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Remuneration Policies and Incentives in Banking After the Crisis

Posted by on Oct 12, 2015 in Business and Finance
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Leading Up to New Regulation

Leading up to the 2008 financial crisis lay a period of unprecedented growth for the industry. This was accompanied by an inflation in bankers’ remuneration packages, which started to move into the spotlight amid the crisis that caused hundreds of thousands to loose their jobs across the world economy but was largely caused by the financial sector in a few countries. The public outcry that followed in the form of various social protest movements such as ‘Occupy Wallstreet’ in the US and ‘Blockupy’ in Europe have likewise been unprecedented and brought politicians and regulators on the scene to scrutinise incentivisation schemes and associated regulation in the financial services industry. Especially governments that had bailed out individual banks and thereby effectively nationalised them, were seeking to cap bonus payments in a way that calmed public sentiment and restored a sense of responsibility and fairness.  

There have also been more rational arguments to scrutinising banker’s and especially trader’s pay more carefully in that, for example, bonuses should better reflect risk and long-term performance. Existing bonus structures often include large cash payments that encourage traders to take excessive risk, which is felt by the bank and the wider financial system long after the bonus has been paid out. It was the FSA’s stance, for instance, that “[..] pay for bankers, and in particular traders, should be adjusted for the risks they take when betting their companies’ capital.” ((Hughes, C. (2008, May 22). Reforms of bankers’ pay in the spotlight. Financial Times , 21ff.)) And already Basel II included mechanisms that allowed regulators in Europe to impose additional capital charges for institutions where incentive structures encouraged risk-driven behaviour. ((Hughes, C. (2008, May 22). Reforms of bankers’ pay in the spotlight. Financial Times , 21ff.)) Martin Wolf of the Financial Times remarked that the world had seen over 100 banking crises over the past three decades and that banker’s pay is rife for regulatory intervention. ((Wolf, M. (2008, Jan 16). Why regulators should intervene in bankers’ pay. Financial Times , 11.)) In addition, there is also a moral argument to be made. For example, while Morgan Stanley announced a US$ 9.4bn charge-off in the fourth quarter of 2007, its bonus pool increased by 18%. Around the same time John Mack, the bank’s CEO, agreed to take no bonus albeit having received a US$ 40m pay-out in just the previous year. ((Rajan, R. (2008, Jan 9). Bankers’ pay is deeply flawed. Financial Times , 11.)) 

The industry along with some leading thinkers added plenty of counter-arguments to the direction this public discourse was taking. Jamie Whyte wrote in the Financial Times that “solving the principle-agent problem […] is difficult, especially in banking where risk and, hence, true economic performance are difficult to measure” and continues that “banks must be willing to experiment” and “regulation will effectively outlaw such experiments”. ((Whyte, J. (2008, Oct 15). Why regulating bankers’ pay is still a bad idea. Financial Times , 17ff.)) Martin Wolf observed that it will be difficult for banks to change their remuneration systems without loosing talented staff and cites this as a primary reason for why regulators will have to reign in the cause of endlessly repeated crises. ((Wolf, M. (2008, Jan 16). Why regulators should intervene in bankers’ pay. Financial Times , 11.))

The issue of pay and incentives at banks has started immediately after the crisis and hasn’t since subdued, although gradually being addressed by international regulators.

Post Crisis Regulatory Framework

Amid the public and political outcry that followed the financial crisis, regulators quickly got to work on addressing remuneration concerns associated with excessive risk taking at financial sector firms. This inspired the Financial Stability Board’s ‘Principles for Sound Compensation Practices’, the European Union’s ‘1-to-1 Bonus Rule’ and the adoption in Basel III of a ‘Capital Conservation Buffer’, which prevents banks from making certain remuneration payments if their Tier 1 capital has fallen below a specified level. ((Thanassoulis, J. (2014). Bank pay caps, bank risk, and macroprudential regulation. Journal of Banking & Finance (48), 139–151.)) Regulators realised that if payments of banks to their shareholders became high enough to be a concern to the well-functioning of the system as a whole, then an aggregated wage bill cannot be permanently at this elevated level. Illuminating this point further, it was calculated how much of an increase in the Tier 1 capital ratio such a remuneration reduction could actually represent by comparing funds saved to total risk weighted assets in Table 1. ((Thanassoulis, J. (2014). Bank pay caps, bank risk, and macroprudential regulation. Journal of Banking & Finance (48), 139–151.))

Reduction in aggregate bank remuneration 5% 10% 15% 20% 25% 30%
Average equivalent increase in Tier 1 levels (bps) 9 19 28 37 47 56

Table 1 – Remuneration reduction expressed as a gain in Tier 1 ratio. Data from 2008 and 2009 by the top 100 global banks ranked by asset value in 2011. ((Thanassoulis, J. (2014). Bank pay caps, bank risk, and macroprudential regulation. Journal of Banking & Finance (48), 139–151.))  

The resulting logic from this study was clear: If banks were to cut their remuneration bills by only 20% then the equivalent increase in the Tier 1 ratio would be 37 basis points on average, which would make banks and their industry safer and more stable.

 

The Financial Stability Board’s ‘Principles for Sound Compensation Practices’

Bonus capped (EU)
<20-30% cash
Remainder deferred
>50% stocks
Bonus capped (US)
<20% cash
>50% deferred

In 2009, reform proposals by the Financial Stability Board (FSB) became an important part of the G20 recommendations for remuneration and incentive schemes in the financial services industry. The FSB recommends deferring significant portions of variable compensation as to reward long-term success and inhibit short-term risk taking. Even claw back clauses made their way into the recommendations with the thinking that money can later be recouped if decisions turn out to have been bad ones later in time. The FSB goes further by recommending stock option bonuses instead of cash payments as well as suggesting greater transparency and establishing board remuneration committees at banks to oversee those schemes on behalf of the board of directors. The overall concern that the FSB intends to address with those measures is the increase in bank managers’ liability at the same time as aligning their interests better with shareholders. It is further important to point out that absolute caps on bonuses were not part of any of the recommendations made by the FSB. Several countries introduced the recommendations brought forward by the G20, which are largely based on those by the FSB, albeit with differences especially among the EU and the US. In Europe, cash bonuses paid out immediately were restricted to 20–30% with the remainder bonus payment to be deferred and at least 50% to be made up by stock payments. There were no absolute limits on bonuses imposed though. In the United States, only 50% are to be deferred and immediate payments in cash restricted to 20%. Remarkably, some countries went further in their implementation and legislated outright compensation ceilings at those banks that received government bail-outs during the crisis. In the United Kingdom, a special tax on bonuses above a certain threshold was introduced. ((Hendrik, H., & Schnabel, I. (2014). Bank Bonuses and Bailouts. Journal of Money, Credit and Banking , 46 (s1), 259-288.))

The European Union’s ‘1-to-1 Bonus Rule’

million dollar clubAcross Europe, the financial services industry is very unevenly spread. This can partly be seen from the distribution of the number of bankers paid more than € 1m in annual bonuses for whom any such caps or further regulation would have the biggest effect. Chart 1 shows that with 2’188 there are more than 30 times more such targets in the UK than there are in Spain and still 20 times more than there are in Germany. This makes is difficult to justify universal regulation for an industry that makes up hugely varied portions of local economies and thus plays different social roles across them. Nonetheless, the EU’s lawmakers have decided to limit bonus payments in 2013 through regulation that was dubbed the ‘world’s toughest bonus rules’. This was bluntly brought forward as a reaction to the ‘gambling culture blamed for contributing to the 2008 financial crisis’. Major European banks have quickly found ways to get around such restriction, however, and policy makers are vowing to refine rules to inhibit such actions. ((Moshinsky, B. (2015, Mar 4). Banks Face Tougher Bonus Rules as EU Moves to Enforce Cap. Retrieved May 2, 2015, from Bloomberg: http://www.bloomberg.com/news/articles/2015-03-04/banks-face-tougher-bonus-rules-as-eu-moves-to-enforce-cap))

The most comprehensive EU regulation on bankers’ bonuses became the so-called 1-to-1 rule. On April 16th 2013, the European Parliament approved legislation CRD 4 to impose caps on bankers’ bonuses. Part of this legislation was that bonuses’ basic ratio of fixed pay to variable pay should be 1:1 with some flexibility to increase that ratio to 1:2 but only by way of shareholder approval. A controversial issue was also the scope of this regulation and it was eventually brought to effect across the EU for both European and non-European banks but only from 2014 onwards. Targeted are those employees whose annual remuneration exceeds € 500’000 or who fall within the highest earning 0.3% of the bank. Employees whose variable remuneration exceeds € 75’000 and 75% of the fixed component of remuneration would also fall under the new regulation. ((Freshfields Bruckhaus Deringer. (2013). New EU rules on bankers’ pay (including the bonus cap). Freshfields Bruckhaus Deringer LLP.))

Basel III’s Capital Conservation Buffer’s Effect on Remuneration

A crucial part of Basel III were the so-called ‘capital conservation buffers’. These require banks to hold an additional 2.5 percent of Total Capital in the form of Common Equity Tier 1, above the 4.5% minimum. This, effectively, brings the Common Equity Tier 1 requirement to 7%. While a bank may go below this ratio in periods of stress, the bank must rebuild the buffer by means of reducing discretionary distributions. The Basel Committee of Banking Supervision (BCBS) contemplates that resulting reduction will come from decreases in dividend payments, share buy-backs and bonus payments. If, for example, a bank had a Common Equity Tier 1 ratio of 5.5% and a capital conservation buffer of only 1%, the bank would have to conserve 80% of its earnings in the following year to rebuild the buffer, as their current year’s ratio is below the standard of 2.5%. This limits discretionary distributions to only 20% of earnings. In many cases this will effectively translate into a cap on bonus payments. ((Weil, Gotshal & Manges LLP. (2011). Banking and Financial Services. Policy Report , 30 (5), 1-18.)) The detailed restrictions of discretionary distributions, under which bonus payments fall are outlined in Table 2.  

 

Common Equity
Tier 1 Ratio (%) Existing Buffer (%) Minimum Capital Conservation Ratio (% of earnings required to hold to rebuild buffer) Percentage of earnings available for discretionary distributions
4.5 – 5.125 0 – 0.625 100% 0%
> 5.125 – 5.75 0.625 – 1.25 80% 20%
> 5.75 – 6.375 1.25 – 1.875 60% 40%
> 6.375 – 7.0 1.875 – 2.5 40% 60%
> 7.0 2.5 0% 100%

Table 2Capital conservation buffers and their effect on staff bonus payments as part of discretionary distributions. ((Weil, Gotshal & Manges LLP. (2011). Banking and Financial Services. Policy Report , 30 (5), 1-18.))

Implementation Issues

Bank’s Reactions

variable bonusVariable remuneration has been the main target of international efforts to rein in bankers’ pay. The extent to which such sch
emes are used varies internationally and the effects have thus been differentiated. Overall, banks were worried about CRD 4, which came into effect on January 1st 2014, and the effect it will have on the bonus culture that has underpinned the banking sector fora long time. ((White & Case LLP. (2013). Shooting in the dark: A review of the implications of the bonus cap. London: Nisus Consulting.)) For many banks, this means having to transform variable pay into fixed pay, which significantly increases bank’s fixed costs. The extend to which this will affect banks across various countries can be estimated from the prevailing fixed-variable pay-ratio seen in Chart 2. Another regulatory requirement that caused severe headaches for banks to implement was Clawback. An executive of Investment House, North America, was quoted as saying “Nobody has a problem with clawback in principle but nobody wants to be the first to test it in a court of law. Going back to somebody and saying ‘We want some of that bonus back’, will be very interesting.” ((White & Case LLP. (2013). Shooting in the dark: A review of the implications of the bonus cap. London: Nisus Consulting.)) It is generally perceived that such clauses will be particularly difficult to enforce in Spain, Germany, Italy and even the UK du to their respective legal systems that are likely to favour the employee in any appeal.

Social Reaction

The general public perceived the prevailing bonus culture at banks as morally broken and the way with which they were defended as arrogant. Many saw the clear issues that arise from banks guaranteeing certain bonus payments for three years, as has often been the case before the crisis. It is obvious that such schemes don’t incentivise employees appropriately and certainly don’t discourage excessive risk taking. While such schemes were common for the industry, it was far from comprehensible to most outsiders. The financial world simply perceived bonus payments to be salary, without regard of performance. As a result it was not uncommon for investment bankers to reason that simply because of who they were, in terms of position or otherwise, they would be entitled to such payments. As banks started to need government support, such thinking became intolerable for policy makers to leave unaddressed as they struggled to explain to their voters why banks – and bankers – had to be saved. (De Cremer, 2015) Public sentiment has remained hostile towards banks, to which the community was reminded by a recent attack on Mario Draghi during a press conference. As regulators are largely driven by politicians, banks will remain their focus for as long as the financial services industry remains untrusted with most voters.

 

Closing Remarks and Outlook

Summary

After decades of deregulation and unsustainable remuneration policies, the recent financial crisis has marked a turning point in the regulator’s eyes. For the first time, both governments and financial regulators have directly targeted banker’s pay in their efforts to deflate a sector that proved too risky to tolerate and in the light of public sentiment. Likewise unprecedented was the scale on which such regulation has been rolled out. While not enacted globally by any stretch, some of the most important financial hubs have seen serious reform targeting remuneration policies and while many financial institutions voiced concern, the need for reform was too obvious to deny. What is more, banks have already started to implement most policies and have already reacted structurally to the policies and regulation enacted by their jurisdictions through restructuring and strategy refocusing. The effects are serious but it is not yet clear if the desired outcome of using remuneration policy as a regulatory tool to deflate risk in an entire industry will materialise. While banks are largely cooperative, they naturally seek to maximise profits and find ways around any regulatory obstacles that might be in the way.

Future Outlook

The Economist recently wrote the following in a remarkably perspicuous essay on what is wrong with finance:

 “When individual banks are too big to fail […] this […] is […] akin to the idea of the ‘resource curse’ that economies with an excessive exposure to a commodity, such as oil, may become imbalanced. Just as the easy money from drilling for oil may make an economy slow to develop alternative business sectors, the easy money from trading in assets, and lending against property, may distort a developed economy.  ((The Economist. (2015, May 1). What’s wrong with finance. Retrieved May 3, 2015, from The Economist: http://www.economist.com/blogs/buttonwood/2015/05/finance-and-economics))

This asserts that an economy can suffer a serious threat to its stability and indeed a wider slowdown from an overblown sector. Much like some countries suffer from a ‘resource curse’, some now evidently find themselves spelled with a ‘finance course’ in which a sector of its economy is blown up to a size far exceeding the benefits it brings to society and other sectors leaving it to creating ‘unnecessary’ systemic instability. This is heavily linked to remuneration in finance, as the sector has on top of that attracted some of the brightest people, through high – and on a bigger time scale unsustainable – pay. Some have argued that banks are actually utilities, providing the necessary ‘resources’ for the economy to innovate and operate efficiently and that therefore they should be regulated as such. As illiberal and anti-free-market it may have seemed to many just a few years ago, regulating pay relative to benchmarks might actually be the key to deflate the financial sector, thus creating a finance industry that better serves the wider economy. Past crisis have proven time and again that an unregulated finance industry poses too high a risk for society to accept. Regulation has been imposed and retracted for over a century to varying degrees of success. Now, remuneration is targeted directly by regulators for the first time and only time will tell if this proves to be the right tool to tame an unabating systemic threat to the world economy.

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