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
