Financial institution pay packages

If you have been following the blog since its inception you know that I have been talking about the ill effects of poor incentive compensation packages on financial institutions. At times I have railed against the packages and have identified them as being one of the primary causes of the financial and economic crisis with which we are all dealing. Today’s Wall Street Journal has an article about this very issue. I have excerpted the entire brief article below:

“Survey Finds Banks Aware of Pay Flaws

“By STEPHEN FIDLER

“Banks almost unanimously agree that their compensation packages contributed to the global financial crisis but still are struggling to correct some of the flaws in their pay structures, according to a survey of financial institutions due for publication Monday.

“The survey, conducted by U.K. management consultancy Oliver Wyman, was commissioned by the Institute of International Finance, a global association of banks and other financial companies based in Washington, D.C. It found 98% of responding banks “believe the compensation structures were a factor underlying the crisis.”

“But it also brought to light some of the obstacles to changing pay arrangements, including the concern among bankers they still don’t have reliable methods to measure risks.

“The report comes amid public anger about bankers’ pay and taxpayer bailouts of financial institutions that were engaged in excessive risk-taking, encouraged by their compensation packages.

“”The industry is broadly aware of the need for change and broadly aligned on where they need to go. But the devil is in the detail,” said Nick Studer, who led the study for Oliver Wyman.
The Institute of International Finance set out seven principles of conduct last July aimed at better aligning pay with shareholder interests and long-term profitability, discouraging excessive risk-taking and making sure pay wasn’t out of line with overall bank profitability. The Financial Stability Forum, an international forum of regulators, has set out similar guidelines. The survey said 60% of banks expected to be following these principles once all their plans had been implemented.

“But 83% said they were still working out how to phase compensation to make sure it reflected the risk being taken over a long period. Without that, bankers are encouraged to take big bets for short-term profits that entail significant long-term risks.

“It said banks were concerned that they hadn’t yet got risk measurements right, so they didn’t know whether it would be useful to incorporate them into performance pay. There were also worries that in complex business areas, such as structured financial products, the only people with a strong understanding of the risks are those directly involved.

“However, one long-standing concern about changing compensation structures — that being the first to move would lead to a loss of some staff to other banks — has been allayed by the current market travails and the fact that most banks are changing their approach to pay.

“Seventy Institute of International Finance members world-wide were invited to respond to the survey, and 37 responded, representing 57% of global wholesale banking activity, the report said.”

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The first thing to note is that it is a sign of progress that the leaders of these institutions are reconsidering their ideas of how to run their businesses. As you know, it is this sort of change that I have been saying was necessary for a true economic recovery to occur. I have also said that the new ideas will be the last thing to come to fruition in the recovery. This is born out by the article above. The institutions are willing to change (a great sign), but are unsure of what changes to make just yet.

Very encouragingly the financial institutions are talking about increasing the time horizon over which their employees are compensated. Again, I have been saying for some time now that the obsessive focus on the short-term results in excessive risk-taking and very poor choices for the long-term health of the economy. One suggestion for the banks, and unfortunately my voice is very quiet in the grand scheme of things, is to reward bankers for 5-year performance. Initially, as their employees get used to their new positions, they will be rewarded for some annual goals, but the larger rewards are those that are awarded for outstanding long-term performance. Banks could even extend the rewards far into the future, say 7-12 year performance. For example, folks could be awarded bonuses for one year performance that could equal their annual salaries, or 100%. But if long-term performance was excellent then the bonus could bump up to something very dramatic like 300-500% of base salary. Those of you not used to the financial industry may find these numbers crazy-big. But I assure you they are in line with typical pay packages.

Discouragingly, the institutions say that they are still uncertain of measures of risk. That disappoints me because many of these banks focus purely on analytical measures of risk, instead of some common sense measures. I once saw former Treasury Secretary, and Citigroup co-Chairman, Robert Rubin speak in Palm Springs, California. He dedicated his speech to the issue of risk as one of his first jobs at Goldman Sachs was in evaluating risk. Rubin said that purely analytical measures of risk were dangerous because by definition, “The greatest risk is the one that you didn’t plan for.” He suggested that his fellow risk-taking bankers use experience and history as a gauge for evaluating risks, rather than just purely analytical methods. Another disappointing aspect of banks stating that they cannot accurately assess risk is that they are also combating regulatory changes that would allow greater transparency into the financial system by regulators. The idea behind that change is to get a better handle on how much risk is present in the system. The institutions’ opposition is self-defeating ultimately. They need to get on board with the transparency plan. If this HUGELY important change is implemented then regulators could agree to share with institutions the overall level of risk in the system without giving away critical secret individual transaction details that would be anti-competitive. In other words, regulators could create a “Financial Risk DEFCON Level,” or some other such nonsensical measure.

In general, the news of the survey is excellent and suggests that change is occurring.

Be very well!

Jason