Compensation has been brought to task as a major contributor to the global financial crisis. Chasing short-term positive results, failing to implement a robust internal control environment, not fully understanding the risks of financial instruments being sold, or, in many cases not caring, simply to pad personal compensation resulted in a major disconnect between company and shareholder interests and the interests of the individual whose contracts provided for incentives tied to profit making. Government initiated “thinking” such as that set out by the Sir Warren in his recent report issued in the United Kingdom , many in the United States Congress and various other country legislative bodies suggests compensation should be more highly controlled, directly or indirectly by the government.
The problem with dealing with compensation and incentives is obvious, it goes against most all notions of capitalism and free markets, and having the government involved in setting compensation policy is generally not considered a positive move in the right direction.
But the way forward is not at all clear. If compensation controls are implemented, or “suggestions” made by regulators that cannot go ignored, e.g., governments providing disincentives through taxation policies mitigating against personal wealth creation, one result is that individuals will simply forum shop, moving to another location to practice their craft. Of even greater concern is that a wrong policy or incentive structure will stifle innovation and initiative will diminish - not a good thing. Regulators have a tendency to overreact in times of stress, and may not necessarily look at an issue as volatile and complex as compensation in a forward thinking and objective manner.
An approach to this issue would be for companies to proactively establish compensation policies tied to long-term incentives and other risk-based compensation methodologies. The financial industry taking a proactive approach would keep governments out of the highly personal compensation issue.
Questions:
- Is there really a compensation solution that is politically viable and commercially acceptable?
- How can compensation policies be linked to the risks a person takes?
- Is this really much to do about nothing in that the problems we’re now dealing with were really only marginally linked to banking compensation and because it is perceived to be generous it has become an easy target?
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6 comments:
Governments will always wield taxation as a blunt instrument of reform, with high impact that may be politically attractive but less effective in incenting desirable practices. In the US, the SEC is proposing to expand disclosure requirements that make the link between risks assumed and compensation granted (http://sec.gov/rules/proposed.shtml, File S7-13-09, Release 33-9052 comments due back to the SEC by 9/15/09) An enhanced disclosure regime like that proposed by the SEC offers investors and their agents a chance to assess compensation and inspire changes as is appropriate. Of course, that assumes that companies understand risks and compensation incentives related to those risks sufficiently, and that Boards can monitor and manage those relationships appropriately, and that shareowners pay attention in the first place.
The above comment is hard to argue with. In my view, while absolutely appropriate, simple disclosure will not necessarily yield desired results because of the complexities of translating that disclosure into actionable steps. The crux of the matter is how to robustly and appropriately link compensation with risk so as to not provide disincentives for innovation and proper risk taking. For example, while a good first step, I don't believe simply raising base salaries and reducing year-end bonuses by effectively the same amount will accomplish that goal. It would be interesting to hear people's ideas about how to define and implement a risk-based compensation system.
In an article in today's New York Times, Floyd Norris quoted a paper by Dr. Rene Stulz and Rudiger Fahlenbrach which concluded that CEO incentives were not to blame for the credit crisis. One of the reasons for this conclusion is that many CEOd did not sell their company stock in advance of the crisis and subsequently lost most of their wealth. Isn't the view set out by the NYT article too basic? Simply because the CEO lost his/her wealth, or great portions of it, doesn't mean their incentive structure was right. Shouldn't executive compensation from the very beginning been more closely aligned to company/shareholder safety considerations such as capital requirements and longer-term returns? One thing the article rightly points out is that regulators are fighting a no-win battle if they try to regulate compensation. The better approach is for regulators to focus on capital requirements and company compensation committees to focus on approriate compensation structures.
The financial market has been overboard one way. We now risk going overboard the other way if we do not balance the arguments with a big-picture view. There is a fundamental need to revisit the structure of Executive Compensation in risk-taking environments.
a) Compensation should
- ex-ante, motivate the desired risk behavior within stated parameters of risk appetite & tolerance.
- ex-poste, be adjusted for actual versus expected behavior, and for Risk-Reward results.
b) Compensation should drip in at the same rate and in the same way as results of risk-taking drip in.
c) There must be complete transparency, across all stakeholders including owner (shareholder), regulator, client, managers/employees. Shareholder buy-in to the structure and methodology is vital.
Today's compensation structures in financial institutions carry the risk of promoting moral hazard ('tail, I win, heads you lose') and adverse selection by giving in fact a free call option on the company's profit and capital to the risk tasker (e.g. the trader or portfolio manager). The challenge is to find ways of limiting moral hazard. Direct intervention by government agencies into the compensation schemes is for obvious reasons hardly the right way to go. Best Practice Codes, such as the one published by the FSA, may not be striong enough. One way of addressing this may be through additional regulatory capital requirements, penalizing compensation schemes in financial institutions which are creating incentives for excessive risk taking and moral hazard.
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