30 April 2015

Senior Manager Regime

One of the frustrations identified by the Treasury Select Committee (TSC) whilst it was investigating the causes of the financial crisis was that the collective responsibility of the board made it difficult to blame any one individual for a bank's perceived failings.  So, by way of example, despite the public consensus that Fred Goodwin was responsible for the failure of RBS, there was no legal basis for holding him personally liable for the collapse of the bank.  To close this perceived gap in the regulatory framework, the Senior Manager Regime (SMR) is being introduced, in part to ensure that there will always be an individual within a bank who is responsible for any failure.  The precise date when the SMR will be introduced is still unclear, but HM Treasury have said it needs to come into force by March 2016.

One of the consistent themes behind the Regulators' response to the financial crisis has been a drive to ensure that bankers have individual responsibility and suffer personal consequences when things go wrong.  That principle is visible in the evolution of the use of remuneration as a tool to discourage bad behaviours: from paying in stock, so that employees suffered losses if the value of the shares was affected, to the development of the concept of "malus" (the ability to reduce earned, but deferred, compensation for several years after the date of the award) to the development of "claw-back" (the right to require employees to re-pay sums that have already been paid to them). This direction of travel continues with the introduction of the SMR.

Under the SMR, banks are required to develop a comprehensive responsibility map which describes the bank's management and governance arrangements.  This will include details of the senior managers and the responsibilities that they hold under the SMR.    To emphasise their obligations, each individual (a Senior Manager) will be required to sign up to a statement of responsibilities, acknowledging their areas of responsibility.  The principle is that, if there is a regulatory breach, the Regulators will be able to look at the map of responsibilities and the statement of responsibility and identify the individual responsible for that area.

The regime will create a rebuttable presumption that, if there is a regulatory breach by the Firm (which would have to be established in the usual way), then the Senior Manager with responsibility for the area in which the breach has occurred, will be assumed to be guilty of misconduct unless that person can prove that this is not appropriate. Experience suggests that in hindsight it is always possible to identify failings of varying degrees of seriousness. Whilst in theory it should be possible for Senior Managers to prove that they did everything reasonably within their power to avoid whatever catastrophe has befallen the bank, given the pressures that tend to apply at times like that (think of the media storm around Fred Goodwin) the risk is that the Regulators may hold individual managers to impossibly high standards.  The Regulators are now consulting on guidance dealing with the kinds of factors that the FCA and PRA will consider when deciding whether or not Senior Managers have taken the steps that a person in their position could reasonably be expected to take.

One of the areas of significant debate in the run-up to the introduction of the SMR was whether it would apply to non-executive directors (NEDs).  It has now been confirmed that NEDs will not be included unless they chair specified board committees.

Whilst the regime is likely to prove effective in satisfying the TSC's identified need for heightened individual responsibility and will undoubtedly make it easier for the Regulators to find individuals on whom they can place blame, there is a question mark over whether it will serve the interests of the industry and the wider public by making the financial services sector a safer and more stable place.  The hope is that banks will introduce better and more effective risk management structures and that the Senior Managers will be highly incentivised to ensure that all internal committees and oversight structures are fit for purpose and operate effectively.  The challenge is that there is a limit to the knowledge and influence that any one individual can have and there is always the possibility of a rogue employee or unforeseeable event.  One of the clear risks of the new regime is that it will potentially create scapegoats to satisfy the appetite of the public for someone to blame when things go wrong, but without actually introducing any real improvement to the corporate governance within the sector.  The potential consequences for Senior Managers are serious and include the increased likelihood of being sanctioned by the Regulators, suffering public censure, personal financial penalties, withdrawal of approval, and the possibility of being banned from holding a regulated position for life. There is also the new criminal offence of reckless misconduct resulting in the failure of a bank, or part of it, reserved exclusively for Senior Managers.

From our discussions with senior executives in the sector, it is clear that this risk of scapegoating may lead to a reduction in the number of senior executives who are willing to accept the senior management roles that will fall under the SMR.  We have seen this already with the rise of senior non-employment roles with titles such as "Special Adviser".  This creates the risk that the Senior Managers in the future will not necessarily be the best managers in an organisation, but will rather be the individuals who are most prepared to take risks – potentially the exact opposite of what is required for many banks.

The increase in regulatory pressure also increases the attractiveness of the shadow banking market.  Institutions such as hedge funds and other financial institutions are not captured by the regime and therefore are able to operate in a more flexible way.  This may be the next big challenge for Regulators.  It also remains to be seen whether the sheer weight of regulation, will accelerate the process of banks and other financial services firms moving to jurisdictions with lighter touch regulation.

There is no doubt that the banking crisis that commenced in 2008 was caused, at least in part, by a regulatory failure.  Equally, it is unarguable, that the country as a whole suffered grievously as a result of that crisis.  It remains to be seen whether the introduction of the SMR will effectively reduce the risk of a future crisis – and if so, whether the price of that reduction is worth paying.