Performance and Reward

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