Vol 7 (2010) - Issue 3

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Remuneration, Corporate Governance and the Banking Crisis

Introduction
Remuneration is only one aspect of the wider problem that the FSA have identified, the principal other aspects being capital adequacy and liquidity. It has contributed to the banking crisis but is not the principal cause.
President Obama referred to remuneration early in his Presidency and identified greed, irresponsibility and short termism as issues. Other issues affecting remuneration were the rating agencies and the auditors who failed to warn of the dangers, given that the profit figures were in many cases an illusion. This was coupled with the fact that in many companies, the profits upon which bonuses were based had not taken account of risk and there had been no charge for capital. All of this has led to a certain amount of opportunism of traders at banks and a culture of risk-taking. That is all well documented, for example in the April 2009 Financial Stability Forum report to the G20. Remuneration is an important ‘window’ on the corporate governance of the company. In general:
– A well-managed process – with a properly constituted remuneration committee which operates fully independently, appoints expert, professional, independent remuneration consultants to assist it, listens to shareholders and management and evaluates their inputs – is a good sign that other aspects of corporate governance will be effective. If, however, the reverse is true, for example, remuneration committee members are seen to be too close to the chief executive, consultants are appointed by and are too close to management, shareholder concerns are ignored and excessive remuneration is awarded, then this is a sign that other corporate governance factors may be poor.
– The choice of performance measures and their relative importance in the delivery of performance- related pay is the second window on corporate governance, as they indicate what is felt to be important in the company. The exclusive use of profit in annual bonus plans is a warning sign. The performance measures that determine the remuneration of the management of the company should be those that drive the future business success, for example, customer satisfaction, customer retention, customer growth, average revenue per customer, employee satisfaction, staff turnover and average length of service, environmental and social responsibility measures, health and safety, effective relationships with regulators etc. If these measures are not part of the incentive plans, then the company may be saying one thing to its shareholders but internally may be behaving quite differently. Hence this is a crucial window on what is happening inside the company.

I. The problems with bankers' pay
1. The way bankers are paid does not work. In most cases the expected value of an executive's pay package will increase if his actions increase tail risk, tracking error and share price volatility. Executives receive asymmetric returns: they are not aligned with those of long term shareholders.
2. There has not been enough deferred pay in the past. This is changing, but historically bankers had too much leverage in their annual pay negotiation. With little or no deferred pay to lose, they threatened to resign and move elsewhere. Consequently they were able to negotiate a higher package.
3. I mentioned above that in many cases paper profits were illusory, with no claw back; that there was no link to risk and there was no cost of capital.
4. We all know that when the tide comes in all the boats rise, but does this mean that is good performance? Bankers pay had no adjustment for a flowing tide or, to mix metaphors, a following wind.
5. Too many managers want to be paid more than or at least in the same ballpark as their subordinates. Sometimes you have to pay the stars zillions, but most of the managers of superstars are paid much less than those they manage (e.g. Tiger Woods' manager).
6. It is expensive to hire top quality executives and hiring people is risky. It is better to plan ahead and grow your own, like for example Goldman Sachs and McKinsey.