19 June 2010

Today I wrote to the Financial Times.

Dear Sir,
I enjoyed Gillian Tett's article Ideas on curbing bankers appetite for risk (15/6/2010 on ft.com) about finding the best incentives for top bankers. I was also interested in Dr Steve Webb's letter (18/06/10) suggesting bonuses be paid in the bank's own long term debt, and requiring that this be held to maturity. My own proposals on executive rewards (Performance and Reward, Troubador 2006) was that payment be made in long term equity, which should be even more sensitive to excessive risks than long term debt.
However since writing that book, I have, like the New York Federal Reserve, come to realise that there are fundamental problems with linking bankers' rewards to profit or returns. The profound links between profit and risk mean that an incentive to increase profit is in fact an incentive to increase risk. Increasingly, because risk is subject to regulation, the incentive is actually to create hidden or understated risk, and this is even more dangerous in the longer term. The great complexity of the area means that there will always be clever people who can make a lot of money for themselves by circumventing or perverting the system. They have made their fortunes long before the world properly understands the dangers involved in what they have done.
This is why I now advocate a brutally simple global cap on bankers' pay. It is the only realistic way of curbing the risk appetite. Such a cap is not against enterprise or investment; rather it is to protect entrepreneurs, business owners and investors from the greed of their agents.
Yours faithfully
The Revd Patrick Gerard

Click here for the original article about a global cap on pay.
Click here for more on the problems of linking pay to profit.

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21 April 2010


Saving the financial system

I today left the following comment on ft.com, in response to an article by Martin Wolf, "Halting the Financial Doomsday Machine"

As you so pertinently point out, the incentives of those who run the system are the engine room of the doomsday machine. It is on the incentives that the really radical change is required. A global cap on executive pay (say US$500,000 per annum) would remove the incentive for top earners to prioritise personal gain. This would give more constructive motivations (such as saving the financial system) a real chance of being heard in the boardroom. Voters might well like to see a cap on pay, and it would free up lots of cash for the banks, allowing them to recapitalise.
And why not? The whole point of competition is to drive out costs and increase efficiency, but this has totally and completely failed in the case of the market for executive talent.

For more on the Global Cap on Pay follow the link in the left hand column of this blog.

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11 February 2010


Changing the mindset

On 7th February 2010 (on ft.com) the Lex Column of the Financial Times published a note on Executive Pay. This can be seen at:
(Subscription may be required.)
I added the below comment:

Lex has precisely identified the problem with the “take one for the team”, “clubby remuneration committee” attitudes. The top people in business are now engaged in a game whereby they compete with each other to extract more and more value from the rest of the community. This is utterly wrong and completely unsustainable. A total change in mind set is needed. We need a global (or G20 wide) cap on pay from employments/directorships. This would promote and enforce the idea that an executive’s job is to work for the benefit of shareholders and wider stakeholders, not for his/her own benefit. This principle of fiduciary duty is fundamental to company organisation. Capitalism is doomed if we can’t get back to this principle.
More on a global pay cap at www.performanceandreward.blogspot.com

See links to "global cap on pay" and "Competition Law" in left hand column.

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04 January 2010


Q&As on the Global Pay Cap - 1

Click here for the original article about a global cap on pay.
Click here for the global-cap-on-pay letter published by the FT, 12/12/2009.

Agreeing a global cap on pay and making it stick would be really tough - look how difficult international leaders have found it to agree anything on climate change. Is it feasible?
I agree that agreeing a global cap and making it stick is a tough challenge. However I can't help feeling that any less radical reform would not really get to the heart of the problem. Also, compared to climate change, a global pay cap has three big things going for it.
1) It is a simple concept.
2) It would be popular with voters.
3) It offers a cheap way of recapitalising banks
Like climate change there would be powerful vested interests working against it, but it is much easier to see it gaining rapid political momentum.
[Incidentally, if the pay of oil chiefs was capped and not affected by oil profits, then I suspect that oil chiefs would be far more ready to work constructively on the climate change agenda.]
Also we have to recognise that as the world gets more and more interconnected then there will be more and more need for global agreements. Truely international issues such as climate change and financial regulation really require international agreements. World leaders are going to have to get much better at delivering them!

To what parts of banking should the cap apply?
I agree that there are issues about where the cap should apply, but in the first instance it is very simple. Money made from someone investing his/her own money or growing his/her own business is not captured. Money made from other people's money or businesses is. All company directors and employees are working for a company and not for themselves so all wages and salaries, whatever form they are paid in, are all captured. All banking activities are clearly captured.
Where it potentially gets more difficult is with people like lawyers, accountants and consultants who are partners in a firm or have a company limited by guarantee, so they do make money from growing their own businesses. However it seems to me that this money should still be captured under the cap because they do not act as "Principals" but rather as "Agents" of their clients. They are therefore working for their clients and owe their clients a Fiduciary Duty.

The really fundamental issue that the cap is trying to address is making sure that "Agents" really do act as "Agents" and properly respect the interests of their "Principals". If agents are highly paid, or on performance related pay, then it suggests that they are working for their own benefit, not for the benefit of the Principal. This agency problem is a really deep problem. See http://en.wikipedia.org/wiki/Principal-agent_problem . It is also an ancient problem. Note that Jesus discusses the agency problem in his parables (e.g. Luke 16: 1-8). Alan Greenspan's comments on the cause of the credit crunch are very important. He says that in 60 years dealing with American business he had always assumed that companies worked to maximise the company interest, and especially to avoid their own destruction. However the risks taken in the build up to the credit crunch show that this assumption was no longer valid. Managers made the decisions that worked for managers, more than for the companies they managed. Part of the reason for this was the intensity of the competitive pressures than managers were facing.

Could not more be done to boost competition in the banking sector which is riddled with cartels and other practices aimed at artificially pushing up profits, and hence bonuses, at the expense of the customer?
I agree that there is a lack of economically effective competition in many sectors of banking. In the left hand column of this blog there is a link "Competition Law" which documents my efforts to get the Office of Fair Trading excited about the competition problems in the market for executive talent. Having said that, I no longer believe that more effective competition could ever solve the problems. The top people in society need to collaborate before they can compete. If they only compete then they pull society apart. Competition is certainly a big factor in the falling apart of the financial sector.

Are you aware of Stephen Green, Chairman of HSBC, and his work on banking ethics?
I am aware of Stephen Green through a Church Times article, but I don't know much about him really. I am interested in his book "Good Value"(although I am hopeless at reading!) HSBC is a good example of a bank that did not allow competitive pressures to distroy it. In the year before the crisis HSBC was under intense pressure from the activist investor Knight Vinke who thought HSBC should use its balance sheet more agreesively to improve "performance". I think HSBC was able to see through this because of its strong comporate culture and its emphasis on long term returns in the pay of top people.

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30 December 2009


Why investors cannot be expected to control pay

The below was pasted onto the ft.com website as a comment on the leading article for 30/12/2009(?). The article can be viewed (subscription may be required) at:

Sadly it is now abundantly clear that action on executive pay must come from governments not from investors. Investors have been struggling to have an impact on this issue for more than 20 years and have failed completely.

One of the main reasons for this is that most shares with voting powers are controlled some kind of professional fund manager. There are many reasons why fund managers can never be effective in controlling executive pay:

- Fund managers are themselves usually very well paid and they benefit from the high pay culture.
- It is easy for a management team under pressure from about executive pay to retaliate, for example by suggesting that the earnings of all fund managers should be made more transparent.
- Investing energy in improving the performance of a company for the benefit of all shareholders does not help an individual fund manager compete with his/her competitors
- Sorting out executive pay is “short term pain for long term gain”. If a fund manager’s performance is measured quarterly then the short term pain shows through straight away, and the manager is unlikely to stay in post long enough to see the long term gain.
- A fund manager making a stand on this issue is likely to lose all his friends and contacts.
- A fund manager taking a stance on executive pay is going to find it far harder to sell his/her services to high paid clients than a fund manager who colludes on pay.
- A management team whose pay is constrained by investors is likely to wriggle! For example they might seek to play off the interests of one set of investors against another. In practice it is impossible for investors to commit the long term persistence necessary. The fact that each only controls a very small shareholding so that co-ordination is required also makes this impossible.
- Professional fund managers often sit in management structures which are headed up by banking executives, insurance executives or other senior executives, often in listed companies. For the fund managers to seek to limit the pay of their own bosses is an obviously bad career move! They are not stupid!

Another problem that investors face is that the standard guidance on this issue of executive pay (The Combined Code on Corporate Governance) was written by highly paid people in order to preserve the interests of highly paid people. From an executive pay perspective it is extremely counter productive. See http://www.freewebs.com/hgerard/FRCCombinedCodeSubmission.pdf .

It is quite clear that the investor route to controlling executive pay has been tried, persevered with, and persevered with again, but can never work. A complete culture change is required. Just as “non smoking pubs” were socially highly desirable, but required a culture change that could not be delivered by the market, so lower executive pay is extremely socially desirable but can only be delivered by carefully co-ordinated government action. It would be all to easy for an individual government to tinker and get it wrong, but a globally agreed (or at least a G20 agreed) cap on pay could provide the culture change required. See http://performanceandreward.blogspot.com/2009/12/case-for-global-cap-on-pay.html .

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23 December 2009


The role of politicans in banking

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.

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11 December 2009


The case for a global cap on pay

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 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 coordinated through remuneration consultancies. I have raised these concerns with the Office of Fair Trading (OFT). 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 seen most clearly 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 motivation.

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 well-being, most tangibly his/her pay. In other words it encourages the top executive to put his/her own interests ahead of the interests 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 entrepreneurs 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.

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Global cap on bankers' pay

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

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Bankers’ pay and the financial crisis

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.

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