in the past, because it is one of the crucial differences between the way in which corporate governance is structured in the UK and elsewhere in the world and, if we don’t use these powers from time to time, we will, I suspect, lose them.
Q151 Andrea Leadsom: Mr Saunders, do you think shareholders should use that power more?
Dick Saunders: I think one is always more likely to see protest votes against incumbent directors than votes against new directors, unless there is some very obvious history there or a very obvious problem, and they may be, to an extent, an unknown quantity. I think that shareholders should be prepared to use these powers. We have seen evidence, I think, latterly that they are prepared to use them. I do think it will tend to go in cycles. One of the outcomes of the so-called shareholder spring will be a renewed effort by boards to reach out to their shareholders at an earlier stage.
Q152 Andrea Leadsom: So you think that boards will fear their shareholders?
Dick Saunders: There may be fewer headlines over the coming years, but I think these things do go a little bit in cycles.
Q153 Andrea Leadsom: Do you think that boards will fear shareholders more in future? They clearly haven’t in the past, have they?
Dick Saunders: I think they are going to pay more attention in the coming years than they have in the most recent years, yes.
Q154 Andrea Leadsom: Thank you. Mr Thoresen, independent non-execs are meant to represent the shareholders. Do you think that they do that or do you think that they tend to go native once they join a board?
Otto Thoresen: Again, I think you have to look at what has been the case in the past and what will be the case in the future. Dick expresses some scepticism about whether we have seen a change that will be a permanent change in behaviour. I believe we have seen a change that will affect all aspects of how boards operate and how shareholders engage with them. When you are appointing a new non-executive, for example, it is the chair and the chair of the nominations committee that are under scrutiny because they are the ones making the judgment about whether this would add in terms of strengthening the team.
A non-executive who is willing to step forward, particularly in a SIFI, to take on that responsibility is going to be very conscious of his or her responsibility, and I think the risks of going native are almost nil now. There is another risk, if I might just extend the answer. There is a risk that executive management find that their ability to run the business becomes constrained, and the non-executives step over a line into executive management. I think the pressure of external scrutiny and regulatory oversight could lead to a point where that balance goes in the wrong direction.
Q155 Andrea Leadsom: But we are million miles from that at the moment, aren’t we?
Otto Thoresen: I think we are some way from that.
Q156 Andrea Leadsom: Yes. A bit more pressure in that direction would not be a bad thing. You said in the ABI’s submission, "The ability of institutional shareholders to exercise persuasion over powerful boards that do not choose to respect their views can be very limited". What do you think there is, going forward, that non-executives can do? Is it simply to leave? We have slightly covered this earlier, but is the option open to them in future? Should it be to vote with their feet, or should there be more tools in place for non-executives to hold sway on behalf of shareholders?
Otto Thoresen: I think the tools are there. The scrutiny that chairmen and those in roles of influence within the board structure, whether it is the risk committee or the remuneration committee, are put under through the private engagement that goes on with shareholders is becoming increasingly clear in what it is trying to achieve. If the non-executives are not having a loud enough voice in terms of directing the business or influencing the business in the direction that shareholders believe is appropriate, then that pressure will continue to be exerted through that engagement with the chair. I think existing tools are already quite effective. Of course, there is a lot of discussion at the moment about extending those tools, potentially to a binding vote on prospective remuneration. When we start to get into that space, we will have a stronger set of influencing devices.
Q157 Andrea Leadsom: Mr Paterson, just going on to the very delicate subject of women on boards, to what extent has that debate about increasing the number of women on boards created a kind of red herring for the need for greater diversity generally on boards?
David Paterson: I must say I have tended to conflate the two and just say that what we are looking for here is diversity of experience, of skills and so on, on boards and to accept that, as part of that process, more women on boards would be a very important development, frankly. From a director’s point of view and a shareholder’s point of view, I would like to see more diversity on boards and I think that going down the "more women on boards" route is a very productive one. That, in itself, will deliver not just diversity by gender, but also by skill base and the rest. So we get to those objectives by focusing on this one point.
Q158 Andrea Leadsom: Okay, thank you. Mr Saunders, do you think that systemically important institutions have a greater or a lesser need for diversity? In other words, is diversity or specialisation the priority in a systemically important organisation?
Dick Saunders: Both are important. They are slightly different in practice, in that they are regulated and so the appointments are subject to oversight by the FSA. That will inevitably make the situation a little different. You do not want a board of a SIFI to look like the three of us, any more than you would want the board of any other company to look just like the three of us. That diversity, the bringing of extra perspectives and extra challenge, is extremely important; but overlaid, perhaps, because they are regulated institutions, is the need to satisfy the regulator as well.
Q159 Andrea Leadsom: Okay. Mr Thoresen, in the ABI’s response you have said that firms would struggle to meet Lord David’s recommendations on women on boards. Do you think, therefore, there is an argument for quotas?
Otto Thoresen: I think the reason that it is likely to be a struggle is the supply problem. To achieve the objective that has been set in terms of targets, we have to work a lot harder at bringing women through the management structures of firms, because that is where the talent is going to come from. What we may see in the short term is a slowing of the improvement because the supply is beginning to become a constraint, but if we can work on developing the talent within our organisations I think we can push on. I still believe that the approach of targeting, rather than quotas, is far more effective in achieving what we all want, which is a diverse and effective board.
Q160 Andrea Leadsom: Final question to Mr Saunders. I have heard it said that there is a real issue, because the push to get more women on to boards and into non-executive directorships has encouraged more women to leave full-time work and go for non-executive directorships because it suits their lifestyle potentially more and that that, in itself, is creating a shortage of talented women to go on to company boards. Do you think there is any truth in that?
Dick Saunders: I confess I have not heard that suggestion. I have not seen the evidence. Slightly off the top of my head, my reaction to that would be, given the numbers involved in boards relative to the number of people in management roles across the economy, even a quite significant increase in women in the former ought not to deplete too much, one would hope, the pool of talent for the latter. But, as I say, I haven’t seen the figures or analysis that underpins that.
Q161 Stewart Hosie: Mr Paterson, we have been talking about the High Pay Centre: "The trustees put fund managers under undue pressure to maximise short-term investment returns or to maximise dividend income at the expense of retained earnings, and…fund managers will in turn be reluctant to support board proposals that do not immediately enhance the share price or the dividend pay-out." Do you recognise that?
David Paterson: I recognise parts of it, but I don’t recognise the whole picture. Pension funds are, by their nature, long-term investors. They have liabilities stretching out for the best part of the century, so their interest is in long-term returns. There is, inevitably, a focus on shorter-term returns because that goes up to make the longer term. My experience directly is that none of the pension funds that I have been involved in, or the ones that I know from our organisation, will look at quarterly returns and, as a result of seeing those quarterly returns, look to make significant changes to their investment process or asset allocation. It is just not how they work. They work primarily on a 12-monthly review cycle and managers, by and large, tend to survive for periods of five to 10 years for one particular pension fund.
Q162 Stewart Hosie: The risk, then, that the focus on short-term returns is taking away time from other things like corporate governance would not be an argument that you would-
David Paterson: I don’t recognise that argument, no.
Q163 Stewart Hosie: You do not recognise that at all. Mr Saunders, FairPensions, which is the Fairshare Education Trust, told us something nearly identical. They suggested, "Institutional investors’ fiduciary duty was widely interpreted as a duty to maximise short-term returns and ignore other considerations, even if they might have a material impact on long-term outcomes for beneficiaries". Would you say that is how your members viewed their fiduciary duty?
Dick Saunders: Absolutely not. The fiduciary duty that investment managers owe is to their clients, whose money they are managing. Their obligation is to try to deliver the best outcome for those clients and, in the case of a pension fund, it is going to be essentially a long-term return. If they don’t deliver that, they lose business. I do not recognise that at all, no.
Q164 Stewart Hosie: So there would be no case to be made for the fiduciary duty of institutional investors being recast to promote a longer-term outlook? Do you think that is already in place?
Dick Saunders: The fiduciary duty owed by investment managers is to their clients. That is the obligation they have, because it is their clients’ money that they are managing. I do not see how that can be somehow recast. There is a variety of investment strategies that people pursue. In the main, they are long-term strategies on behalf of pension funds or on behalf of ordinary investors investing through ISAs and so on. There are people out there, hedge funds and the like, who adopt very short-term strategies, and that is fine.
Q165 Stewart Hosie: Why do you think bodies from the outside, looking at investment generally, are suggesting to us that there is such a focus on short-term return that it is acting to the disadvantage of other aspects of management in the long term and impacting on corporate governance? Why would people on the outside looking in suggest that when none of you have seen that in the sector?
Otto Thoresen: I think there may be two issues here that are becoming conflated. First, on the attitude of pension fund businesses, insurance companies and investment managers-the quarterly performance piece-I see no evidence of that short-termism in the way you have described it. Where there is an adviser or an investment adviser advising the client, similarly, I don’t see that focus on short-termism. There may be an issue, though, around the decisions that investors make about where they should invest, which stocks you should buy, which companies you should invest in.
I am not saying this is a fact, but I am saying there is the potential that short-term returns in terms of earnings, growth or short-term share price movements is an issue that some may focus on to the detriment of investing for the long-term economic value creation of the fund. I think the challenge is to ensure that the way funds report their results, the way they talk about their strategies and the way you engage with funds to understand why they believe in the medium term or long term they are going to be winners and create value, is what is driving the investment decision that you are making as an investment manager.
Dick Saunders: I do think it is important to distinguish between different players in the market here. Sometimes people look, for example, at the stock exchange turnover figures, which have grown markedly over the last 10 years or so. That growth is actually down to the emergence of, for example, high-frequency traders, hedge funds and so on.
We produced a fairly detailed paper for Professor Kay’s review where we tried to look at actual holding periods by, as it were, the traditional fund managers and tried looking at it in a number of different ways. I would be happy to send the paper to the Committee, if that would help. They suggested that holding periods are, on average, three to four years and have been that for quite some time.
Q166 Stewart Hosie: Would it be more accurate then, to say, if these criticisms are not valid, there is, Mr Thoresen, an issue of management looking at peer performance in the short term as opposed to long-term performance, rather than the way it was described previously? On the other issue you raised-how investments are made, and the ongoing issue of the herd instinct guarding against "reckless caution"-are these more valid criticisms, or things to be guarded against?
Otto Thoresen: Dick is probably in a better position to comment on this than I am. The different investment management firms will attempt to achieve success for their customers with different philosophies and strategies. As he says, there will be some who believe, by anticipating share price movements and being active traders, they can generate a return. There are others who buy when they see value because they believe there is potential in a firm that others have not yet spotted. They will buy and hold and hold for the medium term and the long term. It is very dangerous to make a blanket statement.
I think there was a period historically where there was far more focus on peer performance and identification of whether people were relatively succeeding or relatively failing. I get a sense, though, that the challenging economic times we have gone through over the last 10 years have begun to temper that somewhat, or significantly, and that people are beginning to go back more to basics. Certainly, the pension fund industry, the insurance industry and the long-term savings industry are looking for long-term value. The liabilities that we are managing are 20 to 30 year liabilities.
Stewart Hosie: Just finally, it would be useful if you have any research on how many firms still look at peer performance as a key indicator for the staff and those who have moved away to long-term value.
Q167 Mr McFadden: Mr Saunders, I want to return to the issue Jesse Norman and one or two others have raised about the shareholder spring. You wrote a blog in which you posed the question, "Shareholder spring or business as usual?" What side of that do you fall down on?
Dick Saunders: I come back to the point I made a little earlier about the cyclical nature of this. What we have seen this year, in this year’s annual general meeting season, has been very striking. We have seen a succession of votes against boards, a succession of boardroom departures, which I think is the result of concern that has been building for some time about the performances in the individual companies, perhaps brought to a head by the current economic situation that is impacting on the performance of the economy and the companies as a whole. I suspect the evident public anger about some of this has certainly played its part. I wouldn’t want to overplay that.
I think that it would not be healthy to be seeing that happening every AGM season. Let’s not forget that the companies we are talking about are major contributors to the British economy, major employers, and we want them to be well run. We don’t want them to be continually mired in controversy with their shareholders. I think that we would not want this sort of season to happen every year for that reason and, for the reasons that I gave in response to an earlier question, this is a little bit of a wake-up call for boards. They will reach out to shareholders more. There will be more dialogue before we get to this point. We will probably see fewer cases in the coming years.
Q168 Mr McFadden: You may not want to see shareholder rebellions at pay packages every year, but does your answer mean that you do think this indicates a longer-term, more active attitude towards stewardship and ownership on the part of shareholders?
Dick Saunders: Yes, I do and I think that is something that has been building for a number of years now and has come to a head this year.
Q169 Mr McFadden: Mr Thoresen and Mr Paterson, do you agree?
Otto Thoresen: I have a few comments. First, what do I think the shareholder spring is not? It has been explained by some as, "Oh well, we didn’t communicate well enough what we were doing with our remuneration structures and, if we had only communicated it better, everything would have been fine".
Mr McFadden: That is what politicians say, of course.
Otto Thoresen: That is not what it has been about and it has not been about shareholders rebelling against high pay. I don’t think that is what it has been about. I think it has been a combination of other things and each is slightly different, depending on the case. Let me just try to draw out some themes. I think we have seen examples where shareholders have felt that the link between pay and company performance has not been evident or strong enough. We have seen examples where shareholders have felt that reward for mediocre performance or poor performance has been too high. We have seen shareholders rebel because the consultation process has not been a consultation process; it has been one-way. We have had issues around business strategies for funds and the extent to which remuneration is linking strongly to supporting strong business strategy. It has been a different example or a different combination of those points that has led to the strong votes on pay.
What we hope and believe is emerging from this is an approach to engagement that is going to address those issues, so that it is consultation and it is two-way discussion with the boards of companies, and that the combination of simplicity, more transparency and more focus on risk management and strategy will lead to potentially fewer of these significant votes against; but that is because the level of engagement has been effective and people feel their issues are being addressed.
Q170 Mr McFadden: Okay. Mr Paterson, we have been advised in previous sessions that the changing pattern of shared ownership, with more foreign ownership, more hedge funds and so on-perhaps less of what we traditionally think of as shared ownership, which would be insurance companies and pension funds and so on-might militate against this kind of active stewardship. But if Mr Saunders and Mr Thoresen are right, that is not the case.
David Paterson: As I said earlier, we have to remember that pension funds are only about 5 to 10% of the UK market now, as against 30% 30 years ago. So there has been a big change. On the other hand, I do think that, being domestic institutions, we had a closer relationship with UK companies than foreign investors do and that works to our advantage in this context. I think it is important that we use that advantage in order to ensure that remuneration practices and corporate governance practices are of the standard that we are looking for.
If I can just add one more thing to what Dick and Otto have said. An important part of this is the explanation delivered publicly by companies for the pay policies that they put in place, because I think one of the missing pieces is that there is too little willingness to say, "I am paid this because"-I think there is need there for a slightly more open dialogue between companies and investors and, frankly, between executives and their employees in order to try to explain what it is that drives pay policies at senior levels of companies. That is something that we are investigating at the NAPF, and Dick’s organisation released a report just the other day which emphasised the point that there is now a bit more disclosure around what is happening behind the scenes. That is all to the good.
Dick Saunders: Can I just come back to Mr McFadden’s question? UK investment managers account for about 40% of the share registers of UK companies. One should not exaggerate the importance of hedge funds in this. Hedge funds make a big contribution to stock exchange turnover but, in terms of ownership of shares, they are really pretty small. The global hedge fund industry is about half the size of the UK investment management industry, but in the UK hedge funds are only about 5% of the assets of the conventional industry. In terms of the volume of shares, the traditional long-term managers are always going to be completely dominant.
Q171 Mr McFadden: Okay. If you are right that this is a signal about a longer-term increase in engagement and active stewardship and so on, what does that make you feel about the debate about legislation, about binding votes and changing the legislation on this relationship?
Dick Saunders: My own view on the binding votes is that they are a potentially helpful development because, as Otto said a few minutes ago, it brings you more levers. The risk in any legislation-perhaps we have seen this with some of the boilerplate reporting in company reports-is that, if you say, "Right, we must have a binding vote on what the pay policy is", you end up with a very bland and all-encompassing expression of what that pay policy is. You get something like, "The pay policy will be whatever the board decides is in the best long-term interests of the company". The risk is that you end up with something so general as to be meaningless because it turns into a box-ticking exercise. That is what one has to be wary of whenever you come to legislation.
Otto Thoresen: I have just a quick comment. We have been talking about SIFIs today and, when you talk about a binding vote on future pay policy, the opportunity there is created for investors to express a view on the appropriateness of the balance that has been struck in the incentivisation of senior executives. If you go back to the letter we wrote in December, it was about the value distribution between shareholders, employees and executives and capital retention in the fund to ensure its stability and its ability to continue to trade. To a certain extent, with the SIFI lens, the discussion can move beyond the boilerplate, which I agree with Dick is the real risk. If you make this a too big and administrative overhead, it moves more quickly, potentially, to becoming just a standardised piece and a box that is ticked, but with damaging-
Mr McFadden: Does that mean you are for the legislation, then?
Otto Thoresen: We believe it is a positive step, yes.
Q172 Mr McFadden: Okay. Can I go back to Mr Saunders, and just take you to the submission that the IMA made about barriers to collaboration between investors. In any company, there will be a multiplicity of shareholders. We are talking not just remuneration but risk, strategy and all the rest of it. Your submission feared that if there was more collaboration in terms of active management with these issues, there may be issues of insider trading, industry collusion, concert party rules and so on. What kinds of barriers exist to shareholders stepping up to the plate?
Dick Saunders: Just to preface, shareholder co-operation is very important because, when you go to a big company, even a very large shareholder will typically have no more than 1% or 2% of the shares. There are two barriers, I think. One that has been largely dealt with now is the Takeover Code. There were concerns and the Takeover Panel has addressed those and has adjusted the Code. I think now the great majority of investors believe that is okay. They don’t have a risk there.
I think where a number still feel that they have a problem is with the provisions of a European directive, the Acquisitions Directive, which requires reporting to national authorities when you form a concert party that constitutes more than 10%. A number of people see that as inhibiting. Different investment management firms take different views on this. Some of those who are UK in origin-those that came out of the life companies, for example-are possibly a little bit more relaxed about this because I think they are more familiar with the culture. Some of those firms that are effectively headquartered in the US might tend to take a slightly more cautious view of this. I wouldn’t want to overdo this as an issue, but it is seen as an issue by some firms.
Mr McFadden: Does anybody else want to come in on this collaboration point?
David Paterson: From the point of view of the pension funds, who, after all, are the end clients of many of these firms, we see collaboration as being a really effective way of trying to get across the shareholder message, so it is in the Stewardship Code. We think it is really important and we would like to see asset management firms collaborate more, and more effectively than they currently do.
Q173 Mr McFadden: There are significant barriers in the rules to that.
David Paterson: Dick has outlined some of the barriers. The Government here has worked hard to remove domestic barriers and that has been helpful. The points he makes are perfectly valid, but, as I say, from the end client perspective, we would like to see more collaboration and we would like to see these barriers reduced, along with any commercial barriers that may also tend to impede collaboration between asset management firms.
Dick Saunders: Just to stress, I wouldn’t want to overdo this but it is seen as a problem by some firms.
Q174 Mr McFadden: We have been talking about shareholders becoming more active and so on. The final piece I want to take you to is the other side of this coin. If that is the case, are there enough resources within companies on corporate governance and within the boards to engage properly with the shareholders? If we talking about a longer-term change in relationship-we have been informed, for example, that some big companies are reducing the resources that they devote to corporate governance. Is that something that we ought to be concerned about and should we be doing anything to encourage companies to engage more actively with this new breed of active shareholders, if I can put it like that?
Dick Saunders: I’ve not heard that that is a problem, I have to say. Obviously, these big companies do have a lot of resources at their disposal. In my experience, if the big shareholder wants to talk to these companies, they would make time in the diary for that at very short notice.
Otto Thoresen: I think there is inevitably an issue because we are in financially challenged times, whether you are an investment manager or a corporate. There is certainly a risk that some of the resources within the investment management funds that support the corporate governance effort may come under some pressure, but I think there is an opportunity there for the three organisations sitting in front of you to facilitate this process to make it easier to engage with companies, and that is what we have seen happening over the last six to nine months. So I think that will continue.
Q175 Chair: Can I take you back, Mr Saunders, to an answer you gave right at the beginning of those exchanges? You said, and I am paraphrasing, "We do not want a shareholder spring every year. These are major institutions contributing a lot to the British economy. We do not want them in a permanent row with their shareholders". You seemed to be suggesting that the shareholder spring might have eroded shareholder value in those companies or might be at risk of doing so. Is that your view?
Dick Saunders: No, it is not and I apologise if I gave that impression.
Q176 Chair: Do you think it increased value?
Dick Saunders: This comes back to the question you asked David right at the beginning, as to whether corporate governance increases value. I think most of us feel instinctively that it must do, that better-run organisations are-
Q177 Chair: Okay, but that is a general question. I am asking you about the spring now. If I could just give the question in a slightly more precise form. What shareholders have done is said they would like less remuneration and, therefore, by implication, higher dividends, among other things, in the shareholder spring. Do you think that that will reduce shareholder value?
Dick Saunders: I am not sure that is what they have said, Chairman. I think what they have said is that they are not satisfied with the performance they have seen in a number of companies and they want change.
Q178 Chair: They have also said that, but I think it is fair to say that what I have summarised is part of the shareholder spring, is it not?
Dick Saunders: I don’t think there is that explicit link being made between levels of pay and levels of dividend.
Q179 Chair: I said, "By implication there will be more value left in the company for the shareholder". What I am asking you is, will there be less value to the shareholder or the same amount? I am trying to get at whether shareholder activism is generating value for reasons-
Dick Saunders: My belief is that, short-term, it would make no difference, to the extent that long-term encourages improved performance and it will lead to more shareholder value.
Chair: Okay. You got to safe ground in the end.
Q180 Mr Love: Can I come back to the issue of remuneration? Notwithstanding the shareholder spring, you seemed to indicate that you were in support of mandatory voting on remuneration, but with caveats. Are there any other additional measures that you would recommend on the issue of executive remuneration, Mr Saunders?
Dick Saunders: Not beyond what is currently being proposed, no. No, I don’t believe so, unless my colleagues have other thoughts.
Q181 Mr Love: Mr Thoresen, perhaps I can point you in a certain direction. There is some debate about whether the publication of a single figure for executive remuneration would be helpful in this regard. There is also a recommendation flying around that there ought to be greater transparency under remuneration for all employees. Do either of those have any merit in this debate, or are there other measures that you would recommend?
Otto Thoresen: Again, I would support the binding vote on prospective remuneration strategy. I would support the aspiration to make remuneration more transparent and more understandable generally. The complexity of structures and the drivers of outcomes have become very difficult for even the experts to understand and penetrate. Therefore, by definition, it is difficult for boards and non-executives fully to have confidence that they understand what the impact is likely to be. From my own point of view, getting too hung up on whether it is one number or two numbers or two different ways of explaining how the remuneration works-I don’t think we should get too precious about that, but I think simplicity and transparency is extremely positive and helpful.
There is also a discussion, going back to the SIFI point, about what the appropriate measures are that should be driving long-term value incentives for executives. Historically, returning equity was quite often something that was focused on, but to what extent was that the right measure and are there other measures that should be brought into the mix? I don’t have a simple answer I can give you, but certainly we are doing some work at the moment on the relative benefits of moving one way or the other and how those packages should be structured, because that goes back to risk and the extent to which incentives encourage and reward risk-taking, and whether that risk-taking is appropriate. There are some pieces in there that need to be looked at, but I think the binding vote and improved simplicity and transparency are the tools that help us engage with it.
Q182 Mr Love: Mr Paterson, I have one or two questions, but perhaps you can give me an initial response to the question so far.
David Paterson: Yes. I see the single figure as being more or less a given, myself. I think we are going to have that because a lot of people would like to see a single figure. It does hide a huge amount of complexity, as Otto was just alluding to, and I would rather hope-and it is a hope-that the single figure would encourage more simplicity in the construct of a typical pay package. I also think the single figure, applied across all of the UK-listed sector in the UK, would permit comparisons, which, at present, are almost impossible to do because no one presents their data in quite the same way. So I think there are some benefits to the single figure. There are some risks as well because it will hide some of the detail there.
Q183 Mr Love: Let me press you on this. Pay and performance has been an issue. There does not seem to be any direct connect. To what extent are remuneration committees responsible for that failure and how could we make them more effective in ensuring that pay reflects performance?
David Paterson: In submissions to other groups I have always made the point that one has to be careful about how you define performance. Without getting into that existential discussion now, I think it is important that there is an evident link between pay and performance that we can all understand. Going back to Otto’s point about simplicity, we see one of the keys to this as encouraging companies-and we have been doing this-to change the way they think about remuneration in order to get to a point where it is simpler and, frankly, there is a very clear link between pay and performance. We think, in the long run, that is best achieved by executive directors holding large numbers of shares in companies for a very long time. So basically they have shares, they cannot sell them and they are forced to hold on to them through thick and thin. I think that helps to focus their minds quite a lot.
Q184 Mr Love: Mr Thoresen, what is your view about remuneration committees? Do you think there is a requirement to diversify your membership? There has been some talk about having an employee representative, but diversifying your membership may help in this regard.
Otto Thoresen: Yes. Again, remuneration committees have been operating in a much-changed environment. There was a time when the remuneration committee’s role was to ensure that the variable element of pay was truly variable and was truly reflecting the success of the firm. So the idea was that, if a firm was being very successful, it was appropriate that there was a share of some of that success through variable pay. Risk management wasn’t an issue, if you go far enough back, that would have even come across the agenda. Clearly, the world is such a different place now that the demands of remuneration committees are very different, and I think they also have to take responsibility for the broader stakeholders who are interested in the outcomes here. There was a tendency in the past that it was seen as a somewhat technical role with quite an inward-looking focus. If you are a firm that wants to be successful in the UK marketplace, your reputation is as much likely to affected by inappropriate outcomes on remuneration structures these days as it is by many other things that are considered. The remuneration committee has a broader role than it would have had 10 years ago, and I think that has to be reflected in a more diverse group of people being involved with it.
Q185 Mr Love: Mr Saunders, do you echo that view or do you have a different view on remuneration?
Dick Saunders: No, I broadly agree. There has been an unfortunate dynamic at work over a long period of time, which has resulted in this ever-greater complexity by trying to find ever more subtle ways of aligning incentives and pay with that of shareholders. There has been feedback that has gone on between remuneration committees, remuneration consultants and boards that has led to this greater complexity. Perhaps now there is an opportunity to stand back and say, "Okay, let’s try drastically to simplify this".
Q186 Mr Love: Let me ask you, Mr Paterson, an entirely different question. The reality is that although senior executives are paid large salaries, certainly in comparison with the public, in terms of the overall company and its turnover and profitability, these are relatively low figures. It has been put to us that it is a diversion for institutional investors to spend so much time on remuneration when there are other global issues for the company that are far more important. How do you think we get that balance right?
David Paterson: It is a good point. It is self-evident that if you are the senior executive of a very large company with a turnover running into billions, your pay is a tiny, tiny proportion of those billions. If you are paid twice as much or half as much, it is not going to affect the dividend-paying power of the company. I hate to say this again, but the importance is more to do with the culture within the business and the messages it is sending to the work force overall that come from looking at the stretch between higher and lower paid, and those messages have to be very, very clearly conveyed to the employees as a whole. If you get that wrong, you will disincentivise staff throughout the business and you risk seriously damaging the business. Remuneration policy, if you like, is a microcosm of good governance in the business. Good remuneration policy leads to good governance, to good practice by employees throughout the organisation. Get this right and we will have better companies.
Q187 Mr Love: Let me ask you one final question, Mr Thoresen. Shareholders voted against only 8% of remuneration reports. There is a question mark about whether shareholders are actively engaged in these issues. Do you think that is the case?
Otto Thoresen: I think the evidence from the last six months is a very strong supporter of the engagement that is now present.
Q188 Mr Love: A lot of people would suspect that the spring may be somewhat ephemeral. There is a whole debate going on about whether this will become institutionalised.
Otto Thoresen: I am not disagreeing with Dick. I think I am just putting it a different way. I don’t believe that the dialogue between boards and shareholders will be the same as it was before this happened. I think that has changed. I think what we are all hoping is that the consultation and engagement will be far more effective and the result will be that these shocks, if you like, in terms of reputational, media coverage and all the rest, will be fewer, because what we are seeing is good governance over the firms. Back to that question the Chairman asked earlier, "Has this made a difference? Is this making a difference?" I do believe that where change has been driven through shareholder engagement this year, the prospective value in that firm has been enhanced and in two or three years’ time we will be seeing differences.
Q189 Chair: Can I come back to an answer you gave a moment ago, Mr Paterson? You said that you were in favour of incentives or some kind of requirement for longer-term shareholding. Is that not going to entrench poor performance in institutions that know they have a solid group of shareholders who would otherwise want to ditch the stock?
David Paterson: I think perhaps we have this backwards. I was talking about the executive directors of the company holding shares for the long term, not the institutional investors.
Chair: Okay, fine.
David Paterson: I think it is important that institutions can sell stock as well as hold it for a long time.
Q190 Chair: To be clear, that is not also a proposal-
David Paterson: It is not, no.
Chair: -that has been proposed? Various forms of incentives or-
David Paterson: A very large part of the holdings by our members are now in the form of indexed tracking funds. So they are, by definition, very long-term investors.
Q191 Teresa Pearce: We have heard a lot about senior executives linking their remuneration to shares and holdings, but, Mr Thoresen, your organisation has pointed out that many of the highest-paid employees in investment banks were not executive-level at all and they were often the people who took the risky risks yet got the highest pay. How do you think we can monitor that level of pay that is below board, but is where the real problem lies?
Otto Thoresen: My first response would be that, even in those circumstances, the board of those firms, the risk committee of those firms and the remuneration committee of those firms would have been well aware of the structures that were being put in place and the expected outcomes from those incentive structures. I think I would still rely on strong governance and strong, effective boards to ensure that the checks and balances were in place. I think it is also the case that the regulator takes a very close interest in those who have the ability to change the risk balance of the firm and how much they are being paid and how their incentives are structured; so existing regulation already brings extra oversight of those individuals.
One final point, in our discussions with the banks in the first two months of this year we moved on from just looking at the top level of executives to looking at a deeper slice of the executive team and how much of the value in the firm was being distributed to those as reward, and how that had developed over the past 10 years from what the trends were. So we are looking more deeply than just the top level executives.
Dick Saunders: Could I just add a comment? The individuals you talk about are now subject to the Remuneration Code enforced by the FSA and this is an obligation under the existing Capital Requirements Directive so that all people in management roles, all people in risk-taking roles, which would be traders and the like, are now subject to the remuneration rules. Currently, the new directive, which is implementing Basel III, is going through the process of Trilog in Brussels, where the Parliament is proposing very severe limits on remuneration of people in those roles. There is significant regulatory intervention with these people already, with, potentially, a lot more coming down the track.
Q192 Teresa Pearce: We heard that remuneration has fallen in the last three years, which is as you would expect, given what happened. But people’s businesses went to the wall, and lower-paid staff in banks lost their jobs. So the fact that remuneration has fallen should be expected, but, from what you have just said, Mr Saunders, where do you think the failing of the FSA sits in all of this-in what happened about remuneration and people making vast amounts of money when the risk fell elsewhere? Do you think, when you look at the Financial Services Act, they had a role to play in protecting the public?
Dick Saunders: I think the causes of the crisis were many and varied. Yes, there were failings in the FSA. There were similarly failings in the Accounting Standards, for example. The current International Accounting Standards allow profits to be booked whether they are realisable or not. What was happening in banks in the run-up to the crisis was that unrealisable profits were being booked, off the back of which people were being paid enormous bonuses. Then, when the crisis hit, suddenly those profits were not there any more but the bonuses had been paid out.
Q193 Teresa Pearce: Do you think it is fair to say-
Dick Saunders: Was that the FSA’s fault? I think it is difficult to say. A number of these lessons have been learned subsequently, though, I think.
Q194 Teresa Pearce: We took some evidence last week from a remuneration consultant and it seems to me, looking at the complexity of remuneration packages and the amount of time that goes into setting remuneration and all the different levels of board meetings about remuneration, there is a whole industry here just deciding what to pay people. Is that a fair assessment? [Interruption.]
Otto Thoresen: My body was saying yes; perhaps the words will come out now, as well. I don’t know whether it is an industry, exactly, but your point is absolutely-
Teresa Pearce: It is a market, is it not?
Otto Thoresen: The transparency piece, in addition to allowing shareholders to engage more effectively and understand the issues better, would allow the use of time around these issues to become less.
Q195 Teresa Pearce: One of the questions I asked last week to the remuneration consultant was that this was a self-fulfilling role. The more complicated you make it, the more you need remuneration consultants. From what I have seen over the last couple of decades, quite often the complexity arises out of the need to minimise tax and National Insurance payments. Is that something you recognise-why people are not paid just a salary and a bonus if they hit targets? Do you think that there is further benefit to the public in having very complicated remuneration packages?
Otto Thoresen: In any discussion that is going on between an executive and a remuneration committee there are a number of factors that people will be looking at, but I honestly believe that the driver of complexity has been a desire to link reward to economic value-creation in the firm. That is what has been intended.
Q196 Teresa Pearce: What metric do you think is most suitable for assessing performance? What would you use?
Otto Thoresen: We are going through a process at the moment of looking at different metrics. I do believe something that looks more at the returns that are being generated on the assets deployed in the firm, rather than return on equity, is getting closer to something that reflects the economic reality of the organisation, but we are very focused on the financials here. I don’t think one should simply focus on financial outcomes, because firms are a lot more than financials and money. It is about services to customers. It is about its positioning in society. There are a whole lot of aspects to how one should look at reward, not just the financial aspects. But if you are looking at it from the point of view of a SIFI and the financial risk that is in the firm, then I think the discussion needs to be around how incentives reflect good practice in the firm in terms of risk management and value creation.
David Paterson: Certainly, from our point of view, we would want to see more simplicity, as I’ve said several times and as we’ve all said, frankly. I think that means you inevitably will have a structure that will not be as subtle as some of the present structures. Overall, we would benefit from that because greater transparency and understandability of pay structures would make a huge difference to the way in which the industry is perceived by the outsider, and to the way, in fact, it is perceived from the inside. So we are very much in favour of getting rid of the very complex structures, and if that means occasionally pay is not perfectly aligned with performance, I do not really mind. I think that is a price worth paying-as long as it is occasionally, let me stress. It is not something you want to see happening too often.
Q197 John Thurso: Just a very quick question on precisely that last point. The principle behind remuneration in all major PLCs has been that the top executive board’s interests be aligned with those of the shareholders-the principle of alignment. Have we not reached the point where we have to accept that that is a failure and go back to saying, "This job requires somebody to be paid £1 million, £1.5 million, £2 million", and that should be 80% at least of their pay and if the variables are so great that it is more than 100%-in other words, they are going to get more than 100%-they are not being paid to do the job properly in the first place?
Dick Saunders: I would have sympathy with that view. On the whole, people get up in the morning to go to work because they enjoy the job and they derive satisfaction from doing it. I would agree that the levels of gearing on bonus that you sometimes see now don’t reflect what motivates many individuals.
David Paterson: To make the additional point, I think the shareholding/shareowning culture is prevalent throughout organisations nowadays, thanks to the Sharesave schemes and all the rest, and we have seen people make and lose large amounts of money as a result at relatively junior levels of employment. I absolutely agree with you and Dick, and it goes back to the simplicity point. Putting in place something that rewards an individual for doing a good job, as it were-and that is what the base pay ought to be for-is the core of a good remuneration policy. I do think that adding to that the acquisition of shares over time so that he has more skin in the game, if you like, makes sense at the same time.
Otto Thoresen: Just very briefly, I am afraid I disagree. There are two elements here. I don’t think we should give up on the idea that we can align interests substantially with shareholders. I think we can. We have gone too far in complexity, but we can pull back from that, and there is an important element about the variable nature of pay: some component of variable pay that reflects the good times that a firm is having, and the less good times that a firm is having. In fact, as I said earlier, some aspects of what has been happening is that that variable pay has not come back when the performance of the firm hasn’t come through and the economic value isn’t being created. So I think we should be cautious about giving up on the concept completely.
Chair: Come back to us if there are other thoughts that you feel you did not get time to touch on or that occur to you. I will be very grateful, Mr Paterson, if you send us something on the exchange we had earlier about major transactions. Thank you very much for extremely thoughtful evidence. We are very grateful.