Implementing Reward Regulations in The Financial Industry: A Stage Model of Change Management

The nature and scope of the reward function in financial industry has been undergoing a change since 2008 financial crisis. In general, the reward function in a dynamic and constantly changing industry, such as financial services, is expected to evolve continually to address new challenges and build capabilities required for dealing with new business models, economic and business cycles, technological innovations, and the changing nature of capital markets.  That said, it can be argued that the changes in the nature of the reward function (i.e., what and how of the reward function) since 2008 crisis days are qualitatively different, and they influence and get influenced by stakeholders’ emerging expectations, regulatory requirements, and industry-specific challenges.

1. Perspective

The reward function deals with the single largest cost in most of the financial firms, which, in case of investment banks, could generally range between 35% to 60% of their net revenue.  Compensation costs, and their productivity, are therefore strategic from the standpoint of a firm’s performance, whether measured in terms of financial matrices, such as Return on Equity (RoE), and/or the behaviours they presumably trigger.

In a growing economy, which was largely the case prior to 2008 financial crisis, the reward function was mostly tasked with recommending the compensation levels/spends and developing reward designs that minimized the opportunity cost of compensation for both the firm and employee. The opportunity cost for the firm could be failure to hire or retain someone, who could have added revenue or market share or built new business, while for the employee it could be what s/he could get elsewhere, including from setting up own hedge funds.

While the nature and complexity of change experienced by the reward function in pre-crisis days differed depending on the firm, the expectations from the reward function itself were range bound.  To put it another way, the objectives of the reward function were, generally speaking, did not change much, and, in the main, focussed on developing reward designs that incentivised achievement – or maximisation – of a given business goal. Since firms had a broader choice in terms of reward design, this sometimes led to complexity and high agency costs. The reward function was largely a “closed system” in the sense that it could operate with minimal engagement with control functions, its’ range of stakeholders was limited, and the relationship between performance and reward was assumed to be direct and simple with low transactions costs in terms of monitoring unintended behaviours and long term consequences.

2. Stages in Reward Change Management

The impact of 2008 financial crisis on the reward function in last ten years was mainly through three inter-related influences, namely, regulation, business/industry challenges, and higher scrutiny by expanded set of stakeholders including media.  Of these three influences, perhaps the most immediate were regulatory requirements/expectations with respect to remuneration principles and framework. They focussed on, among other things, risk alignment effects of incentives and pay levels in industry, and broadened their scope – and complexity – over the years.  The expectations, which were themselves dynamic and evolving, were expressed either through regulations and directives or as unstated new norms, and represented a step-change in the mandate for the reward function.  They impacted each firm differently, and led to a combinatorial complexity through which the reward function in each firm continues to navigate to find right approach in terms of application of reward provisions, reward processes, organizational design and structure, capabilities and skill-sets, and goals of the reward function.

While this navigation is unique to each firm, it is possible to identify four main stages in the way the reward function experiences the challenges involved. These four stages are:

(a)   Alignment;

(b)   Improvisation;

(c)   Consolidation;

(d)   Normalisation.

These four stages do not have clear boundaries between them, and, while sequential in nature, vary in terms of time each firm (or rather its’ reward function) spends in each stage. It is likely for reasons beyond a firm’s control that a firm may get held up at a particular stage, or even back-slide to previous stages.  The resources and capabilities required also vary for each stage, as does the time needed to prepare for the next higher stage – or to stay in the same stage.

The main features of these stages are discussed below:

(a)   Alignment

Alignment stage refers to transitioning, or aligning, the reward function from an unregulated or lightly regulated reward context to a state, where its’ processes, role and deliverables are compliant with the new regulatory context to which the firm is now subject to.

Since the financial crisis, reward leaders had to deal with an ever increasing pace of changes triggered by new and evolving regulations and business uncertainty. This entailed not only understanding different requirements covering varying aspects of remuneration, but also interpreting and implementing them for various legal entities within a firm. This also entailed preparing stakeholders, particularly senior leaders and various specialist functions, such as risk, compliance, and legal, in developing a shared agenda to implement the requirements.

What does it take to align?

The main challenges for reward leaders and their teams are three-fold:

(i)              Assimilating the overall regulatory ask and expectations;

(ii)             Engaging with stakeholders to interpret and develop an action plan; and

(iii)            Developing the execution capability.

These challenges are generally accomplished with specialist help from external consultants. The focus, in this stage, is on understanding and meeting the base-line requirements and ensuring that the key stakeholders are engaged in the right way in the process.  Alignment stage could challenge firms multiple times in different forms. In the early days of regulation, nearly ten years back, big banks faced alignment challenge when new regulation started coming in.  For other firms, it could be when a legal entity changes the proportionality tiers. Firms could re-experience alignment stage, when they implement new requirements, such as Senior Management Regime and bonus cap, or when a new reward leader joins and wants to “re-align” the approach.

Alignment stage, in general, entails a fresh start with no previous foundation to build upon, and therefore it is difficult to perfectly execute this stage the first time, particularly when the firm is going through other strategic and organizational changes as well, and there are resource constraints including the headcount constraint.  In addition, reward leaders also have to rely, in this stage more than any other stage, on inputs and support from external and internal stakeholders, and there may be factors beyond their control to perfectly align everything in a given time-window.

What are the challenges at the alignment stage?

There are a number of things that can go wrong in alignment stage, even if the initial objective of implementing the regulatory requirements is met.  Examples include: stakeholders may not feel sufficiently engaged, firm may be very conservative in its’ implementation, reward processes may not be implemented fully or consistently, or different interpretations are relayed to various stakeholders.  At the implementation level, the challenges include: the information that reward relies on may not be fully updated or even accurate, impacted employees may feel dissatisfied, as they may compare with their situation with other colleagues or at previous employer or may have doubts and lack of trust in the firm itself on the need, extent and interpretation of regulatory ask.

How do we enhance the probability of success?

Given that alignment is a foundational stage, reward leaders may like to get it as right as possible the first time, as it helps to build the credibility of the reward function as well as minimizes the time and energy business and HR leaders have to spend dealing with issues including employee dissatisfaction arising out of this stage.  There are a number of things that can be considered to make this foundational stage both effective and efficient.

An understanding of technical aspects of reward regulation and having a broader industry perspective is a start point – a deep understanding helps to build credibility with stakeholders, develop scenarios to integrate regulatory provisions with organizational processes, identify risk areas and build new capabilities needed within the firm and reward team.  Though the importance of technical knowledge is well known, what is perhaps under-appreciated is the extent of technical band-width needed right from the foundational stage, and how the failure to get the right combination of broader perspective and band-width could waste organizational energy, particularly at the level of senior leaders, in the later stages.

Another under-appreciated fact is reward leaders – and their teams – need to be more than just technically brilliant. They need to know the business, organization design, various organizational processes, and most of all organizational culture. This stage marks, in significant ways, a shift for reward towards a function driven by multi-disciplinary skill-set. Though optically the implementation of regulatory requirements in this stage seems like a technical project, a successful implementation requires a multi-disciplinary approach.  If reward leaders are not sufficiently in touch with organizational reality, then converting the technical knowledge into successful implementation may need additional resources including time and luck.

An additional consideration for reward leaders is to resist the instinct to use the technical complexity to add to the mystic and the Subject Matter Expert (SME) status of the reward function, and further isolate it from the rest of the HR and business. While it is logical to keep the technical knowledge within reward and lighten the burden of the HR function, keeping HR on the margins or involved in a perfunctory manner (as opposed to proactive) runs the risk of missing important organizational design and talent nuances. Even if reward leaders are technically brilliant and organizationally savvy, it is almost impossible to anticipate all angles and nuances involved when technical knowledge meets organizational reality, and the HR function and businesses can proactively help in this journey.  While the reward function owns the responsibility and “enjoys” the SME status, the implementation is an organizational and senior leadership task, and should be considered in that light from the initial stages.

(b)   Improvisation

 While the alignment stage is about implementing the regulatory provisions for the first time, improvisation stage focusses on using the experience and learning from the previous stage to execute the processes in a smarter and more holistic manner next time.  Even in situation when the alignment stage is well executed, given the nature of change process, there are always learnings and experiences to improve the processes further.  However, the improvisation is not only about finessing the existing processes; it is also about adding depth and breadth to the processes as well as building organizational knowledge base and capabilities. This is also the stage when HR and business start building aspects of regulatory reward into their own decisions, such as organizational design, hiring, transfers, and committee memberships.

A question of interest at this stage is:

How does a firm or its’ reward leader know that it is in Improvisation stage as opposed to alignment stage?  

There are few heuristics that can be used to form an informed view whether or not the reward function is still in the alignment stage.  Firstly, if the reward function and its’ stakeholders, such as senior managers and control functions are debating or planning to look afresh at the technical aspects of the regulation for better implementation, then it prima-facie suggests that implementation is still in the alignment stage.  This of-course excludes the re-assessment arising out of substantial restructuring or changes in strategy/business model. Secondly, if the implementation is largely at the same level of seniority – or has gone up in terms of review – then it means that the reward function is still in alignment phase. A successful implementation, in general, leads to delegation of at least few aspects of implementation at mid-or lower levels. Thirdly, if the organizational memory keeps the scars of first time implementation in subsequent years, then it means that the reward function is still partly locked into the alignment stage. Finally, if there is feedback and/or audit or formal failures, then it means that the reward function has further work to do on the alignment phase.

From an organizational point of view, the distinction between the two stages is important in terms of resources required and organizational engagement. Alignment phase requires a multi-disciplinary reward leadership, and while hiring, it is better to err on the side of more band-width and broader perspective than settling for limited range and specialism, and expecting to compensate it later with senior level hiring. In the improvisation stage, “business as usual” reward leadership will possibly not pose a serious risk, and a firm may have greater tolerance in terms of hiring decisions.  The organizational mind-set in improvisation stage is more in terms of smart execution, which could perhaps be done effectively at mid-levels.

What are the things a firm could do to make this stage effective, and make an early transition to the next stage? 

The firm could start working with the unknowns and unintended consequences, which have come to light out of implementation experience so far. These could be resistance from the newly Identified Staff, expectations of higher pay from Identified Staff, sub-optimal structures and design, difficulties in hiring, or general de-motivation.  Each firm could have its’ unique challenges in this regard, and handling them from the beginning, as they come up, could shorten the organizational time in this stage. Routinization of new tasks and deliverables, and delegating them down in terms of processes will help in embedding the change efficiently.  This is also a stage when the regulatory reward principles and concepts should start playing a role in decision making processes.  Finally, change is a way of organizational life, and it is likely that organization experiences restructuring, change in business models, business relocations, and other significant changes. Reward and HR could proactively be engaged in these processes from reward perspectives, so that unintended consequences of such changes are minimised.  How long should the improvisation stage be?  In theory, a part of this stage will always be on, since organizations are unlikely to achieve perfection given the changes they experience on an ongoing basis.

(c)    Consolidation

 Consolidation stage involves encoding regulatory reward principles and frameworks into the organizational way of working, and into its’ culture. By the time, a firm reaches consolidation stage, irrespective of trajectory followed, overall regulatory reward approach and frameworks are established.  In this stage, firm uses them as anchor while making business and organizational decisions.  It is assumed that any major restructuring or strategic changes will largely fit into the reward frameworks already established instead of trigging significant changes in the established reward framework itself to fit the new strategic context.

An important feature of consolidation stage is its focus on connection, consistency and integration among reward processes and deliverables over time, across functions (such as hiring, international assignments, and SMR regime), stakeholders and employee levels. It is also expected in this stage that business managers at various levels are likely to have understanding of regulatory principles and aspects of reward, and take lead in initiating conversations about routine business decisions with potential reward implications.

What are the markers, which a firm or HR/reward leaders could use to assess that they are in consolidation stage? 

A good heuristic to know whether a firm is moving towards consolidation stage is when surprises and new angles stop emerging from the analysis and from the impact of last implementation. Another heuristic is lack of new (and significant) reward implications emerging that were not previously considered during business level changes (such as new strategy or business relocation or reorganization), which happen with increasing frequency in financial firms.  In this stage, any new developments, whether in terms of new reward regulation or business level changes, are unlikely to have an outsized impact on established approach and processes.

Consolidation stage differs from the improvisation stage in few key areas  

Consolidation stage is more about routinization, integration and embedding of reward processes and information over a larger scale of time (across the years), functions (HR, culture, hiring), and levels (senior levels to mid and lower levels). Improvisation could also happen in this stage, but it would mostly be tactical in nature and unlikely to risk the foundational work done in previous stages. Improvisation stage mainly deals with fixing the glitches at the level of individual reward processes and making them effective one at a time. Consolidation stage involves, among other things, looking at both organizational and reward processes in an integrated manner. The changes in consolidation stage include re-working on organizational as well as reward processes with the goal of routinizing reward deliverables. The implementation responsibility, including designing features, is progressively delegated at mid- and lower-levels reflecting the confidence gained from previous stages.  In the consolidation stage, the retrieval and analysis of legacy (regulation specific) reward information is likely to be a routine matter unlike re-initiation stage, where it did not exist, or improvisation stage, where it was limited in scope or processes were yet to be optimised.

Main challenges for reward and HR leaders in consolidation stage

For reward and HR leaders, main challenge in consolidation stage is not to make the assumption – and fight the organizational instinct – that “completion” of improvisation stage marks the end of change process. As this section indicates, though there are overlaps in improvisation and consolidation stages, they are two different stages in terms of challenges and areas to focus on.  Consolidation stage also requires a constant training and updates to broader set of stakeholders, as the knowledge base probably would have established in a piecemeal manner over last two stages giving rise to the risk of mis-interpretation of certain aspect of a process or policy.   Another challenge, which begins and continues from the previous stages, relates to employee perceptions of bureaucracy, and that the firm is not doing enough in terms of pay to mitigate the “hardships” imposed by regulatory requirements.  This is largely an area, where culture, constant communication and presence in important meetings is helpful.

Consolidation stage benefits from multi-disciplinary reward approach, but, if previous stages are well implemented, does not depend on it. This has implications in terms of hiring and placement decisions in the reward function. While large band-width and previous experience in leading various stages is almost a pre-requisite in hiring for key reward roles in re-initiation stage (contrary to popular perception that senior talent is not needed), hiring in the consolidation stage could consider the role (whether of a reward leader or at other levels) as a part-developmental opportunity, as the foundation is already built.  The skill-set needed for the most part includes a base-line technical knowledge, and an ability to execute well. This execution, in some respects, is qualitatively different from the traditional implementation skill-set, which for the most part was to execute and optimise within a given specialism, such as legal, taxation or accounting. The ability to execute well in the consolidation stage requires ability to look beyond one particular specialism and its’ day to day implications. Integration and embedding of change over multiple domains requires holistic thinking, ability to connect dots and an interest in looking at bigger picture.

Consolidation stage, like the previous improvisation stage, is never fully over. It is on-going in nature though the resources and level of work would come down, as time progresses.  Though this stage seems tactical, there is a strategic need to re-assess and re-validate the framework, when a significant organization change is considered or a new regulatory requirement needs to be complied with.

(d)   Normalization

The last stage, normalization, “begins” when the firm -and its’ reward function -reaches a point, when regulatory aspects of reward cease to dominate the agenda/discussions in reward and HR community within the firm.  The firm considers regulatory reward processes as “normal” and “routine”, and ready to move on to focus on culture, employee capability and creating other talent advantages. To the extent, regulatory reward gets attention, it is to deal with new developments, updates and changes.

Organizations in this stage have an advantage over other firms still in previous stages in two main ways. Firstly, firm with its’ reward function in the normalization stage can concentrate on building talent capabilities and culture, which generally gets overshadowed by the urgency and pressures of implementing reward regulations.  Secondly, the firm is likely to have ready answers to many questions that internal employees, external hires business leaders and international assignees ask to understand the impact of regulation on their future reward packages.

The advent of normalization stage does not mean that the reward function is now purely in the maintenance mode, or it lacks challenges. Normalization stage makes space for three key reward areas, which might -or might not-have been addressed in previous stages because of time and resource constraints.  These three areas are also strategic in nature, and discussed below:

Simplicity and transparency: Normalization stage provides the band-width, time and resources to focus, either for the first time or in a more involved way if already initiated, on making the reward and related organizational processes simpler and more transparent. In the improvisation and consolidation stages, the emphasis largely was to make processes effective and consistent, which could lead to complexity not as much by design, but perhaps due to incremental and piece-meal manner of implementation.  By the time, a firm is in the normalization stage, there is critical mass of organizational learning, which could be used to make processes simpler, transparent and error-free.  Simplicity and transparency itself could be a source of talent advantage, as they lead to higher trust in the organization.  Making organizational and reward processes simpler is however not a simple process, particularly when complexity was a by-product of changes introduced to cover various regulatory provisions of reward in a tactical manner over time.

Re-framing the questions: Normalization stage provides the space and opportunity to reward leaders to bring to the centre-stage the question: What is the right thing for the firm, and use it as a test question while making decisions on reward processes? This question generally gets covered narrowly in terms of ensuring technical correctness in previous stages owing to the pressures of implementation and learning curve involved. Normalization stage provides opportunity to ask this question broadly from organizational and cultural perspectives as well, if not already done in previous stages.

Integration with culture: Embedding the principles and reward frameworks into culture is a difficult challenge, which perhaps could be addressed in a serious manner only in the normalization stage, once the pressures of regular implementation are over.  The change process from the previous stages would have influenced or been reflected in culture, perhaps with both intended and unintended consequences.  The integration of reward principles and framework into organizational culture progresses through various stages, which requires a separate paper.

Operationally, a key challenge for reward leaders in this stage is to keep the momentum going, provide a pragmatic framing of goals of the reward function for the firm, and attend to changes required, which if ignored for long may potentially take the function back to the previous stages.

3. Implications

It is almost ten years since Financial Services Authority (FSA), then UK regulator, published its’ initial draft code on remuneration practices. Since then, reward functions in financial firms have faced challenges of varying complexity and scope to implement reward related regulations. This has raised the profile of the reward function, and also required it to become multi-disciplinary in nature and more integrated with the organization.  As firms implement and fine-tune their reward frameworks, it is also important to remember that implementation of reward principles and frameworks is not a pure “technical” reward project; instead it is a broader organizational change effort, which involves various organizational processes.

The stage model presented above is a simplification of a complex reality, particularly when organizations have different regulatory priorities and agenda in different locations, regulatory regimes and legal entities. An organization could be in multiple stages at the same time, or may go back to previous stages, if it is not keeping pace with the changes and has not developed internal capabilities.  The stage model suggests that reward functions go through various stages that require different focus, change management skills, technical and organizational band-width, and cognitive diversity in the team.  A key challenge for reward leaders in all these stages is to re-define and re-position the role of the reward function in the context of regulatory requirements, stakeholders’ expectations and organizational strategy.