PS16/23 – Remuneration: Enhancing proportionality for small firms

1: Overview

1.1 This policy statement (PS) from the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) (jointly, ‘the regulators') provides feedback to responses to the PRA’s consultation paper (CP) 5/23 – Remuneration: Enhancing proportionality for small firms and the FCA’s CP23/11 – Remuneration: Enhancing proportionality for dual-regulated firms (‘the CPs’).

It also contains the regulators’ final policy as follows:

• amendments to the Remuneration Part of the PRA Rulebook (Appendix 1);
• amendments to the PRA’s supervisory statement (SS) 2/17 – Remuneration (Appendix 2);
• amendments to the FCA Handbook: Senior Management Arrangements, Systems and Controls (SYSC) sourcebook (Appendix 3);
• amendments to FCA non-Handbook Guidance:
  • General Guidance on Proportionality: The Dual-regulated firms remuneration code (FG23/5) (Appendix 4).
  • Dual-regulated firms Remuneration Code (SYSC 19D) – Frequently asked questions on remuneration (FG23/4) (Appendix 5).
  • General guidance on the application of ex-post risk adjustment to variable remuneration (FG23/6) (Appendix 6).

1.2 The regulators have considered the responses to feedback independently of one another, and in accordance with their statutory objectives. Final policy is being published jointly to avoid unnecessary duplication and familiarisation costs for firms.

1.3 This PS is relevant to UK banks, building societies, and PRA-designated investment firms, including third-country branches, which are subject to the Remuneration Part of the PRA Rulebook and the Dual-regulated firms Remuneration Code (SYSC 19D) of the FCA Handbook (collectively referred to in this PS as ‘firms’).

1.4 While this PS does not affect FCA solo-regulated investment firms that are subject to other Remuneration Codes, it will be of interest to solo-regulated investment firms that are members of a group to which the Dual-regulated firms Remuneration Code applies on a consolidated basis.

1.5 On 4 May 2023, the Chief Executive of the PRA received a letter from the chair of the Treasury Sub-Committee on Financial Services Regulations about CP4/23 and CP5/23. Sam Woods replied to this letter on 18 May 2023.

Background

1.6 In CP5/23, the PRA proposed to enhance the proportionality of the remuneration requirements that apply to small firms by amending:

• PRA rules that set out the definition of a ‘small CRR firm’ and ‘small third-country CRR firm’ (referred to together as ‘small firms’ in this PS) to bring these in line with the proposed Small Domestic Deposit Takers (SDDT) regime size threshold (£20 billion), and for firms with over £4 billion in total assets, with reference to selected other SDDT criteria under the Strong and Simple framework (trading book size; foreign exchange; commodities; clearing, and settlement, and custody services to third parties; and payment system operator);
• PRA rules and references in SS2/17 to remove application of the rules on malus, clawback, and buyouts to small firms;
• SS2/17 to introduce an expectation that small firms report material changes in their remuneration structures to supervisors; and
• SS2/17 to remove references to proportionality on remuneration disclosures as these are now set out in the Disclosure (CRR) Part of the PRA Rulebook.

1.7 In CP23/11, the FCA proposed changes to its existing approach in SYSC 19D that were consistent with the changes proposed by the PRA. The FCA also proposed to make a number of consequential amendments to align with the PRA. Specifically:

• The FCA proposed amendments to its General Guidance on Proportionality (FG23/5) to reflect the regulators proposals above. This includes amending the description of the three proportionality levels to reflect the new proposed thresholds for application.
• The FCA Dual-regulated firms Remuneration Code (SYSC 19D) – Frequently asked questions on remuneration (FG23/4) include questions on proportionality. The FCA proposed changes to this guidance to reflect the proposed amendments to the application of proportionality.
• The FCA proposed amendments to its General guidance on the application of ex-post risk adjustment to variable remuneration (FG23/6) to reflect proposals outlined above. This includes guidance on both malus and clawback, alongside in-year adjustments to variable remuneration.
• The FCA also proposed updating the definitions of ‘dual-regulated firms remuneration code staff’ and ‘material business unit’ to align with the PRA’s definitions in respect of material risk takers, in addition to making a number of minor wording amendments in its Handbook to ensure its rules align with the PRA.

Summary of responses

1.8 The PRA received 6 responses to its CP, and the FCA received 5 responses.

1.9 Most respondents generally welcomed the regulators’ proposals. Respondents who welcomed the proposals noted that:

• the measures would make the UK a more attractive place to do business and innovate;
• the proposed changes acknowledge that the risks associated with some activities (e.g. trading) are different from those in retail banking, and recognise the unintended consequences caused by the current requirements on challenger banks;
• by retaining foundational remuneration rules for small firms, the proposals still ensure that they take a prudent approach to aligning risk and reward;
• both the regulators’ consultations align, which will simplify firms’ understanding of the remuneration requirements; and
• the measures would ensure that the thresholds for remuneration and the SDDT regime are harmonised, while excluding the less relevant criteria in a remuneration context.

1.10 However, some respondents also commented that:

• (in response to CP5/23) the use of the SDDT criteria (for example on foreign exchange positions and on trading book size) adds an additional layer of complexity for branches;
• (in response to CP5/23) the proportionality criteria set out in the Disclosure (CRR) Part of the PRA Rulebook are less proportionate than those currently set out in SS2/17; and
• (in response to both CPs) exempting small firms from the remuneration rules regarding ex-post risk adjustment mechanisms (i.e. the requirement to apply malus and clawback terms) and buyouts would not promote sound and effective risk management or support the regulators’ objectives.

1.11 In addition, some respondents requested that both regulators:

• publish the final PS for both the removal of the bonus cap (as in CP15/22) and the small firms’ rules (CP5/23 and CP23/11) concurrently;
• review the rules on deferral periods and the number of staff that are captured under the definition of material risk takers (MRTs) as part of broader changes to the remuneration rules;
• streamline thresholds created for banks in different regimes on remuneration, resolution, and other matters noting the benefits of proposing reforms as a package; and
• conduct a survey following the implementation of the small remuneration firm reforms to understand the effects on proportionality.

1.12 In response to the FCA’s consultation, respondents welcomed the other proposed minor changes (as described above) to its Handbook and associated non-Handbook Guidance.

1.13 Details of the responses, the regulators’ feedback, and final decisions (including amendments made to draft rules) are set out in Chapter 2 and Chapter 3.

Changes to draft policy

1.14 The FCA’s policy position, as was set out in Chapter 3 and 4 of CP23/11, has not changed following consultation. In its CP, the FCA proposed to amend the proportionality thresholds for the application of remuneration requirements by dual-regulated firms and to the malus and clawback requirements for firms who meet the proportionality thresholds. The FCA’s intention remains that all dual-regulated firms within the same group must be subject to the same remuneration rules. The FCA does not think there should be a scenario where one firm in a group benefit from the proportionality- based exemptions and another does not.

1.15 Whilst no changes to the FCA’s policy position have been made, there have been some clarificatory changes to the FCA’s rules post-consultation which are explained in paragraph 3.2 below. The FCA’s changes make clear that the thresholds based on a firm’s average total assets need to be met not just by each individual firm, but also by the group on a consolidated basis. The changes also explain how the various qualitative thresholds are to be applied where a firm is part of a group, making clearer which are relevant to an individual firm within the group, and which also need to be met by the whole group.

1.16 The PRA’s intention remains (as was explained in PS26/20 Capital Requirements Directive V (CRD V)) that all firms within the same group must be subject to the same remuneration rules; a more proportionate regime would only be applicable if all firms in the group, and the group as a whole, meet the conditions set out in the definition of small firms in the PRA Rulebook. Following the publication of CP5/23, the PRA noted that the rules as proposed did not reflect this policy intention. Consequently, the PRA has amended the conditions in the definitions of small CRR firm and small third-country CRR firm to: 1) align with the final rules setting out the SDDT criteria (Chapters 2A and 2B of the SDDT Regime – General Application part)^{footnote [1]}; and 2) clarify how the criteria in those definitions apply in the group context (set out in Condition 2 of those definitions).

1.17 If these definitions do not apply, the full remuneration regime applies to all CRR firms and third-country CRR firms within that group. This change brings the PRA’s rule on group application in alignment with the FCA’s proposed approach as set out in CP23/11, and the PRA’s policy intention as set out in CP12/20 – Capital Requirements Directive V (CRD V).

1.18 The regulators do not consider that the impact of the final rules on mutuals following these changes would be significantly different to the impact of the draft rules on mutuals or to the impact on other authorised firms.

1.19 When making rules, the regulators are required to comply with several legal obligations, including publishing an explanation of each regulator’s reasons for believing that making the proposed rules is compatible with its objectives and with its duty to have regard to the regulatory principles.^{footnote [2]} In CP5/23, the PRA set out this explanation in Chapter 2, and in CP23/11, the FCA set out this explanation in Annex 3. The regulators are also required to consider responses to consultation, which the regulators have done, as explained in this PS.

1.20 The regulators consider that the changes with regards to group application of the rules (for the PRA this relates to definitions of small CRR firm and small third-country CRR firm, and for the FCA this relates to the proportionality criteria at SYSC 19D.3.2BR) do not change how the final policy is compatible with the regulators’ objectives, or their duty to have regard to the regulatory principles, relative to the explanations set out in their respective CPs.

1.21 The regulators must also publish a summary of the purpose of the proposed rules.^{footnote [3]} The regulators’ rules following the changes referred to in this PS aim to ensure that dual-regulated firms are subject to remuneration rules that are more proportionate to the risks these firms pose to consumers and markets in the UK. The regulators consider that risks to their respective statutory objectives for the proposed firms in scope can be mitigated sufficiently by other remuneration rules that the regulators are not modifying.

1.22 The regulators have taken into account the impact of the final rules on their cost benefit analyses (CBA). They do not consider the limited changes (as described in this PS) result in any material changes to their original CBAs (as published in their respective CPs). Therefore, they consider that the CBAs as consulted on remain appropriate.

1.23 The changes resulting from this PS will come into force on 8 December 2023. The PRA Rulebook and FCA Handbook amendments will apply to a firm’s performance year starting on or after 8 December 2023. The PRA supervisory statement and FCA non-Handbook guidance changes apply from the 8 December 2023.  

1.24 Although firms are entitled to apply the proportionality exemptions if they fall under the revised PRA definitions of small firms and meet the FCA criteria, they may, if they wish, choose to continue the application of malus and clawback.

1.25 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [4]}

2: Feedback to responses

2.1 Before making any proposed rules, the regulators are required by the Financial Services and Markets Act 2000 (FSMA) to have regard to any representations made to them. The regulators must publish an account, in general terms, of those representations and their feedback to them.^{footnote [5]}

2.2 The regulators have considered the responses received to their individual CPs. Most respondents welcomed the proposals. This chapter sets out the responses, the regulators’ feedback to those responses, and their final decisions. The responses have been grouped as follows:

• small firm criteria
• small firm rules
• clarification of remuneration disclosures
• timing of policy publication
• wider reform and evaluation

2.3 In summary, the regulators are implementing the final policy as consulted, with the minor amendments and clarifications set out in Chapter 3 below. The regulators consider the responses to their respective CPs did not significantly alter their consideration of the matters to which they must have regard in implementing the final policy.

Small firm criteria

2.4 In CP5/23, the PRA proposed amendments to the definition of ‘small CRR firm’ and ‘small third-country CRR firm’ for remuneration purposes in line with the proposed SDDT regime size threshold, and with reference to selected other SDDT criteria under the Strong and Simple framework (as consulted on in CP5/22 and CP16/22).

2.5 Similarly, in CP23/11, the FCA set out proposals for changes to the proportionality thresholds for the application of remuneration requirements by dual-regulated firms and to the malus and clawback requirements for firms who meet these thresholds. In doing so, the FCA sought to take an approach that is consistent with the PRA’s proposals to develop an approach more suitable and proportionate for the UK market.

Application of criteria to branches

2.6 The regulators proposed for the simpler remuneration regime to also be available to third-country CRR firms.

2.7 One respondent noted in its feedback to the PRA (CP5/23) that the use of the SDDT criteria (for example on foreign exchange positions and on trading book size) adds an additional layer of complexity for branches. They asked the PRA to consider whether risk metrics related to capital (such as those above) needed to be used for remuneration purposes. The respondent also asked the PRA to consider using just a balance sheet test alongside a principles-based/materiality-based approach suitable to the scale and complexity of the organisation and subject to PRA review. This respondent did not provide a response to the FCA’s CP.

2.8 Having considered this feedback, the PRA has decided not to amend the draft policy. The additional criteria (e.g. not having large trading books) are designed to reflect the inherent risks in a firm’s business model and are not capital related. The small CRR firm and small third-country CRR firm criteria are important in excluding from the scope of the small remuneration firm regime those firms whose activities and complexity could give rise to greater risk, because they serve as indicators of the riskiness of a firm’s business model.

Small firm rules

2.9 The regulators proposed the disapplication of rules on malus and clawback. In addition, the PRA also proposed the disapplication of buyouts for firms eligible to the small firm regime.

Risk management for small firms

2.10 One respondent commented in response to the FCA’s CP23/11 that they intend to continue the application of malus and clawback. Another respondent noted in response to both regulators that they did not believe that exempting small firms from the remuneration rules regarding ex-post risk adjustment mechanisms (i.e. the requirement to apply malus and clawback terms) and buyouts would promote sound and effective risk management, or support the regulator’s objectives of safety and soundness and enhancing integrity of the financial system. They further noted that recent events in the US banking market might also suggest that firms that have availed themselves of regulatory exemptions based on their size still have the potential to cause harm. The respondent however welcomed the principle of proportionality and was supportive of both CPs’ overarching aims of reducing complexity for small firms.

2.11 Having considered this feedback, the regulators have chosen not to amend the policy as proposed in their CPs for the reasons set out below:

• Proportionality: The regulators apply the remuneration regime in a way that seeks to be proportionate to a firm’s size, internal organisation, and the nature and scale of its activities. Since the implementation of CRD V, the regulators have seen increasing evidence that the regime has been costly and burdensome for firms including through waiver applications and firm responses to a PRA survey. The regulators’ proposals on the size threshold are stricter than the preceding CRD IV regime. The CRD IV threshold in SS2/17 was a size only threshold with no additional criteria. The regulators’ application of additional criteria for small firms in the Remuneration Part of the PRA Rulebook (to which the FCA Handbook cross-refers) that reflect the SDDT criteria for firms above £4 billon total assets means that riskier firms would not be included in the ‘small’ category.
• Safeguards in the remuneration regime: Firmwide remuneration rules, which continue to apply to dual-regulated small firms, provide a minimum baseline of assurance that incentives are aligned with the long-term financial performance of the firm, thereby advancing safety and soundness. All firms are still required to assess individual and firm performance and only award variable remuneration where justified, based on financial and non-financial criteria. Firms are also required to ensure that remuneration does not limit their ability to strengthen their capital base.
• Safeguards proposed in CP5/23: The PRA has also introduced a new paragraph (5.48) to SS2/17 to create an expectation that small firms should proactively disclose any material changes in their remuneration structures to their supervisors. This gives the PRA the enhanced ability to review and monitor small firms’ compliance with all applicable remuneration rules, and any effects on incentives and behaviours.

FCA Proposals to make certain rules ambulatory

2.12 In CP23/11, the FCA proposed to make certain rules and definitions ambulatory (these references have the effect of automatically updating references to the PRA Rulebook in the FCA Handbook each time the PRA updates its own rules). This is to ensure continuing consistency with the PRA’s rules and to avoid the need to reconsult on minor changes being made by the PRA in the future (specifically, changes to the definition of Code staff, material business unit and the criteria dual-regulated firms are required to meet to fall within the proportionality thresholds) where the FCA agrees with the changes the PRA is making.

2.13 Where feedback was received on making certain rules ambulatory, respondents welcomed the proposal. The FCA intends to proceed with its use of ambulatory references. The FCA has updated its use of ambulatory references since consultation to ensure that cross-references to the PRA Rulebook in terms of group application of the rules are also ambulatory. The specific rule changes the FCA has made are detailed below in Chapter 3.

Clarification of remuneration disclosures

2.14 There was an inconsistency between the way that the Disclosure (CRR) Part of the PRA Rulebook sets out the proportionality threshold for remuneration disclosures, and the guidance on proportionality for remuneration disclosures described in SS2/17. To provide clarity, the PRA proposed deleting references to remuneration disclosure proportionality from SS2/17.

2.15 One respondent noted that the proportionality criteria set out in the Disclosure (CRR) Part of the PRA Rulebook are less proportionate than those currently set out in SS2/17.

2.16 Having considered this feedback, the PRA has chosen not to amend its proposals. Subsequent to CP5/23, on 19 July 2023, the PRA consulted on measures to ensure the proportionate application of remuneration disclosure requirements within CP14/23. CP14/23 proposed to introduce lighter remuneration disclosure requirements for SDDTs, small CRR firms not eligible for the SDDT regime but in scope of simpler remuneration requirements as consulted on in CP5/23, and SNCI transitional firms. PS15/23 published concurrently with this PS makes these proposals into rules. This addresses the respondent’s concerns.

2.17 The amended definitions of small CRR firm and small third-country CRR firm affect the population of firms eligible for proportionate remuneration disclosures as proposed in CP14/23, but the PRA considers that this change does not affect the analysis of objectives and have regards supporting the changes proposed in CP14/23.

Timing of policy publication

2.18 One respondent requested that the regulators ensure that the publication of the final PS for both the removal of the bonus cap (proposed in CP15/22) and the small firms rules (PRA CP5/23 and FCA CP23/11) takes place concurrently to enable banks that are reconsidering remuneration structures in light of the (proposed) removal of the 2:1 cap to review their structures in light of the 'small firm' final remuneration rules.

2.19 Having considered this feedback, the regulators have chosen not to amend the timing of policy publication. On 24 October 2023, the regulators jointly published (PRA PS9/23 and FCA PS23/15) – Remuneration: Ratio between fixed and variable components of total remuneration (‘bonus cap’).

Wider reform and evaluation

2.20 The following section lists some additional yet out-of-scope remarks from respondents to the regulators.

2.21 Some respondents noted that deferral periods in the UK remuneration regime are more stringent than those required in the home country for firms headquartered outside the UK. Two respondents further noted that longer deferral periods make it more difficult to attract talent internationally. Additionally, one respondent indicated that the PRA should consider reviewing the number of staff that are captured under the definition of MRT as part of the broader changes to the remuneration rules.

2.22 Two respondents noted the uncertainty and risks created by a piecemeal approach to regulatory reform of the remuneration regime, which makes it harder for firms, especially small ones, to understand the consequences of various components, their dependencies, and interactions. A respondent further suggested the need to streamline thresholds created for banks in different regimes on remuneration, resolution, and other matters noting the benefits of proposing reforms as a package. One respondent also requested confirmation that the PRA would conduct a survey following the implementation of the small firms’ reforms to understand the effects on proportionality.

2.23 One respondent noted (in response to CP23/11) that the FCA should implement similar changes to its solo-regulated firms (under SYSC 19G).

2.24 The regulators noted that these comments are beyond the scope of the consultation. As such, the PRA and the FCA will consider these comments as part of any wider review of their remuneration regimes.

3: Changes to draft rules

3.1 Both regulators are making amendments to clarify the application of proportionality to small firms in groups that include larger institutions. The PRA has made changes to its definitions of small CRR firm and small third-country CRR firm to achieve the regulators’ existing policy intention as set out in paragraph 1.14 above. The changes made to the FCA’s rules are intended to align with the changes made to the PRA’s definitions referred to above.

Application of proportionality to small firms in groups that include larger institutions

3.2 The amendments made to both regulators’ rules clarify that where a firm is part of a group, it can only benefit from the more proportionate remuneration regime where:

• Either, both of the following conditions^{footnote [6]} are met:
  • each firm in the group to which these rules apply on an individual basis has average total assets less than or equal to £4 billion; and
  • where any firm in the group to which these rules apply on an individual basis is a member of a UK consolidation group, the UK consolidation group has average total assets less than or equal to £4 billion on a consolidated basis;
• Or, all of the following conditions^{footnote [7]} are met:
  • each firm in the group to which these rules apply on an individual basis has average total assets that are less than or equal to £20 billion;
  • where any firm in the group to which these rules apply on an individual basis is a member of a UK consolidation group, the UK consolidation group has average total assets that are less than or equal to £20 billion on a consolidated basis; and
  • the additional criteria set out in Chapter 2A.1 or 2B.1 of the Remuneration Part of the PRA’s Rulebook are met (the PRA and FCA rules explain in detail which requirements need to be met on an individual basis and which on a consolidated basis).

3.3 In the FCA’s Handbook, the changes explained above are reflected in its dual-regulated remuneration code in SYSC 19D.3.2BR. The changes make clear how the rules should be applied on an individual basis and, where the firm is part of a wider group, how the rules should be applied to that group. The rule makes clear whether the criteria need to be met by firms in the group (to which these rules apply) on an individual or a consolidated basis.

3.4 The proposed changes to the application of the regulators’ rules on groups clarify the existing policy intention and the long-standing regulatory approach to avoid rule arbitrage. The regulators will continue to review and monitor the application of the rules in respect of firms’ group structures and take supervisory or enforcement action if appropriate.