Performance and Reward

I was encouraged by an excellent article by philip Stephens in the FT 21/12/09. This can be seen at http://www.ft.com/cms/s/0/222e7a5e-ee6c-11de-944c-00144feab49a.html (subscription may be required).
Philip argues powerfully that politicans need to be involved in banks. I posted the following comment (on 23/12/09):

I did appreciate this article which was brave enough to confront the key issues. I was particularly glad to see talk of a long term cap on remuneration. (What does long-term mean in this context?) Remuneration caps are all-important if the incentive problems are to be solved. (See my letter in FT 12/12/09 and my blog www.performanceandreward.blogspot.com.)
The incentive problem is illustrated by "Young NY Banker" note to self below. All the concerns mentioned concern his/her own personal situation and prospects. None of it concerns the public good or the way in which we all need to help one another if we are to get along sensibly as a society. The incentive regime has utterly eliminated such "altruistic" concerns from present day banking, but now that the banks are supported by public money these questions must be put centre stage once again. Making sure that finance properly benefits the whole of society has to be the top priority. Politicians are the people to whom we entrust such decisions and they have to be centre stage.
We used to turn a blind eye to selfish practices in banking because banks created wealth in which we all shared in, at least to some extent. The crisis however has revealed that much of the wealth created was less real than it seemed. Current profits in banking are very heavily dependent on artificially cheap money, so it is still far from clear that banks are creating real wealth. Politicians have got to get involved big time.

Labels: common incentives, pay cap, Politicans, public good

Why a global cap on pay makes sense now
The argument for high pay is that businesses have to compete to secure the best talent. This is a real problem but it would disappear if all top business people worldwide were paid no more than say US$500,000.
Economists usually support competitive markets because competition forces out costs and increases efficiency. However competition has manifestly failed in the market for executive talent. Costs have spiralled, but the performance of the FTSE100 since has been dismal since Dec 1999. In my opinion the failure of competition in the market for executive talent is caused by distortions in the market. The executives have considerable market power and there are concerted practices co-ordinated through remuneration consultancies. I have raised these concerns with the Office of Fair Trading. My dialogue with the OFT can be viewed by clicking on the link “Competition Law” in the left hand column.
Actually it seems to me that a truly competitive market in executive talent could never lead to efficient outcomes in appointing people to top posts. It is more likely to ensure that we appoint the most ruthless people to top jobs. We need to develop a culture in which top people are motivated by (or at least mindful of) their responsibilities to the rest of society. Money fuelled competition between top people inevitably pulls society apart in a destructive way. This has been most clearly seen in the financial sector, but it can also be seen in all sectors of society where pay has been used aggressively to motivate top people.

The purpose of the pay cap
The cap is not to get vengeance on bankers, although it might be politically popular for this reason.

The cap is not to raise revenue, although it will free up a lot of revenue in the banks, helping them to recapitalise.

The purpose of the cap is to solve structural problems in executive incentives. It addresses problems in executive motivatation.

My recent blog post “bankers’ pay and the financial crisis” shows how performance related pay is profoundly flawed for top bankers because it colludes with a culture which assumes that the banker’s top priority is his/her own personal wellbeing, most tangibly his/her pay. In other words it encourages the top executive will put his/her own interests ahead of the company he/she manages. This is a recipe for disaster. Alan Greenspan could not believe that American Banks behaved in ways that were so destructive to themselves. The reason they did this was because the top executives were paid to look out for themselves. I have written a book on performance related pay for top executives (see link “View the book” on the left) but increasingly it seems to me that the goal of alignment between shareholder and executive interests is not realistic because it colludes with selfish desires on the part of managers and does not build a culture in which managers put the company interest first. It undermines the Fiduciary Duty on which our companies’ structures are founded.

A global cap on cap would go a long way towards eliminating selfish financial interests from the motivation of the top people in our banks and other companies. Once you reach the US$500,000 level you can go no further financially. You have to start looking for other forms of motivation. This will create space for more generous motivations orientated towards the good of shareholders, employees, suppliers and customers and towards the wider public good.


Who should NOT be captured by the cap
Wealth creators (entrepreneurs) should not be affected by the pay cap. People who make money by growing their own business, or investing their own money should be encouraged to do so. The cap would imply no extra taxation on capital gains caused by increased business value, and no extra tax on company dividends.

The public can have quite a lot of confidence that entrapeneurers who get rich have done so by creating real value in business (and so hopefully in society). It is much harder to have this confidence about someone who has got rich by being well paid. The entrepreneur makes no money until all employees and suppliers have been paid. Bank loans and corporate taxation must also have been paid. Only after all this money has gone out to other people does money become available for dividends to the business owner. Further the wealth created in this way is critically dependent on the long term success of the business. The incentives are therefore for long term corporate successes. This contrasts sharply with the banking bonus culture which gives rise to incentives which are short term, individualistic and independent of the long term interests of the institution.

Company owners must be encouraged to take their profits out of businesses as dividends not as salaries. Only in the former case can we be sure they are creating business value.


Who should be captured by the cap
The cap on pay should apply to people who are officially working for the interests of others, not for themselves. This certainly includes all company directors and employees. It includes everyone in government.

There are grey areas. Footballers are basically working for others; their club. Pop stars might be working for a record company, or they might have their own record company and be making their own sales. Film stars are probably working for a studio, but they may well be shareholders in their own film companies. Money (or value) received as salary, fees, pay, pension, bonus, share schemes, company cars, perks, etc. should all be captured by the cap. Money received by company owners as dividends should usually not.

Accountants, lawyers and consultants
Any work that requires a fiduciary duty to others should certainly be captured by the cap. Lawyer, accountants and consultants are therefore captured. Partners in big law/consultancy firms should not earn (or take home in profits) more than the cap, even if they are owners of the firm. This is because the same issues about incentives and motivation apply to consultants in respect of their clients, as apply to normal business executives with respect to their shareholders.

Consultants have massive incentives to build large and profitable firms/companies/practices which make money by providing services to other people or companies. Because the money is made by working for others it must be caught in the cap, even though it might be paid out to partners as dividends. This is important because without it consultants have an incentive to increase the scope of their work for the client and to build dependency in their clients. A consultancy business is likely to want to grow its size and profits, but the public need to be satisfied that this is really happening for the benefit of the consultants’ clients, and not just at their expense. One example is computer consultancies who have incentives to sell vast and unrealistic computer projects to governments. Another example is remuneration consultants, as described in Performance and Reward (The book – see link on left) pages 152 to 156. In fact in the case of lawyers, accountants and consultants there is a case for a much lower cap on pay so as to avoid undesirable incentives and to strengthen fiduciary duty.


The problem of loopholes
There is a danger that a great deal of effort and talent will go into looking for loopholes in the pay cap. People will try to restructuring jobs so that they are paid separately by several different companies or in different counties. They will restructure normal pay to look like dividends. They will try to seek pay through their expenses. They will try all manner of tricks. It is very important that all such tricks must fail quickly and firmly.

Loopholes in the cap could be extremely damaging. If executives sense a loophole then very perverse incentives might arise, and very destructive behaviours might be encouraged. Executives must be so clear that there are no loopholes that they do not waste effort looking for them. The law therefore needs to be very strong. I would suggest three aspects:

1) An obligation on companies to be able to demonstrate simply (i.e. without the use of a computer model, or long remuneration reports) that the total value of all their pay to any individual in any period of 365 days does not exceed the cap. The obligation should be so strong that most companies will find that the most convenient way of paying their top employees is a simple cash payment of 1/12th of the cap each month. All value transferred from the company must be included: salary, bonus, share option, pensions, benefits, club memberships, private financial advice, cars, private use of company jet etc..

2) An obligation on individuals not to receive more pay than the cap. Seeking to structure business activities or payment arrangements to avoid the cap must be an offence. Fines for looking for loopholes must be big enough to ensure that there is no incentive to do so.

3) An obligation of tax authorities to search for pay that exceeds the cap, and to tax it at, say 200%.


How will people respond to the cap?
I believe that top executives first reaction will be to look for ways around the cap. This activity must be firmly discouraged, as discussed above. There will also be an increased interest in getting money out of companies through different kinds of fraud. Vigilance must be maintained.

If there appears to be no way round the cap many executives, and bankers in particular, will feel extremely demotivated. There will be a huge motivation problem. The effects of this problem will turn out to be far less serious than they initially appear, because it is only selfish motivation that is being curtailed. Motivations arising from doing things for other people, or because they are worthwhile in themselves will still be retained.

Really talented people, who really do want to get seriously rich will leave employment and establish their own businesses. This will be a very good thing.

Many people who are not so sure that they can make money as entrepreneurs are likely to retire prematurely to enjoy the money they have earned. This will also be a good thing.

People who remain in top jobs will do so because they are interested in the job, because they think it is worthwhile and because they want to do good things for shareholders and other stakeholders. They will be far more ready to prioritise company interests over their own. Fiduciary Duty will be strengthened and companies and institutions will start to look much stronger. This is the real reason for making the change.

There will be increasing interest in making top jobs attractive in ways that do not involve higher pay; shorter working hours, more holidays, and better staff restaurants etc. This will be a good thing.

Several thousand people will have their earnings capped. These people will no longer be competing with each other for better pay. It is likely that they will still compete for reasons of power and prestige, but a great deal of the heat of competition will disappear. Top executives will start to find it easier to work together, easier to like each other and easier to form constructive and rewarding relationships. They will start to enjoy work in a much fuller, more holistic way. New and imaginative collaborations will be born. This will be a good thing.

99.9999% of the global population will earn less than the cap and will not be affected. Many of them will still regard the cap as a very good level of pay and there will still be a lot of competition to get top jobs.

The motivation problem will lead to much simpler business structures and to a much slower and more gentle pace of life in financial centres around the world. GDP will initially fall but this will matter much less than might be expected, because the economic output that disappears will primarily be the output that selfishly favours top people. Its impact on other people will be much less. However, ordinary people will benefit enormously from a more humane and holistic business culture.

Labels: global cap, incentives, motivation

Following Alister Darling's one-off bonus tax I have today written to the FT. This letter was published by the FT on Saturday 12/12/09.

Dear Sir,
Surely the time is now right for a global cap on bankers pay?
The argument for high pay is that banks have to compete to secure the best talent. This is a real problem but it would simply disappear if all top bankers worldwide were paid no more than say US$500,000.
Economists usually support competitive markets because competition forces out costs and increases efficiency. However competition has manifestly failed in the market for banking talent. Costs have spiralled and, but for government intervention, most banking institutions would be insolvent. Why do we allow such destructive competition to continue?
Yours sincerely,
Revd Patrick Gerard

Labels: Bankers, capital, competition

The Ecumenical Council on Corporate Responsibility (ECCR- see http://www.eccr.org.uk/index.html) have published an article of mine on bankers' pay (the bulletin No 75 - December 2009). A near final draft of the article is included below.

One of the most disturbing aspects of the apparent recovery in world markets since March 2009, is that banking is still being conducted in much the same way as it was before the crisis. Certainly there is much more talk about regulation, and banks are working on reducing their leverage, but the banking business model has not changed. It seems extraordinary that the traumatic events of autumn 2008 have had so little impact on banking behaviours.
One reason for this is that normal market disciplines have not been applied. Had market discipline applied then most, if not all, of our financial institutions would have collapsed. The economic consequences of this would have been apocalyptic, so it was not allowed to happen; governments bailed the banks out. Banks now operate with their risks underwritten by government. Unfortunately this means that the banks have less incentive to behave responsibly than they had before the crisis.
Another reason is that it is taking a great deal of time to define new regulation for the banking sector. The best way to regulate the banks is not obvious and sophisticated lobbying to defend vested interests is causing confusion in the process. On top of this many of the new regulations will need to be agreed internationally, so new regulation will not be implemented quickly.
But it seems to me that there are profound cultural reasons why banking behaviours have not changed, and these cultural problems most typically arise from the way that bankers are paid.
Banking culture assumes that a banker’s objective is to maximise his or her personal pay. Banks seek to constructively harness the bankers’ desire for personal reward by linking their pay to the profit of the bank. The message to bankers is, “If you make more profit for the bank, then you will be paid more!” Although very widespread, this link between profit and pay has proved to be fundamentally flawed and can only lead to further disasters if it is not changed.
The first central flaw in the pay-for-profit paradigm is that it values profit higher than the safety of the banking institution. Bonuses are far more likely to be paid for generating profit (which is readily quantified), than for keeping banks safe (which is hard to quantify). But in banking there is always a clear link between risk and reward. The most direct route to increasing profit is to increase the risks that are taken. The banker who is powerfully motivated to increase profit is therefore driven to find new and creative ways of increasing risk. This is why, in the build up to the crisis, banks increased their leverage, created hidden risks off balance sheet, and devised complex financial instruments that had the effect of hiding risk.
This is a fundamental problem. Whatever new regulations are devised by governments and whatever new controls are put in place by institutions, individual bankers still have massive incentives to create risk, to hide risk and to place risk with people who do not really understand it. It is clear that during 2006 many bankers could see that the force feeding of mortgages into the market was not sustainable, but they continued to do it anyway. Why? Because that is what they were paid to do!
But there is an even more fundamental problem with the massive incentives that bankers have to generate profit. The incentive regime has generated a culture which is entirely driven by the supercharged desire of individuals to make money for themselves. The banks can only succeed as institutions if they can constructively harness this volatile (and morally dubious) aspiration of their employees. The big problem is that it has proved impossible to perfectly align the self-interest of individuals with the long term interests of banking institutions. Forms of remuneration that take incentive alignment seriously have to have a long term focus, and have to make bankers accountable for the risks that they take. Unfortunately such forms of remuneration are considered uncompetitive in the marketplace for hiring banking talent; bankers (like everyone else!) prefer their rewards to be immediate and secure from claw back.
The gap in incentive alignment means that bankers can often maximise their own rewards in ways that are damaging to the banking institutions, especially over the longer term. Individual bankers, under intense competitive pressure, inevitably exploit incentive alignment gaps to their own advantage even if this damages the financial institution. The self-interests of bankers have therefore prevailed over the interest of banks and their shareholders. The culture has evolved into the precise opposite of Fiduciary Duty, that extraordinarily high duty of care which a company director is legally obliged to show to the company.
Bankers’ pay has therefore created a culture in banking in which the rewards of individuals are prioritised above the health and security of the financial institution they work for. This culture is extremely dangerous to financial institutions and to the governments that underwrite them. A complete change of culture is essential, and this can only be brought about by very radical changes in the way that bankers are paid.

Labels: Bankers, culture, Fiduciary Duty, incentives

This can be found at:
http://sermonsandprayers.blogspot.com/2009/09/business-ethics.html

Labels: Ethics, Lehman Brothers

The FT Lex column (on ft.com) had an article about the G20s efforts to develop international financial regulation. This can be viewed at http://www.ft.com/cms/s/3/e0c5d822-9890-11de-807a-00144feabdc0.html 9Subscription may be required).

In response I wrote to the editor of the FT (published 8th Dec 2009, at least on ft.com) as follows:

Dear Sir,
The Lex column is quite wrong to describe the G20's focus on bankers' pay as "populist but often tangential". Bankers' behaviour is driven by pay, and so bankers' pay has to be absolutely central to regulation of behaviour in the financial sector. It is essential that the incentives that arise from pay lead to constructive, value creating behaviours and not to behaviours that undermine the system.
As Lex points out that, "the architects of boomtime credit innovations are returning to their desks, finding new ways to tinker with balance sheets and carve through rules that are still being developed. The regulated are already moving ahead of their minders." Such behaviour could all too easily send us back into crisis, and yet the behaviour arises because of the incentives in bankers pay.
Removing incentives for destructive behaviour from bankers pay is an essential first step before any other new regulation has a chance of succeeding.
Yours faithfully,
The Revd. Patrick Gerard

Labels: Bankers, G20, incentives, regulation

Willem Buiter, Professor of European Political Economy, London School of Economics and Political Science, often writes in the FT and has a blog on FT.com. His article in the FT, 1/9/09 about Tobin Tax caused me to write the below response.
The original article can be seen at http://blogs.ft.com/maverecon/ for 2nd Sept 2009 (subscription may be required).


I don’t think that you can argue that the financial sector is too large because government effectively subsidises its cost of capital by providing guarantees. This form of governmental help is less than a year old, but the problem of the oversized financial sector had developed well before that time. In fact it was the oversized “too big to fail” aspect of the financial sector, which effectively meant that government had no choice but to provide the guarantees.

It seems to me that your analysis of the problems is absolutely correct. You mention excessive churning, incentives that drive traders to make transactions, too much financial activity that is not just socially worthless but actually harmful, and too much speculation and not enough insurance. You imply that regulation should be used to directly restrict the undesirable features of contracts.

But how in practice could regulators do this? How could they keep pace with market innovation? How could they be sure that each regulation added does not create some new perverse incentive?

The first step for regulators must be to distinguish socially helpful financial transactions from unhelpful ones. It seems to me that there is no clear cut test for this. However as a general rule of thumb the nearer a transaction is to the real requirements of the real economy the more likely it is to be socially helpful. If a business needs to buy a currency in order to pay for a particular import, then this is a real requirement for a currency transaction. If a foreign currency is required in six months time for an import in six months time that must be accurately costed in the home currency now, then this is a real requirement for a currency futures transaction. Such transactions, driven by real requirements, create real value in the real economy and so are socially helpful.

In contrast a financial transaction that represents a nil sum game between the participants is much more likely to be socially problematic. When a trader takes a long or short position against another trader such that one will win money and one will lose money on the transaction then this is a nil sum game which adds no real value. A small number of such transactions are useful because they provide liquidity and facilitate the efficient spreading of risk. However a large number of such transactions actively destroy value because the transaction costs are high (traders are well paid) and risks inevitably flow towards places where they are hidden or not properly understood.

In real life it would be almost impossible for regulators to distinguish socially helpful transactions from unhelpful ones. Any attempt to do this would create an unhelpful incentive to disguise transactions to make them look socially helpful. However a Tobin tax does have a real chance of making the correct distinction. Basically a transaction that is driven by a real requirement in the real economy can usually afford to pay a small Tobin tax. In contract a nil sum game transaction cannot, because it becomes a negative sum gain after the tax has been deducted.

The question you quite rightly ask is “What distortion is a tax on financial transactions targeted at?” The answer is that we have far too many nil sum game transactions, and a Tobin tax targets these because it makes them economically unattractive.

Labels: regulation, Tobin Tax, trading

Because of the speaking engagement on 18th May (see previous blog entry) I have been asked twice recently about the contribution that Christianity and Christian values can make to business life and to the world of economics. This caused me to write the following brief reflection.

It seems to me that the wealth of the Western world has, in large part, grown out of its religious (primarily Christian) values. The deterioration we have witnessed in those values over recent decades has been a major factor leading to the credit crunch. I don’t believe that we will find any lasting solutions to our economic problems before religious and ethical considerations are once again given far more prominence in our society and public life.

In particular we need a society where co-operation in building up the common good, takes precedent over competitive considerations. This requires a fundamental change in attitude! Competition has a useful function of controlling costs and ensuring efficiency. However this can only contribute positively to society of it takes place in the context of co-operation and a common vision at the top end of our society. Top people, (top business people, politicians, professionals) have a responsibility to work together for the good of all society. Excessive competition between top people has the effect of pulling society apart, just as we have seen our financial services sector pulled apart. Competition between top people also seems to increase pay and other costs, rather than control them.

We need to find ways of encouraging top people to co-operate in building a society that benefits everyone. The way that top people are paid is very relevant here because often it is higher pay that causes top people to compete with each other. The hope of higher pay can encourage top people to develop new agendas (for example setting up new investment funds) which might pay well, but do not actually benefit society. There is therefore a case for a cap on pay, which affects top people only. It should apply only to pay received for working for others as employees or as people who owe a fiduciary duty to others. Entrepreneurs should not be affected. People who want to become seriously rich should be encouraged to set up and grow their own businesses.

The management of risk also needs reform. Risks must be shared in a way that provides proper incentives to mitigate risk; they cannot simply traded away or insured away. Banks must take direct responsibility for the risks associated with the loans that they make. They should be able to evaluate and control these risks better than insurers. Banks should take proper account of the limitations of using of credit rating agencies. There is a serious conflict of interest associated with the issuing of a credit rating. Also, when making a loan, a bank needs to know if others are also making loans on the back of the same credit rating. Banks therefore need a far more traditional relationship with the people they lend money to.

Greed within general management must be constrained so that managers (especially top managers) are working primarily for the benefit of their company members (shareholders) rather than for themselves. Greed especially needs to be constrained in the financial services sector, where the top priority should be maintaining the health of the financial system as a whole. The second priority should be serving the genuine needs of the clients. Both of these activities must take much higher priority than maximising the profit of the financial services firm. A cap on pay could be helpful in constraining greed in these situations and restoring focus on fiduciary duty.

All these changes require far more attention to relationships, working together and values that are held in common at the top of our society. This is where I believe that the religions can contribute something extremely valuable to society and to the economy in particular.

Labels: capital, Christian, competition, cooperation, top people

Ecumenical Council for Corporate Responsibility West Midlands


Invites you to


Redeeming the Market ?

Introduced by
Reverend John Johansen Berg


With

Father Patrick Gerard author of ‘Performance & Reward'
The Bonus Culture, its impact on companies, relationship and behaviour
&

Professor Chris Mallin of Corporate Governance & Finance.
Issues of ownership and control – the evolving role of shareholders



4.30pm – 6.30pm on Monday 18th May
@ Carrs Lane Church Centre
(Carrs Lane, B4 7SX)

Carrs Lane Church Centre is located opposite Moor Street Station, for more details please visit their website
http://www.carrslane.co.uk/

For more information please contact Barbara Hayes at cigb@birmingham.anglican.org