18 October 2008
Regulation of Bankers Pay
On Wednesday 15th October the Financial Times published a very good article by Jamie Whyte about the diffiulties of regulating bankers pay. The article can be read (by subsribers?) at http://www.ft.com/cms/s/0/62601d32-9a51-11dd-bfe2-000077b07658.html . The article discusses the principle-agent problem (how does an owner get a manager to work for the owner's interests and not his own) and advocates inovation in devising new arrangements for performance related pay.
I responded by writing to the FT letters column. My letter was not published but is included below.
Dear Sir,
I appreciated Jamie Whyte’s excellent analysis in “Why regulating bankers’ pay is still a bad idea” (FT 15/10/08) even if his conclusions are not quite right.
Mr Whyte points out that if a business owner wants to get good performance from a greed free manager then the owner must rely on the manager’s desire to what is best for the owner. Mr Whyte then suggests that it is over optimistic for an owner to assume that he has found such a manager. Clearly to “assume” this is over optimistic, so the real challenge is to find ways of building trust between the owner and the manager such that, over time, the owner comes to know that the manager really is working for the owner’s best interests.
Trust and fiduciary duty are fundamental to success of capitalism because they are the only satisfactory solution to the “principle-agent problem”. It is hard work to sustain trust and fiduciary duty and as concepts they might be profoundly unfashionable, but we shall not escape the financial crisis until they have been re-established.
Mr Whyte prefers the alternative which is to devise remuneration schemes that align the interests of the managers with the interests of owner. In adopting this approach the owner is seeking to harness the managers’ greed to his own advantage. This drives the principle-agent relationship towards mutual exploitation and away from trust. The approach breaks down because the managers have a strong incentive (which remuneration consultants collude with) to move remuneration practice along to make it easier for managers to secure higher rewards. The moving along of remuneration practice is often presented as “innovation”, but the innovations that are easiest to agree and get implemented are the ones that work best for the managers.
Under the incentive model, owners should insist on stable long term incentives that align the managers interests with their own. One reason why they fail to do this is because owners are themselves really managers (fund managers) who are themselves seeking higher rewards from principles, so they find it convenient to collude. In reality remuneration schemes like the FILLIP, which are really serious about aligning owner and manager interests, are of little interest in the market place of remuneration ideas.
Mr Whyte’s criticisms of regulation have some validity, but regulation that imposed and kept stable real long term incentive alignment between management and owners might well be the lesser of many evils.
The real solution however is to build trust with talented and hard working managers who are willing to work for the ownership interest. How does the manager build trust? Well accepting a flat salary with no extras of, say, US$500,000 would be a very convincing start.
Yours faithfully,
Revd Patrick Gerard
I responded by writing to the FT letters column. My letter was not published but is included below.
Dear Sir,
I appreciated Jamie Whyte’s excellent analysis in “Why regulating bankers’ pay is still a bad idea” (FT 15/10/08) even if his conclusions are not quite right.
Mr Whyte points out that if a business owner wants to get good performance from a greed free manager then the owner must rely on the manager’s desire to what is best for the owner. Mr Whyte then suggests that it is over optimistic for an owner to assume that he has found such a manager. Clearly to “assume” this is over optimistic, so the real challenge is to find ways of building trust between the owner and the manager such that, over time, the owner comes to know that the manager really is working for the owner’s best interests.
Trust and fiduciary duty are fundamental to success of capitalism because they are the only satisfactory solution to the “principle-agent problem”. It is hard work to sustain trust and fiduciary duty and as concepts they might be profoundly unfashionable, but we shall not escape the financial crisis until they have been re-established.
Mr Whyte prefers the alternative which is to devise remuneration schemes that align the interests of the managers with the interests of owner. In adopting this approach the owner is seeking to harness the managers’ greed to his own advantage. This drives the principle-agent relationship towards mutual exploitation and away from trust. The approach breaks down because the managers have a strong incentive (which remuneration consultants collude with) to move remuneration practice along to make it easier for managers to secure higher rewards. The moving along of remuneration practice is often presented as “innovation”, but the innovations that are easiest to agree and get implemented are the ones that work best for the managers.
Under the incentive model, owners should insist on stable long term incentives that align the managers interests with their own. One reason why they fail to do this is because owners are themselves really managers (fund managers) who are themselves seeking higher rewards from principles, so they find it convenient to collude. In reality remuneration schemes like the FILLIP, which are really serious about aligning owner and manager interests, are of little interest in the market place of remuneration ideas.
Mr Whyte’s criticisms of regulation have some validity, but regulation that imposed and kept stable real long term incentive alignment between management and owners might well be the lesser of many evils.
The real solution however is to build trust with talented and hard working managers who are willing to work for the ownership interest. How does the manager build trust? Well accepting a flat salary with no extras of, say, US$500,000 would be a very convincing start.
Yours faithfully,
Revd Patrick Gerard
Labels: alignment, banking, Fiduciary Duty, incentive, Jamie Whyte, regulation, trust
17 October 2008
10th October 2008
Rt Hon John McFall MP
House of Commons
London SW1A 0AA
Dear Sir,
Banking Bonuses
I was very pleased to read that the Treasury Select Committee is to examine the large scale financial rescue package. I was particularly pleased that it will look at the bonus culture in the City, and the damage that this might have caused.
In this respect I hope that the committee will find my book (enclosed) useful. The book rigorously examines the incentives that arise from the typical structures of pay of top managers and executive directors. It shows how the incentives are very often too short term in outlook and too individualistic to ensure a coherent long term focus at the top of an organisation. It also proposes forms of pay that are much better aligned to the long term needs of shareholders.
With best wishes for your difficult job in these most difficult times.
Yours faithfully,
Revd Patrick H. Gerard
Rt Hon John McFall MP
House of Commons
London SW1A 0AA
Dear Sir,
Banking Bonuses
I was very pleased to read that the Treasury Select Committee is to examine the large scale financial rescue package. I was particularly pleased that it will look at the bonus culture in the City, and the damage that this might have caused.
In this respect I hope that the committee will find my book (enclosed) useful. The book rigorously examines the incentives that arise from the typical structures of pay of top managers and executive directors. It shows how the incentives are very often too short term in outlook and too individualistic to ensure a coherent long term focus at the top of an organisation. It also proposes forms of pay that are much better aligned to the long term needs of shareholders.
With best wishes for your difficult job in these most difficult times.
Yours faithfully,
Revd Patrick H. Gerard
Labels: Bonus, John McFall, Treasury Select Committee
16 October 2008
Letter to Hector Sants at the FSA
10th October 2008
Hector Sants
Chief Executive Officer
The Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
Dear Mr Sants,
Banking Bonuses
In your speech about principled-based regulation on 15th May you spoke of your concerns about asymmetrical risk in the compensation schemes of securities traders. You mentioned the need for payment schemes where employees and shareholders shared more properly in the upside and downside of risks. Recent events have further reinforced the importance of your remarks! I was pleased to see in yesterday’s Financial Times that the FSA is preparing a Code of Conduct on banking bonuses.
You are absolutely right that the structures and incentives associated with banking pay have been a major factor in the development of the current crisis, and need urgent attention. This is especially important for the very top people in banks, to whom securities traders ultimately report. If executive directors and top managers have the right risk symmetry then appropriate incentives should be expected to cascade down the organisation without the need for too much prescription. My book (enclosed) makes a rigorous examination of the incentives that arise for executive directors. It makes important recommendations of how the incentives can be improved and made much safer for the longer term. I hope that your team working on the Code of Conduct will be able to make good use of the book.
There is, of course, an existing Code of Conduct on executive pay included in the Combined Code, administered by the Financial Reporting Council. This code has been singularly unsuccessful on the issue of executive pay, and any new Code of Conduct must take account of the reasons for this. An analysis of the problems is displayed at:
http://performanceandreward.blogspot.com/2006/04/combined-code.html.
With best wishes for your difficult job in these most difficult times.
Yours sincerely,
Revd Patrick H. Gerard
Chief Executive Officer
The Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
Dear Mr Sants,
Banking Bonuses
In your speech about principled-based regulation on 15th May you spoke of your concerns about asymmetrical risk in the compensation schemes of securities traders. You mentioned the need for payment schemes where employees and shareholders shared more properly in the upside and downside of risks. Recent events have further reinforced the importance of your remarks! I was pleased to see in yesterday’s Financial Times that the FSA is preparing a Code of Conduct on banking bonuses.
You are absolutely right that the structures and incentives associated with banking pay have been a major factor in the development of the current crisis, and need urgent attention. This is especially important for the very top people in banks, to whom securities traders ultimately report. If executive directors and top managers have the right risk symmetry then appropriate incentives should be expected to cascade down the organisation without the need for too much prescription. My book (enclosed) makes a rigorous examination of the incentives that arise for executive directors. It makes important recommendations of how the incentives can be improved and made much safer for the longer term. I hope that your team working on the Code of Conduct will be able to make good use of the book.
There is, of course, an existing Code of Conduct on executive pay included in the Combined Code, administered by the Financial Reporting Council. This code has been singularly unsuccessful on the issue of executive pay, and any new Code of Conduct must take account of the reasons for this. An analysis of the problems is displayed at:
http://performanceandreward.blogspot.com/2006/04/combined-code.html.
With best wishes for your difficult job in these most difficult times.
Yours sincerely,
Revd Patrick H. Gerard
Labels: Bonus, Code of Conduct, FRC, FSA, Hector Sants, trading
15 October 2008
Executive pay and the banking crisis
On 13th October Hector Sants, Chief Executive of the FSA wrote to banking CEOs about remuneration policies. The letter can be viewed at: http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf
The FSA is absolutely right that reform of banking pay is essential. The FSA's current thinking on remuneration, set out in the appendix, is a step in the right direction but much, much more is required.
The book Performance and Reward (see link "View the Book" in the left hand column) is more relevant than ever. The book proposes a form of remuneration called a FILLIP. FILLIP remuneration addresses all the FSA's concerns in a bold and systematic way, avoiding the pitfalls associated with bonus claw back. FILLIP remuneration is a straight forward way for companies to demonstrate that they have taken seriously the need to reform executive pay. The FSA says that it is difficult to be prescriptive about Executive Pay, but they could do far, far worse than prescribe FILLIPS.
Earlier today I posted onto an FT.com discussion blog the following justification for the FILLIP style approach. This was in response to a Lombard comment which can be viewed at http://www.ft.com/cms/s/0/1e710a20-9a0e-11dd-960e-000077b07658.html (Subscription may be required.)
Andrew Hill argues that “It will be bloody if regulators take axe to bonuses”. He is absolutely right, but the frightening truth is that it will turn out even more bloody if regulators do not block bonuses. The extraordinarily powerful financial incentives that have driven banking behaviours over the last ten years have led to value destruction on an unprecedented scale. Banking incentives must be completely redesigned if we are to break out of the loop of value destruction.
The top priority has to be the top people in the bank. The only credible incentive to give a Chief Executive or member of the top team is an incentive linked to long term growth in shareholder value. For top executives, all bonuses and performance related pay should be deferred. After five years they can be paid out in proportion to the total of shareholder value growth over the five year period. This approach solves many problems:
1) Risks have come to maturity before risk taking is rewarded.
2) The capital employed in creating profit is taken account of in reward.
3) There is proper focus on the long term. Behaviours with a short term focus are rewarded only in so far as they contribute to long term value.
4) The growth in shareholder value over five years is completely objective. There is no need to the resort to messy and value destroying arguments about whether past bonuses should be clawed back.
5) As a performance measure the five year growth in shareholder value has a rolling quality that evens out short term distortions. If shareholder value is overstated at the end of one five year period then growth over the five years just ending is overstated, but growth over the five years just starting is understated.
6) If all top executives have this same common incentive then many conflicts of interest are eliminated, because all top executives share a common incentive.
7) Effective team working in the top team is properly rewarded.
8) The common incentive incentivises the team of top executives to form a common mind about whether risks are justified, and the overall position of the bank relative to the market.
9) The common incentive makes top executives properly accountable to one another because they share the same objective.
10) If a large group of people at the top of the organisation all share a common incentive to grow shareholder value over the long term then there can be far more confidence that appropriate remuneration arrangements will cascade down to traders and other employees.
Revd Patrick Gerard
www.performanceandreward.blogspot.com
The FSA is absolutely right that reform of banking pay is essential. The FSA's current thinking on remuneration, set out in the appendix, is a step in the right direction but much, much more is required.
The book Performance and Reward (see link "View the Book" in the left hand column) is more relevant than ever. The book proposes a form of remuneration called a FILLIP. FILLIP remuneration addresses all the FSA's concerns in a bold and systematic way, avoiding the pitfalls associated with bonus claw back. FILLIP remuneration is a straight forward way for companies to demonstrate that they have taken seriously the need to reform executive pay. The FSA says that it is difficult to be prescriptive about Executive Pay, but they could do far, far worse than prescribe FILLIPS.
Earlier today I posted onto an FT.com discussion blog the following justification for the FILLIP style approach. This was in response to a Lombard comment which can be viewed at http://www.ft.com/cms/s/0/1e710a20-9a0e-11dd-960e-000077b07658.html (Subscription may be required.)
Andrew Hill argues that “It will be bloody if regulators take axe to bonuses”. He is absolutely right, but the frightening truth is that it will turn out even more bloody if regulators do not block bonuses. The extraordinarily powerful financial incentives that have driven banking behaviours over the last ten years have led to value destruction on an unprecedented scale. Banking incentives must be completely redesigned if we are to break out of the loop of value destruction.
The top priority has to be the top people in the bank. The only credible incentive to give a Chief Executive or member of the top team is an incentive linked to long term growth in shareholder value. For top executives, all bonuses and performance related pay should be deferred. After five years they can be paid out in proportion to the total of shareholder value growth over the five year period. This approach solves many problems:
1) Risks have come to maturity before risk taking is rewarded.
2) The capital employed in creating profit is taken account of in reward.
3) There is proper focus on the long term. Behaviours with a short term focus are rewarded only in so far as they contribute to long term value.
4) The growth in shareholder value over five years is completely objective. There is no need to the resort to messy and value destroying arguments about whether past bonuses should be clawed back.
5) As a performance measure the five year growth in shareholder value has a rolling quality that evens out short term distortions. If shareholder value is overstated at the end of one five year period then growth over the five years just ending is overstated, but growth over the five years just starting is understated.
6) If all top executives have this same common incentive then many conflicts of interest are eliminated, because all top executives share a common incentive.
7) Effective team working in the top team is properly rewarded.
8) The common incentive incentivises the team of top executives to form a common mind about whether risks are justified, and the overall position of the bank relative to the market.
9) The common incentive makes top executives properly accountable to one another because they share the same objective.
10) If a large group of people at the top of the organisation all share a common incentive to grow shareholder value over the long term then there can be far more confidence that appropriate remuneration arrangements will cascade down to traders and other employees.
Revd Patrick Gerard
www.performanceandreward.blogspot.com
Labels: banking, Book, FILLIP, incentive, value
11 October 2008
Faith and Finance Forum
On 8th October 2008 I was asked to speak at a "Faith and Finance Forum" at St Faith and St Lawence Church in Harborne, Birmingham. I was asked to present a business perspective on Finance in ten minutes!
My slides can be accessed through this link.
Most of the presentation concerns financial businesses, and the difficulties that have lead to the credit crunch.
http://www.freewebs.com/hgerard/Faith%20and%20Finance%20Forum%20-%20Business%20Perspective%2008%2010%2008.ppt
My slides can be accessed through this link.
Most of the presentation concerns financial businesses, and the difficulties that have lead to the credit crunch.
http://www.freewebs.com/hgerard/Faith%20and%20Finance%20Forum%20-%20Business%20Perspective%2008%2010%2008.ppt
Labels: business, credit crunch, Faith
05 October 2008
The New World for Banking
On 4th October 2008 a poll by ft.com asked the question, "Will the rescue plan work?". This was a reference to the $700bn rescue plan for the financial services industry finally approved by the US Congress earlier that day. I posted in the following comment, which can be viewed at
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?a=tpc&s=646099322&f=851094803&m=9531017771&r=9531017771 .
The $700bn rescue plan can, at best, only help in the short term. Unfortunately the underlying long term attitudes which caused the credit crunch are still very firmly in place.
We should certainly hope that the $700bn might last long enough to allow development of new and tighter regulation for banks that is internationally agreed. Sadly it is hard to find solid grounds for this hope, because the regulation that banks really need is likely to work against the instincts and vested interests of most of the people involved in the discussions.
Banking need to be much, much simpler so that financial markets are more readily understandable. Complex derivatives proved to be much more effective at hiding risk that at managing it efficiently. Banks need to be much smaller so that failures are more manageable. Banks need to be less leveraged so they are safer and have more of a utility feel. The capital banks have available for speculation must be linked to market making obligations. Speculative capital should be strictly limited so that huge movements in short term capital cannot cause market lurches.
The incentives that drive banking behaviours need far more attention. The incentives that arise from holding a "long" equity position are much more constructive to the economy as a whole that the incentives which arise from holding a "short" position. The incentives that arise from pay need careful consideration. Top bankers should not be eligible for annual bonuses; all incentives should be on a long term basis. The top mangers in a bank must all have common incentives so that they work together, share information and form a common mind on the banks position and the state of the market. Above all the pay of top bankers must be much lower so that shareholders can feel confident that the top bankers are working for the shareholders' benefit not their own benefit. Very high pay increases the likelihood of ruthless and self-seeking characters at the top of the organisation; if you pay gold you get pirates!
In summary banking needs to become much, much more boring! Banking careers should appeal to steady and consistent people. Just like top athletes, top bankers should be subjected to regular drugs tests. The supercharged performance currently expected is not human and its puts inhuman pressures on other parts of the system.
Unfortunately we are still a very long way from a safe and boring banking system. And in the meantime what are the whiz-kids doing? Well I expect that the big prizes right now are for finding the best schemes to persuade government to take over and pay too much for the very worst assets. All this overcharged pursuit of money has killed many of our financial institutions. Are we going to allow it to kill our public finances?
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?a=tpc&s=646099322&f=851094803&m=9531017771&r=9531017771 .
The $700bn rescue plan can, at best, only help in the short term. Unfortunately the underlying long term attitudes which caused the credit crunch are still very firmly in place.
We should certainly hope that the $700bn might last long enough to allow development of new and tighter regulation for banks that is internationally agreed. Sadly it is hard to find solid grounds for this hope, because the regulation that banks really need is likely to work against the instincts and vested interests of most of the people involved in the discussions.
Banking need to be much, much simpler so that financial markets are more readily understandable. Complex derivatives proved to be much more effective at hiding risk that at managing it efficiently. Banks need to be much smaller so that failures are more manageable. Banks need to be less leveraged so they are safer and have more of a utility feel. The capital banks have available for speculation must be linked to market making obligations. Speculative capital should be strictly limited so that huge movements in short term capital cannot cause market lurches.
The incentives that drive banking behaviours need far more attention. The incentives that arise from holding a "long" equity position are much more constructive to the economy as a whole that the incentives which arise from holding a "short" position. The incentives that arise from pay need careful consideration. Top bankers should not be eligible for annual bonuses; all incentives should be on a long term basis. The top mangers in a bank must all have common incentives so that they work together, share information and form a common mind on the banks position and the state of the market. Above all the pay of top bankers must be much lower so that shareholders can feel confident that the top bankers are working for the shareholders' benefit not their own benefit. Very high pay increases the likelihood of ruthless and self-seeking characters at the top of the organisation; if you pay gold you get pirates!
In summary banking needs to become much, much more boring! Banking careers should appeal to steady and consistent people. Just like top athletes, top bankers should be subjected to regular drugs tests. The supercharged performance currently expected is not human and its puts inhuman pressures on other parts of the system.
Unfortunately we are still a very long way from a safe and boring banking system. And in the meantime what are the whiz-kids doing? Well I expect that the big prizes right now are for finding the best schemes to persuade government to take over and pay too much for the very worst assets. All this overcharged pursuit of money has killed many of our financial institutions. Are we going to allow it to kill our public finances?
Labels: banking, incentives, regulation
