Compensation culture

Salaries and incentives at financial services firms are coming under attack from politicians around the world. Ellen Davis considers whether the attacks are justified, and solutions to the problem

Thanks to the subprime crisis and resulting credit crunch, compensation and incentive schemes at financial services firms are a new risk management frontier. Regulators, politicians and shareholders around the world are baying for blood - pointing out with some justification that current remuneration packages at financial services firms do not align the risk profile of the firm and specific products involved with that of the employee.

The industry - while resisting a regulatory answer to this tricky issue - is equally troubled. It recognises there is a real challenge here. Many firms would like to put in place some kind of structure that would better align an employee's interests with those of the firm - traditional equity-based schemes have proved inadequate for a variety of reasons and senior bankers are scratching around for other ideas. On the other hand, most fear that even if a new, 'magic' compensation scheme were developed, it would be almost impossible to implement because of the stiff competition for talent among firms, which has usually dealt the employee a stronger hand than in other industries when dictating the terms of compensation arrangements.

So what should firms do? Regulators, politicians and others are beating the drums for change. Almost all the papers published earlier this year that attempted to analyse the causes of the subprime and credit crises fingered the seemingly tone-deaf compensation packages that financial services executives were on. From mortgage brokers to collateralised debt obligation (CDO) structurers, packages usually focused on hitting monthly or quarterly targets. Sometimes there would be an equity element - part of the bonus would be held back and paid into the firm's shares - but in general the star performers could negotiate higher cash-upfront levels in their packages. These short-term targets focused minds on creating the highest deal volume possible, at the expense of the underlying risk of each individual transaction. It was a recipe for disaster.

"Unbalanced remuneration incentives are another source of excessive risk-taking," said Nout Wellink, president of the Netherlands Bank and chairman of the Basel Committee on Banking Supervision, in a speech in late May. "Employees who receive massive bonuses when earnings are high but are hardly hit when losses are made are probably less prudent than they would be in the interest of their employer."

Others have weighed in as well. Callum McCarthy, chairman of the UK's Financial Services Authority (FSA) said at a British Bankers' Association (BBA) conference in early June: "The present bonus system places excessive emphasis on the short-term performance of individual parts of an organisation, and it encourages the taking of trading positions whose immediate profitability (often unrealised but marked to market) is rewarded, but whose accompanying risk is neither properly recognised, nor disincentivised. This is a problem that has long been faced in traditional banking in respect to credit, where the immediate income on arranging a loan is offset by the provisions that inevitably attach to advancing loans. We need to have comparable incentives - and disincentives - on the market side."

This comment built on those made by the FSA's chief executive officer, Hector Sants, in a BBC interview in February: "I think we would say there is a risk that the remuneration structures are too short term and that they do incentivise behaviour that is not helpful in terms of maintaining long-term financial stability," said Sants. "There is an asymmetry, as we would say, between the return to employees and the return to shareholders."

The FSA - and the UK government in general - is taking a very measured approach to the issue of compensation, however. Kitty Ussher, member of parliament and economic secretary to the Treasury, made this clear in a speech to the BBA conference. "We will resist calls for more prescriptive regulation - and while I'm on the subject of regulation, we will also resist the calls that have been made for direct regulation of executive pay," she said. "Of course, remuneration packages should be strongly linked to effective performance, and incentives should be aligned with the long-term interests of the business and of shareholders - and we don't support 'rewards for failure'. And over the past 10 years, we have taken steps to improve transparency, and to encourage shareholders to improve accountability. But I'm clear that executive pay is a matter for boards and shareholders - not for governments."

The tone is very different on the continent, with politicians across the EU weighing in on the perceived injustice of bankers' compensation packages and the need to regulate executive pay across the board more closely. For example, Horst Kohler, former head of the International Monetary Fund, called the financial markets a "monster" in an interview with Germany's Stern magazine, and added: "The complexity of financial products and the possibility of carrying out huge leveraged trades with little (of their) own capital have allowed the monster to grow ... also responsible (is) the grotesquely high compensation of individual finance managers." Kohler called for "more severe and efficient regulation, higher capital requirements" and a host of other new frameworks - all to be overseen by the International Monetary Fund.

In this sense, the compensation issue has become something of a totem for many politicians when discussing the credit crisis in continental Europe. Both French president Nicholas Sarkozy and his finance minister, Christine Lagarde, have publicly criticised executive pay, for example. The issue is also making its way on to the agenda of the European Union, with Jean-Claude Juncker, the president of the eurogroup of finance ministers and also the president and finance minister of Luxembourg, calling excessive executive pay a "scourge". The EU is looking at enacting enhanced corporate governance rules that would enable shareholders to have more say on pay packages, but the sabre-rattling on this issue won't die down soon.

Indeed, the corporate governance move is something of a compromise and many expect the issue to hot up again when France takes over the presidency of the European Union. Some countries are already looking at more restrictive legislation. For example, in the Netherlands, a new law on executive pay is being debated in parliament - it would circumscribe 'golden parachutes' and would set EUR500,000 as the level of annual salary or severance payment at which extra taxes must be paid. In Germany, the Social Democratic Party is also advocating new pay legislation, although this is being resisted by the government.

In the US, public pressure on executive compensation is taking the form of so-called 'say on pay' corporate governance schemes. Even US presidential contenders are publicly backing these schemes, which allow shareholders a non-binding say on the compensation packages of top executives. Oddly, shareholders are not. Recent votes on the issue at the annual meetings of Citigroup, JP Morgan, Merrill Lynch and Morgan Stanley showed a decrease in support on this issue from last year. That said, the number of such resolutions being voted on in this year's annual meeting season in the US jumped by 50% over 2007, according to reports from shareholder activist groups.

All of this political pressure explains why financial services trade associations - and the firms themselves - are taking the threat of regulatory intervention on executive compensation seriously. The Washington, DC-based Institute of International Finance (IIF) published an interim report from its committee on market best practices in April - the purpose of which was to demonstrate to regulators, politicians and others that the financial services industry is taking this issue seriously.

"There is a strong sense that externally mandated compensation policies would be at odds with the need to forge competitive, efficient firms that serve the interests of consumer and corporate clients," said the report. "While recognising that compensation policies should remain subject to the discretion of the CEO and the oversight of the Board, there is strong support for the view that the incentive compensation model should be closely related by deferrals or other means to shareholders' interests and long-term, firm-wide profitability. Focus on the longer term implies that compensation programmes ought as a general matter to take better into account cost of capital, not just revenues. Consideration should be given to ways through which the financial targets against which compensation is assessed can be measured on a risk-adjusted basis. The principle of making the compensation model consistent with shareholders' interests is well established in some contexts but has been unevenly applied across the industry, especially with respect to compensation of sales and trading functions."

The subcommittee is working away on its final report, which is expected to be published in mid-July, and this report is expected to provide more detail around best practices for compensation and incentive packages, as well as confront other issues that have arisen as a result of the subprime debacle.

A few firms are taking this issue in hand and attempting to confront it head-on. Deutsche Bank - whose chief executive Josef Ackerman is also chairman of the board of directors of the IIF - announced at the end of May that it is considering reforms to its employee compensation structures, including potentially a multi-year bonus scheme. Switzerland-based UBS also recently produced an internal report that concluded that the firm's bonus scheme was partly to blame for the losses it suffered - the equity-related part of bonuses had been ditched for high performers in an effort to keep them on staff, compensation for some traders was not risk-based, and traders invested in CDOs because they paid higher fees.

But what can be done about restructuring bonus and compensation schemes? This is tricky for banks, which want to attract the top talent from what is a limited global pool. Basel's Wellink says bonus programmes "should be designed in such a way that curbs exist on inappropriate behaviour. Perhaps one way to improve this is to ensure that an employee's time horizon is aligned with that of more general interest, for instance by making bonus payments dependent on broad performance indicators over a longer period."

This is easier said than done. "Historically, the financial services industry has tended to reward rainmakers on production (for example, the volume of loans originated) and/or short-term reward (for example, this year's earnings)," says Carol Beaumier, executive vice-president, global industry programmes, at Protiviti. "Aligning incentives more closely with risk, the longer-term reward and the interests of shareholders probably requires some discounting or lag in the payment of incentives to allow for evaluating longer-term impacts. This may be easier to do with, for example, traditional lending activities where it is possible to make some judgements about future performance based on history; it will be much more difficult to do with innovative new products. Finding the right balance will not be easy and will require a cultural shift in thinking about how compensation schemes should be structured."

"How do you bring risk-adjusted performance into compensation arrangements?" asks Ali Samad-Khan, head of the operational risk consulting practice at KPMG in New York. Samad-Khan says it's tricky, especially given that the discipline of operational risk - a substantial component - is still in the early stages of developing statistical analysis. But he suggests that perhaps compensation can be approached the same way as expected and unexpected loss are now being factored into product pricing in some areas.

Lloyds TSB is one firm that is tackling the problem - although the firm says it expects to make modest changes overall to their compensation scheme. Roger Stockdale, senior manager - framework, policy, process and methodology in group compliance and operational risk department at Lloyds TSB in London, is working with executives across the business to get to grips with a new level of best practice. "All our staff have a risk component within their balanced scorecards but we wish to ensure that we have clearer visibility of their effectiveness and that incentive schemes are subject to reviews by divisional risk teams/group HR within the second line of defence," says Stockdale. He adds that "operational risk can aid understanding of risks and the associated downsides and so influence the wording and measures used in individuals' balanced scorecards. To be effective, this requires the operational risk analysts to be able to review data and provide relevant analysis that enables differentiation of risk exposures by risk types and business lines. We already use scenarios to better understand risks arising from future regulatory perceptions of historic product sales and consider the causal factors that could result in regulatory interest as part of the scenario analysis."

Firms have been toying with risk-based compensation schemes for decades - one of the more famous failures was when Warren Buffett attempted to impose such a regime on Salomon Brothers in the early 1990s. Eddie Niestat, head of the financial services practice at PA Consulting in New York, says when Buffett tried to reform Salomon - which had just endured a massive bond trading scandal - "people voted with their feet" and simply left the firm.

But, he adds, the current market downturn could present firms with a "potentially unique opportunity to introduce stricter compensation schemes." A consensus among both regulators and firms could be used to change compensation structures across the industry simultaneously, which would reduce the impact of competitive pressures for recruitment, which is what has always previously prevented such changes from becoming a reality.

He adds that op risk executives should make sure they include compensation issues in their analysis, to continue to raise awarenss of the issue among the business lines and senior management. For example, operational risk executives could look at how their loss data relates to compensation issues within different business lines, perform stress testing on various compensation approaches, and incorporate compensation into their scenarios.

Ultimately, though, firms may struggle in the short term to change their incentive schemes to something that is either longer term or more risk-based. One ray of light - the IIF's initiative - could help to provide a road down which firms could go in this regard, but whether they will stick to the new compensation packages once times are good, remains to be seen. The best operational risk executives can do - according to industry experts - is to keep the issue front-and-centre with business lines and senior management, and seek to influence the culture around the compensation culture.