Justification for the Regulation on Supervisory Requirements for Remuneration Systems of Institutions (InstitutsVergV)

Justification for the Regulation on the Supervisory Requirements for Remuneration Systems of Institutions (InstitutsVergV) October 6, 2010

A. General Part B. Specific Part

A. General Part

A remuneration policy oriented towards short-term parameters and rewarding success unilaterally, without sufficiently sanctioning failure, can lead to losing sight of long-term and sustainable corporate success. Such a remuneration policy runs counter to appropriate risk management. As the financial crisis has shown, the misaligned incentives created by a flawed remuneration policy can pose risks not only to the stability of individual companies but also to financial stability in general.

To counteract these developments, the Financial Stability Board (FSB) developed principles for sound compensation practices ("Principles for Sound Compensation Practices" of April 2, 2009) and concrete standards for sound compensation practices built upon them ("Principles for Sound Compensation Practices-Implementation Standards" of September 25, 2009) in the financial sector, which were endorsed by the Group of Twenty (G20). The requirements established in the principles and standards aim in particular at a stronger orientation of remuneration structures towards the long-term success of the company and the appropriate consideration of risks assumed. For the banking sector, the FSB principles and standards are largely mirrored at the European level in the proposal for a Directive of the European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and securitisations and as regards the supervisory review of remuneration policies (CRD III) - currently considered as Document No. 11749/10 of the Council of the European Union of July 12, 2010. Based on Article 22(4) of the Banking Directive (2006/48/EC) newly inserted by CRD III, the Committee of European Banking Supervisors (CEBS) is tasked with drafting guidelines on the remuneration requirements from CRD III (CEBS Guidelines). The previous draft versions of the CEBS Guidelines have already been taken into account in this regulation. However, a final version is not expected before December 2010, so that in the event of significant substantive changes to the CEBS Guidelines in their final version, the regulation may need to be adapted.

The InstitutsVergV, together with the Insurance Remuneration Regulation, is the final step of the three-stage package of measures by the Federal Government to implement the FSB principles and standards as well as the remuneration-related provisions in CRD III as quickly as possible. The previous steps were the self-commitment of eight large banks and the three largest insurance companies in December 2009, and the circulars of the Federal Financial Supervisory Authority (BaFin) on the requirements for remuneration systems of December 21, 2009. Under the Act on Supervisory Requirements for the Remuneration Systems of Institutions and Insurance Companies of July 21, 2010, the details regarding remuneration systems are now defined by statutory instruments.

Section 25a(1) sentence 3 no. 4 of the German Banking Act (KWG) supplements the legally regulated (minimum) requirements for the risk management of institutions with requirements for appropriate, transparent, and sustainable development-oriented remuneration systems. According to Section 25a(5) KWG, the Federal Ministry of Finance may issue further provisions by statutory instrument. The InstitutsVergV corresponds materially largely to Circular 22/2009 (BA) of the BaFin, which is to be repealed upon entry into force of the regulation. Employee participation rights are not affected by the statutory instrument.

In the version of publication from: BaFin - Justification for the Regulation on the Supervisory Requirements for Remuneration Systems of Institutions... Page 1 of 7 http://www.bafin.de/nn_722756/SharedDocs/Aufsichtsrecht/DE/Verordnungen/Institu... 10.10.2011

The regulation changes eleven information obligations for the economy, which cause total bureaucracy costs of EUR 974 thousand. The calculation was carried out using a standardized procedure ("Time Value Table") and, in the absence of concrete experience values, represents only a rough estimate. Deviations in bureaucracy cost burdens compared to Circular 22/2009 (BA) are essentially due to changed case numbers.

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B. Specific Part

Institutions within the meaning of Sections 1(1b) and 53(1) KWG are covered by the scope of application of the regulation. Special features in groups are addressed by Section 9.

The regulation distinguishes in Section 1 between requirements that apply to all institutions and to the remuneration systems of all managers, employees, and staff (§§ 3, 4, and 7) and significantly more demanding special requirements (§§ 5, 6, and 8), which are only relevant for significant institutions and the remuneration systems of their managers and certain employees and staff.

An institution is significant within the meaning of this regulation if its total assets averaged on the respective balance sheet dates of the last three completed financial years reached or exceeded EUR 10 billion and it reaches the assessment based on a risk analysis that it is significant. In the risk analysis, particular account must be taken of the size of the institution, its remuneration structure, and the nature, scope, complexity, risk content, and internationality of the business activities conducted. The risk analysis must be documented in writing. The analysis must be plausible, comprehensive, and understandable to third parties. The more likely it is that the criteria for applying the special requirements speak, the more intensive the risk analysis must be. In contrast, for smaller institutions with manageable business and remuneration structures, the risk analysis can be designed more simply. The conduct of a proper risk analysis and compliance with the special requirements are monitored by the BaFin as part of appropriate and effective risk management during ongoing supervision. The supervisor has a graduated range of instruments in case of violations of Section 25a KWG. If the risk analysis does not meet the requirements, particularly regarding plausibility, the supervisor will usually initially only request a revision of the risk analysis taking into account the supervisor's opinion. Institutions whose total assets averaged on the respective balance sheet dates of the last three completed financial years reached or exceeded EUR 40 billion are regularly to be regarded as significant. This legal presumption is intended to serve as a guide for institutions and can be rebutted within the framework of the risk analysis that must nevertheless be carried out, if the classification as a significant institution appears to be not risk-adapted as an exception taking into account the relevant criteria. Conversely, institutions whose total assets averaged on the respective balance sheet dates of the last three completed financial years reached or exceeded EUR 10 billion but fell below EUR 40 billion can also be significant. Institutions whose total assets averaged on the respective balance sheet dates of the last three completed financial years were less than EUR 10 billion are not significant within the meaning of Section 1(2) from the outset. These institutions therefore do not need to conduct a risk analysis. With the flexible gradation of the scope of application, in accordance with the requirements of CRD III, while generally capturing all institutions, differentiation is made according to proportionality considerations in terms of regulatory intensity.

According to Section 25a(1) sentence 3 no. 4 of the Banking Act, the requirements for remuneration systems are not to be applied to the extent that remuneration is agreed by collective agreement or, within its scope of application, by agreement of the parties to the employment contract on the application of the collective agreement provisions or based on a collective agreement in a works or service agreement.

Section 2 of the regulation contains various definitions that are relevant for the application of the regulation. Remuneration within the meaning of the regulation includes not only financial benefits and benefits in kind of any kind but also benefits from third parties that a manager, employee, or staff member receives in relation to their professional activity at the institution. This constitutes remuneration, for example, in the case of profit participation within the framework of so-called carried-interest models. However, financial benefits or benefits in kind granted by virtue of a general, i.e., person-independent, and furthermore discretionary-independent and institution-wide regulation, which do not have an incentive effect to assume risks, do not constitute remuneration within the meaning of this regulation. These include in particular discounts, occupational insurance and social benefits, and for employees and staff, benefits for statutory pension insurance within the meaning of Book Six of the Social Code (SGB VI) and occupational pension provision within the meaning of the Occupational Pensions Act (BetrAVG). In the event of a conversion of part of the variable remuneration, the requirements of this regulation nevertheless apply, namely even if the variable remuneration is converted into such remuneration instruments that have no incentive effect to assume risks. Discretionary benefits for old-age provision are all financial benefits and benefits from third parties for old-age provision that a manager, employee, or staff member receives in relation to their professional activity at the institution and that are agreed with regard to a specific impending termination of the employment relationship at the institution.

Discretionary benefits for old-age provision are a purely calculatory part of the variable remuneration. This has the consequence that discretionary benefits for old-age provision must be taken into account in the calculation, particularly in determining an appropriate ratio of fixed and variable remuneration (§ 3(5)), the portion of variable remuneration to be withheld (§ 5(2) no. 4), and that portion of remuneration dependent on the sustainable value development of the institution (§ 5(2) no. 5), without the discretionary benefits for old-age provision themselves being affected by these requirements. Requirements concerning discretionary benefits for old-age provision themselves are subject to specific regulations in this regulation, namely in Section 5(3) and (4). Employees are all natural persons whose services the institution uses in conducting banking business or providing financial services, in particular due to an employment, business agency, or service relationship, and all natural persons who, within the framework of an outsourcing agreement with an affiliated outsourcing company for which Section 64b of the Insurance Supervision Act in conjunction with the Insurance Remuneration Regulation does not apply, are directly involved in services for the institution for the purpose of conducting banking business or providing financial services (§ 2 no. 6). Temporary agency workers also fall under this definition of employee. Commercial agents within the meaning of Section 84(1) of the German Commercial Code (HGB), whom institutions frequently use for the distribution of their products, do not fall under the definition of employee. This exception does not relieve institutions of the obligation to deal with the special features of this distribution channel (usually fully variable remuneration), particularly from the perspective of reputation and liability risk. For these purposes, institutions must establish suitable control structures.

Performance contributions are the actual benefits and successes determined on the basis of remuneration parameters that flow into the determination of the amount of variable remuneration components. Performance contributions are negative if specifications are not met.

Regarding §§ 3, 4, and 7 (General Requirements)

The general requirements apply to all institutions and to the remuneration systems of all employees.

Remuneration systems are also a corporate management instrument and must therefore, according to Section 3(1) sentence 3, be oriented towards achieving the goals set out in the institution's strategies. To ensure an attractive remuneration level, remuneration-relevant goals were sometimes defined in the past that were easy to achieve and did not fit the goals set in the corporate strategies. If even these often little ambitious remuneration-relevant objectives were not achieved, variable remuneration was occasionally decided and granted subsequently with reference to, for example, exogenous effects. The orientation of remuneration systems on the institution's strategies is intended to contribute to the fact that the remuneration-relevant goals are sufficiently ambitious and that the remuneration systems can make an effective contribution to achieving the goals in the corporate strategies.

Remuneration systems are appropriately designed if incentives for managers, employees, and staff to assume disproportionately high risks are avoided and if the remuneration systems do not contradict the monitoring function of the control units.

Incentives to assume disproportionately high risks can arise, inter alia, according to Section 3(4) sentence 1 no. 1, particularly through a significant dependence of managers, employees, and staff on variable remuneration. A significant dependence on variable remuneration does not exist if the proportion of fixed remuneration in the remuneration is so high that the institution can pursue a flexible remuneration policy in every respect, which also includes a complete melting down of variable remuneration. Depending on the overall success of the institution or group, the performance contribution of the organizational unit, and the individual performance contribution, there must be a realistic possibility that the variable remuneration can be completely melted down.

Contractually based claims to benefits in the event of termination of activity also include discretionary benefits for old-age provision within the meaning of Section 2 no. 4.

According to Section 3(5), fixed and variable remuneration must be in an appropriate ratio to each other. The ratio is appropriate if, on the one hand, there is no significant dependence on variable remuneration, and on the other hand, the variable remuneration can set an effective behavioral incentive. The institution must determine an appropriate upper limit for the ratio between fixed and variable remuneration. In this regard, different maximum ratios may be specified for different employee groups.

Remuneration systems contradict the monitoring function of control units according to Section 3(6) in particular if the amount of variable remuneration of employees and staff of the control units and the institution-internal organizational units controlled by them is determined significantly by the same remuneration parameters and there is a risk of a conflict of interest. This takes into account Standard No. 2 of the FSB. The "elements of the offense" (concurrent parameters, risk of a conflict of interest) must be fulfilled cumulatively. Concurrent parameters are generally possible as long as there is no risk of a conflict of interest. However, the alignment of remuneration parameters is an indication of a present conflict of interest, which the institution must rebut in individual cases.

Guaranteed variable remuneration is not consistent with appropriate risk management and the principle of performance-oriented remuneration. In implementation of Standard No. 11 of the FSB, therefore, according to Section 3(7), guaranteed variable remuneration is only permissible within the framework of the commencement of a service or employment relationship and for at most one year. Guaranteed variable remuneration includes, for example, variable remuneration components whose payment depends solely on the affected person remaining until a certain point in time.

The risk orientation of remuneration may not be restricted or abolished by hedging or other countermeasures according to Section 3(8). Institutions must implement appropriate compliance structures to prevent such measures. This may include in particular the obligation of managers, employees, and staff not to take personal hedging or other countermeasures that restrict or abolish the risk orientation of their remuneration. This requirement is based on Standard No. 14 of the FSB. In order to be able to align their behavior with the remuneration system, managers, employees, and staff must be informed in writing about the design of the remuneration systems relevant to them, according to Section 3(9), for example by information letters or e-mail. General statements, such as in notices, or a mere reference to framework agreements on variable remuneration do not suffice for this requirement. This also requires that the remuneration parameters are fixed at the beginning of a calculation period and not changed subsequently. Institutions must also be able to make the determination of variable remuneration for the affected person and, if necessary, third parties, comprehensible afterwards.

Managers must inform the administrative or supervisory body at least once a year about the design of the company's remuneration systems, according to Section 3(10), so that it can form its own opinion on their appropriateness. Pragmatic solutions are conceivable regarding the manner of reporting, as long as this does not restrict the legitimate information needs of the administrative or supervisory body. If no changes occur in the remuneration systems over time, reference can be made to previous information in the current reporting.

The organizational policies underlying the business activities (e.g., manuals) must also contain principles on remuneration systems, according to Section 3(11).

Section 4 takes into account Standard No. 3 of the FSB and is in line with Section 45(1) sentence 1 no. 4 KWG.

Section 7 is based on Standard No. 15 of the FSB and the provisions in Annex XII Part 2 Number 15 Letter (a) to (f) of the Banking Directive in the version amended by Annex I Number (5) Letter (b) (iii) of CRD III and the CEBS Guidelines. The regulation includes publication obligations for all institutions. The level of detail of the information to be published depends on the size and remuneration structure of the institution as well as the nature, scope, risk content, and internationality of its business activities. For smaller institutions, whose total assets, for example, fall below EUR 10 billion, some basic statements are sufficient regarding the presentation of the design of the remuneration systems. There is no need to go into greater detail on the collective agreement-based remuneration systems of collective agreement employees. In particular, significant institutions must ensure a level of detail in their information, while protecting their legitimate business secrets and taking into account their competitive position, that enables an outsider to understand the substantive compliance of the remuneration system with the requirements of this regulation. This includes in particular the decision-making processes in determining remuneration policy/strategy, the relationship between variable remuneration and remuneration parameters as well as performance contributions, the respective relevant remuneration parameters, the manner of considering risks and maturities as well as capital and liquidity costs, the designs regarding the requirements according to Section 5(2) nos. 4 to 6, and the design of the requirement according to Section 5(3) and (4). The aforementioned information must be separated by the individual business areas of the institution. Smaller institutions may, in individual cases, refrain from subdividing by business areas.

Regarding §§ 5, 6, and 8 (Special Requirements)

The requirements of §§ 5, 6, and 8 are only to be observed by institutions that are significant within the meaning of Section 1(2).

The requirements always apply with regard to managers. Significant institutions must determine via a risk analysis whether they have employees whose activities have a significant influence on the overall risk profile. These can also be employees working in control units. With regard to the employees identified in this further risk analysis, Section 5 and Section 8(3) are to be observed. For the risk analysis, criteria such as the size, the type of business activity (e.g., investment banking), the business volume, the amount of risks, and the earnings of an organizational unit can be used. The activity (e.g., as a trader), the position, the amount of previous remuneration of an employee, and a pronounced competitive situation on the labor market are also conceivable as criteria. The risk analysis must cover all organizational units of the institution. The higher the probability that in individual business areas (e.g., investment banking), activities...