Vol 9 (2012) - Issue 2

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Changes in Regulations on Executive Remuneration in UK Banks Have Achieved Little in Remedying the Underlying Human Frailties that are Exacerbated by Variable Pay – Part One

Introduction
The variable performance based element of executive remuneration in financial institutions has been propelled to the forefront of public and political consciousness in the last two to three years. This is because of the lucrative cash bonuses, share and stock options that executives, especially in investment banking, received in return for undertaking excessively risky transactions that incurred heavy losses for financial institutions and the overall economy. It was perceived that these executives were being rewarded for failure and causing losses for the banks, while the public had to suffer austerity measures imposed by governments in order to pay off the public debt generated from bailing out the very same institutions. Accordingly, a public and political outcry has arisen in response to these unfair remuneration practices.
However, in spite of the current wave of resentment towards variable remuneration, performance based pay was initially introduced in the nineties as a corporate governance mechanism to mitigate the traditional agency and moral hazard problem of ensuring that executives ran the business in the interests of the shareholders. This was achieved by remunerating executives in accordance with achieving various performance targets and paying them in stock options and shares of the company. The culmination of the two would ensure that executives maximised value for shareholders. These measures were fully endorsed by academics and were even actively encouraged by governments.
Research though from a variety of academic disciplines ranging from law to psychology seriously challenge whether pay based on performance is an effective means of remunerating workers. The reasoning used to substantiate these challenges is linked to 'who and how we are as human beings'. Indeed, evidence from new research into the ways in which humans make decisions and choices, their bias, their 'self-serving nature and their perceptions of fairness' undermine the use of performance based pay. However, very little of this literature has found its way into the debate and examination of executive remuneration in banking. Consequently, the assumption that continues to underpin executive remuneration in banks correlates to the traditional views on mitigating agency and moral hazard problems in that if executives receive monetary incentives, they will produce value for their shareholders. The corollary assumption is that if explicit monetary incentives are withdrawn, executives are inadequately motivated to produce value for their shareholders. These assumptions do not consider the impact that performance based incentives have in practice on its recipients. They also ignore 'the effects of the system we have designed to create such incentives on our preferences, our thinking and our behaviour'. The two fundamental parts of this system are the setting of performance targets and benchmarking pay with peers.