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The US compensation battle

By Martin Davies

23 February, 2009

The US compensation battle
The latest musings on the credit crisis or perhaps the outcome of the event (one single occasion is usually driven by many causal factors), is corporate compensation.
This week president Barack Obama called the bonus payouts for banks receiving rescue funds as "shameful" and that the government will require financial companies on the aid trade to cap compensation for top officials at USD 500,000 a year.
Obama stated that he was responding to a public outcry "in bad taste" over bonuses paid to bankers and wanted to enforce greater transparency of expenses and restrict severance pay when executives leave the company.

The Irony
He has a point of course, why should the tax payer fund the compensation of corporate individuals who have been partially responsible for destroying rather than created value in their firm. Ironically there is a sniff of pharisaicalness in all of this considering that his cabinet has been implicated with their own inability to manage tax liabilities. Not even one month in, Tom Dasche the former senator selected by Obama for Health and Human services was scrutinized for lodging tax errors and secretary Nancy Killefer appointed last month by the president to probe government spending, has also fallen through the moral floor of the inland revenue system.

This is all partially jocular but it is not the feature of this journal. More importantly we want to ask ourselves:

• What is the purpose of this blanket policy over its decorous gesture?
• Is corporate banking compensation policy skewed or failing in the first place?
• Could such caps drive some kind of different dysfunction?

The World of Banking
Banks have been renowned for sometime as being places where corporate perks and cash incentives are generally lucrative, none of this is new and it attracts some of the best minds because of this mere fact. Really this remuneration process isn’t that obscure from say the commission paid to a car salesman for the revenue he delivers to the door however, what is different is that the stakes are substantially higher in financial institutions. A recent report from Salary.com ranks banks NOT at the top of the list when it comes to compensation payouts for CEO’s and there is also extremely high variance between small commercial banks and large conglomerates.
What actually is the problem is not the size of the benefit but its application. Rewarding good corporate behaviour is prevalent everywhere however in a bank staff are paid on their ability to perform as a major benchmark and that translates to higher risk taking.

Why? Well generally higher risk is akin to higher yield.  

If a broker wants to propagate ever increasing returns against this baseline, they have little or no choice but to go deeper on a position even though that might have negative marginal utilities of return. The foundation of this very system needs to be addressed, not the size bucket but the downside; the risk-reward-appetite of each individual or team in the bank needs perhaps a different approach. More concerning is that most incentive programs are short term and aggregate the upside but do not weight the downside equally.

Then of course as employees climb the corporate ladder their compensation accelerates and their ability to influence the executive team also becomes more prevalent.

In most cases or measures there is going to be a left or right zone and it is argued that Merrill Lynch sits squarely in that flange. Bloomberg Jan 29 – “New York Attorney General Andrew Cuomo may demand the return of $4 billion in bonuses paid by Merrill Lynch & Co. just before it was acquired by Bank of America Corp. Cuomo also wants to know whether [ALT] Bank of America Chief Executive Officer Kenneth Lewis knew about the accelerated bonuses and about Merrill’s surprise $15 billion net loss in the fourth quarter” – That is probably pushing the boundaries however a blanket policy might not be the right approach either as it paints all banks with the same brush. 

On Consideration

Within hours of the Obama blanket policy, there was also a response from the industry. Gloldman Sachs Group stated that it “wants to repay the 10 billion it received from the US Treasury last year to signal the firm is healthy and escape any imposed limitations on the funds” and is going to raise additional funds in the equity markets to balance this when the time is appropriate. What value is going to be derived from transferring one obligation to another is yet to be determined.

One of the main problems for blanket incentives is that they can drive institutions to become baron places of innovation especially when the floor is adjusted to some arbitrary mean as it is in the current process. In such a situation an executive might only work till they reach the incentive barrier and then take an attitude of languor in their work, others might simply leave the institution.

Some argue that the incentive scheme for large banks should actually be focussed more on share options than cash incentives; in this way if the firm actually performs bonuses should be reflected appropriately in the share price.

Last year when the Troubled Asset Auction Program was launched by the federal reserve, it also inserted the following ruling “Any financial institution participating in the Capital Purchase Program will be subject to more stringent executive compensation rules comprising of three key criteria:

• Incentive compensation for executives does not encourage excessive risk taking that may threaten the value of the financial institution.
• Clawback of any bonus or incentive compensation paid to a executives based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.
• Prohibition on the financial institution from making any golden parachute payment to a executives.

So what went wrong?

Well firstly there are no limits on pay or linking of pay to performance. In addition, definitions around what is risk taking and when are such risks to be booked to the balance sheet is also omitted. The definition of what is excessive pay is actually totally lacking and there was no criteria on the clawback of bonuses. While firms that sold troubled assets to the government were not allowed to deduct pay that exceeds USD 500k from their corporate income taxes, such a ruling was only applied to these firms in the program and not to the broader industry that might have received support.

The web site common dreams puts it this way “The current U.S. tax code places a $1 million cap on tax deductibility for executive compensation, but this provision has been meaningless in practice because it allows exceptions for "performance-based" pay. Most companies simply limit top executive salaries to around $1 million and then add on to that total various assortments of "performance-based" bonuses, stock awards, and other long-term compensation. The bailout legislation was designed to close this loophole by eliminating that exception for executives of bailed-out firms.”

So where does that brings us up to today?

Going forwards I would say this is going to be a contentious area that will require more carefully thought through policy. A policy that perhaps balances talent retention with performance based incentives that are linked to risk-adjusted reward and the downside outcome.
 

About the Authors

Martin Davies is a principal consultant risk based banking SME and a managing partner within the business solutions competency at Causal Capital.