Performance and Reward

Q&As on the Global Pay Cap - 1

2010-01-04T10:08:00.010Z

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.

The book: Performance and Reward

2006-04-02T17:45:00.002Z

Click here to view the book on the publishers website. Google Preview is available through this site, allowing you to read most of the book and to search its pages.

Click here to view the book on Amazon.co.uk. From this site it is possible to search the pages of the book.

Click here to view the book on Google Books. It is possible to read most of the book from this site using a larger window than in Google Preview.

Performance and Reward was published in April 2006. The book reviews typical executive pay practices in the UK and highlights the problems that these cause. It also shows how the problems can be solved.

Most of the book is concerned with a detailed examination of the incentives arising from a typical executive reward package. Unfortunately the incentives are seldom properly focused on the creation of long term shareholder value. Short term, individualistic incentives are far too common, and the book shows how damaging these can be. The book proposes a new executive pay structure called a FILLIP, which ensures that executives have incentives to create shareholder value in the long term.

The last part of the book is concerned with the level of executive pay. It explains how the current very high levels of pay have come about and examines some of the problems that these have caused. The book highlights the limitations of a comparative approach to setting executive pay. It encourages remuneration committees to consider the leadership message that is conveyed by the level of executive pay.

The book is important reading for anyone directly involved in executive pay policy. Members of remuneration committees will find it particularly useful, although all directors of listed companies need to be aware of its main points. Activist shareholders, consultants, lawyers, accountants and regulators concerned with executive pay will find in the book an essential critique of current practice and constructive suggestions for making improvements.

Why investors cannot be expected to control pay

2009-12-30T15:33:00.002Z

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:
http://www.ft.com/cms/s/0/d256c8ca-f4af-11de-9cba-00144feab49a.html

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 .

Global cap on bankers' pay

2009-12-11T11:24:00.005Z

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

The role of politicans in banking

2009-12-23T22:22:00.003Z

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.

The case for a global cap on pay

2009-12-11T13:56:00.003Z

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.

Bankers pay at G20

2009-09-06T15:40:00.004Z

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

Bankers’ pay and the financial crisis

2009-12-11T11:12:00.004Z

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.

Sermon on Lehman Brothers anniversary

2009-09-21T11:53:00.003Z

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

In defense of the Tobin Tax

2009-09-03T15:30:00.000Z

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.

Christian contribution to business and economics

2009-04-17T20:38:00.005Z

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.

Event notification - "Redeeming the Market ?"

2009-04-05T15:47:00.000Z

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

Lobbying, big business and the Common Good

2009-03-02T12:17:00.004Z

I was recently sent some material raising concerns about the decisions made by leading politicians, civil servants and their advisers. The concern is that pubic decisions and proposals are often developed in close collaboration with big business. Are they developed to serve the public interest or to serve the needs of big business?

It was pointed out to me that the UK Government’s Public Administration Select Committee [PASC] has recently called for:

1) consistent rules to prevent former ministers and other public servants from using contacts built up in public office to further their own and others’ private interests.
2) a single body to oversee and regulate lobbying.

Groups such as Vested interest in Politics [VIP] support this proposal and call for the banning of lobbies, large-scale funding of parties, and the revolving door (the practice of ministers, diplomats, civil servants and government advisors passing through the revolving door between government and private sector posts).

I was asked to comment on this. My comments are below:

I too am very concerned about the influence of big money on our public life. I certainly worry that many of our public policies e.g. on NHS drugs, satellite TV, financial regulation, armaments, and to a lesser extent energy and transport, are driven much more by the needs of the companies providing products and services than they are by the desire to serve the public good. To me the most outrages cases occur in the courts. It seems to me that if a case is presented in court, then justice requires some proportionality in the resources that the two disputing parties have to put into the legal case. I fear that sometimes (especially in the US) court cases are won by sheer weight of legal representation.

Unfortunately it is often very difficult to distinguish legitimate lobbying from illegitimate lobbying. Many areas of public life are now so complicated that professional input is absolutely necessary, even though it often represents a self-interest agenda. For example there are many areas of the debate about Nuclear Power, that only those involved in the Nuclear Power industry can properly comment on. Those people, and the consultants that they hire, almost always have a vested interest in the development of the Nuclear Power industry. Despite this it is still definitely in the public interest that their arguments are properly presented, even if we disagree with them and even if they are tainted by self interest.

When I lobby on the subject of executive pay, I have sometimes obtained lists of people who have submitted responses to a formal consultation about proposed amendments to the Combined Code on Corporate Governance for example. Overwhelmingly the responses come from corporations or consultancies who have the resources to get properly to grips with the issues and submit a constructive response. A few private individuals respond, but they usually have had some previous professional interest in the question. Responses from completely independent parties are very rare, and usually (like mine!) so tangential to the overall sense of direction that they cannot be worked with constructively.

What can be done?

We can't ban all lobbying; how would government ever know what to do?

I think we should do what we can to make the revolving door turn much more slowly. To ban it completely government would have to be able to grow and retain its own expertise among its own staff. This is made difficult by the hugely better pay and rewards that exist in the private sector. This could be addressed through better public sector pay, but I think that would just force the private sector pay higher. The better (but harder) solution is to constrain private sector pay. Another approach is to assume that the public sector will hire consultants when it needs expertise, but this is at best a partial solution too, because consultants always want to see growth and development in the sector they serve.

To me the most important thing is to build and develop in the Civil Service a very strong sense of public service and of the need to do things for the public good. This can only happen if the top people in the Civil service are those who have demonstrably done this over many years. It is undermined if the top people are those who have come in recently through the revolving door. It seems to me that this sense of making decisions for the public good must always be strengthened. Without this there is a danger than any restrictions on lobbying simply create a dangerous vacuum.

As ever there is an executive pay angle on this, because incentives drive our behaviours. The best rewarded people in our society should be those who make decisions for the benefit of the whole public interest; the common good which especially includes the good of the poor and those unable to represent themselves effectively. One would hope that such best rewarded people would include top civil servants and government ministers. Private sector pay, pay in specific sectors (such as healthcare) and most especially pay for consultancies, should generally be lower than top public sector pay. People who are paid owe a duty to work for the good of their employer. High pay suggests that this duty is being eclipsed by self interest. At present the top paid people in specific sectors are those who best demonstrate to the wider world the importance of the sector and why it should be developed. This situation somehow needs to be reversed. The best paid people in a sector should be those with a strong common good credentials who can explain to the specific sector how best it can serve the common good. Obviously we are a very long way away from this, but somehow the competition paradigm that we currently live under needs to be replaced by a public interest/common good paradigm, which is strong enough to control competition.

Obama Introduces Limits on Bankers Pay

2009-02-05T10:14:00.004Z

Comments in response to a Robert Peston BBC blog entry:

President Obama’s cap on pay is an important step forward. US$ 500,000 is a sensible limit. It is high enough to avoid the “If you pay peanuts you get monkeys” problem, and low enough to avoid the “If you pay gold you get pirates” problem.

It is far too easy to be cynical about the “nice warm glow” that a manager should feel for doing a service to shareholders or the public. Top people need to feel that they are making a positive contribution to society. This should always be a central aspect of their motivation for working. Without it they will never feel fulfilment from work, however high the salary. Without it we will never get a society that is run for the benefit of all. In recent years this “nice warm glow” aspect of remuneration has been total eclipsed by the issue of pay. One powerful reason for capping pay is that it will bring it back firmly into focus.

The measure applies only to the very top people in the institution. This is important because it means that, in theory, institutions can continue to pay superstar traders and other top performers very high salaries; far higher than those of the CEO and executive directors. In practice however company boards have allowed the salaries of superstar traders to become grossly inflated because they help to justify higher salaries at board level. Once board level salaries are capped we can expect, over time, to see the board make a far more realistic assessment of what star performers are really worth. I have no doubt that this will lead to reduced requirements for traders, and to lower trader salaries.

The measure is not retrospective. Companies are only affected by the limit as they increase their dependence on government. This unfortunately creates a massive incentive on the institutions to avoid or taking government help. This will lead to some completely unjustifiable behaviours rather like Barclays accepting very expensive new capital from the middle east to avoid taking much more affordable government aid. It could also lead to banks concealing their true problems in order to delay the taking of government aid. Such behaviours, it seems to me, will lead inevitably to the nationalisation of banks. This is a serious problem, but it should be seen as a transition issue, not as a problem with the measure. Quitting our addiction to high executive salaries was never going to be easy.

In his speech (4th Feb 2009) President Obama hit the key point. He said, “But in order to restore our financial system, we’ve got to restore trust. And in order to restore trust, we’ve got to make certain that taxpayer funds are not subsidizing excessive compensation packages on Wall Street.” Fundamentally the credit crunch is a problem of trust. There is an underlying question, “For whose benefit is this company being run?” Trust can never be restored while executive pay policy suggests that companies are being run for the benefit of the executives. The public sector can enforce lower executive salaries, but in the private sector they must be self imposed. If the private sector fails to do this then it will gradually disappear into the public sector.

For Obama's speech see:
http://www.ft.com/cms/s/0/ce4790c4-f2d6-11dd-abe6-0000779fd2ac,dwp_uuid=a4559040-e7c3-11dd-b2a5-0000779fd2ac.html
(Subscription to ft.com may be required.)

Full text of Robert Peston entry is at:
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2009/02/obama_biffs_bonuses.html?moduserid=movabletype69_55678&pid=75447959&upm=False&asb=False&pmp=False#dnaacs
Among other things he said, "Those running banks or car manufacturers or any business which would fall over in the absence of funding from taxpayers will probably have to take much of their reward in the form of the nice warm glow that they ought to feel for doing their public duty - and defer the bonuses for a year or five."
My comment was No 229 rejected, replaced at 233.

Regulation of Bankers Pay

2008-10-18T11:38:00.005Z

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

2008-10-17T11:00:00.000Z

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

Letter to Hector Sants at the FSA

2008-10-16T11:28:00.000Z

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

Executive pay and the banking crisis

2008-10-15T10:11:00.006Z

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

Faith and Finance Forum

2008-10-11T17:47:00.003Z

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

The New World for Banking

2008-10-05T11:39:00.006Z

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?

Letter to Mervyn King, Governor of the Bank of England

2008-07-18T14:00:00.001Z

18th July 2008

Mervyn Allister King, Esq.
Governor, Bank of England
Threadneedle Street
London EC2R 8AH

Dear Governor,

Executive Pay in Banking

I am writing to say how much I appreciate your recent decision to forgo a large salary rise. This action demonstrates that it is more important to do the right thing for the community than to accumulate personal reward. I think it is a profoundly helpful leadership example in these most difficult of times.
In April you told the Commons Treasury Committee that, “I intend the bank to contribute to the design of regulatory and incentive structures … to try to curb the excessive build up of risk taking…” It seems to me that you are absolutely right to highlight the incentives which drive banking behaviour. It is far more important and realistic to regulate these incentives than to attempt to control behaviours that are driven by such powerful incentives.
With regards to executive directors and the very top executives in a bank, there are two specific problems with the incentives arising from current remuneration practices.
(1) Bonuses are paid for short term (annual) performance. It is far too easy to get a big bonus for behaviours which might prove to be damaging in the longer term.
(2) Conflicting personal incentives at the top level obscure a clear and common understand of the banks overall position. Banks that have retained some partnership feel at the top (e.g. Goldman Sachs) have faired much better than those with individual star performers at the top.
You might be interested in my book (enclosed). The book proposes a remuneration structure called a FILLIP, which address these two problems. All top executives have just one incentive; to create shareholder value over the long term.

Yours faithfully,

Revd Patrick Gerard
Copied to http://www.performanceandreward.blogspot.com/

To see the book click on "View the book" in the left hand column.

Rise in executive pay - is it sinister?

2008-06-13T22:00:00.001Z

Letter to "The Economist", 13th June 2008 (not published).

Dear Sir,

Executive Pay – Let the fight begin (Economist 14th - 20th June 2008 – page 18)

Your leader on executive pay, surprised me with the comment, “Managers’ pay has grown faster that workers’ pay, but the reasons for this are not sinister. Whereas workers’ pay depends on the labour market …, managers’ bonuses are chiefly tied to returns on capital”
The thing which does appear “sinister” is that executive pay appears to have no relationship to supply and demand in the market for executive talent. The difficulty of recruiting and retaining executive talent in a highly competitive international market is often cited as a reason for increasing executive pay. However if prices in that market are not related to supply and demand then that market cannot be competitive in the sense that leads to economic efficiency.
If prices in the market for executive talent are not driven by supply and demand then we have to ask what does drive them. The most likely answer is the market power of directors of public companies, who are both the principle suppliers and principle purchasers in the market for executive talent. The link between executive pay and returns on capital reflects the balance of power between executives and shareholders. The market power of a chief executive can be seen most clearly in severance payment. At the point of severance the company is not paying to recruit or retain executive talent, but rather it is buying off market power. An outgoing chief executive still has huge power, which could be used to damage the company.
The point about Ronaldo being paid vastly more than Pele is relevant, but it is not the whole story. Footballer talent can be assessed quite quickly, but the assessment of what a business manager contributes is far more subjective. Footballers are more readily interchangeable than executives. The market for footballer talent is more transparent and has better separation between buyers and sellers than the market for executive talent. Severance payments are less significant.
The market for executive talent certainly has its sinister aspects, which should be scrutinised by regulators, especially those who enforce competition law.

Yours faithfully,
Revd Patrick Gerard

Note: My dialogue with the Office of Fair Trading on this subject can be seen by clicking on the link "Competition Law" in the left hand column.

Executive Pay and Corporate Responsibility

2008-01-30T21:50:00.000Z

Rewarding Virtue - Effective Board Action on Corporate Resposnsibility

This most interesting report was recently brought to my attention. The executive summary can be accessed from:
http://www.bitc.org.uk/resources/publications/rewarding_virtue.html.

I have examined the report from an Executive Pay perspective. It is very noticeable that many of the points made in the report have points about executive pay lying behind them. There are very clear links between good practice on Executive Pay and good Corporate Responsibility.

In the following commentary I frequently refer to the book Performance and Reward. To find out more about this book follow the link "View the book" in the left hand column of this blog.

Tempatations against Corporate Responsibility

The report summary discussed two main "temptations" to be irresponsible.

1) Market failure creating incentives to be irresponsible.
This is precisely why it is so important that executive directors are rewarded only for long term performance. The graph top, right of page 4 suggests that (except in the case of persistent market failure) at 3-5 year delay on performance assessment would substantially remove the incentive to behave irresponsibly.
The report talks about the balance between short and long term rewards. The important point in the Performance and Reward book is that if Total Shareholder Return (TSR) is used as a performance measure for executive directors then the appropriate balance is 100% long term, 0% short term, because the long term TSR metric properly captures the lasting impact of all short term actions.

2) Internal incentives, e.g. from pay schemes, to act irresponsibly.
Executive directors (and other senior managers) usually seek to align the incentive schemes of their staff with their own incentive schemes in order to make sure that the staff and rewarded if and only if the director is rewarded. This means that incentive schemes tend to cascade down organisations. In other words if the directors rewards are based on appropriate long term measures then it is likely that the directors will resolve most other problems lower down the organisation.
The more difficult internal incentive problem concerns the incentives arising from promotion prospects. It is all too easy to promote people for good short term performance.

Exacerbating factors

The report summary notes that the two "temptations" can be exacerbated by pressure from investors and competitors.

1) Pressure from investors for short term returns is a very real and big problem that I suggested might be worthy of more research by ECCR. I sometimes fear that we have a "persistent market failure" problem here, which could be disastrous for our economies in the long term.

2) Pressure from competitors is discussed up "keeping the sector healthy" below.

The Report's six recommenations

Executive pay is an important background issue in all of the six recommendations of the report. I can't help feeling that the report has not quite grasped the nettle in working out the full implications in respect of executive pay.

1) Set Values and Standards
Executive pay is key to the values of the company. (See discussion of the Leadership Message in Performance and Reward, page 168ff.) Does the company have any values beyond seeking financial reward?

2) Think Strategically about Corporate Responsibility
This is a very important point, but it obviously prioritises the long term over the short term. Short term rewards are a big threat to this aspiration. [It is also interesting to notice how the HBOS example sees complexity as a long term problem. The credit crunch witnesses to this. (Complexity is also a problem in executive pay - see page 47, 143-146 of Performance and Reward.)]

3) Be constructive about regulation (This is discussed under "keeping the sector healthy" below).

4) Align Performance Management
This is clearly about pay, but the need to prioritise long term performance should come over much more strongly.

5) Create a Culture of Integrity
"Values" and Leadership Message are important here. This means that the level of executive pay is important. If the company incentives are too heavily dependent on financial reward then the main "value" in the company becomes "maximise your personal pay" which is a bad starting point for ethics. A more ethical organisation is going to focus more on the intangible rewards discussed at the end of page 3 of the report.
Also common incentives are very important here. See Performance and Reward pages 28-32. It is very hard for Director A to criticise Director B for behaviour which is necessary for Director B to get his bonus. However if the directors all have the same corporate objectives then they are much more accountable to each other for their behaviour.

6) Use Internal Control to secure responsibility
The common incentives point continues to be important here. Without it, it is very hard to blame someone for stretching boundaries to achieve a reward outcome. Precisely the reason that the incentive was set was to make the person stretch boundaries to achieve it!

Keeping the Sector Heathly

The report makes important points about being constructive about regulation and working with competitors to solve market failure problems. Incentives for "keeping the sector healthy" are extremely important to the public good, but are seriously undermined by comparitive forms of performance measurement. This is discussed in detail in Performance and Reward pages 37-41. The incentives would work far batter if all companies only used absolute measures of company performance. [The trouble is that it is comparative considerations that are used to justify high executive pay - so they are very popular].

The point can be taken even further. It is important that all executive directors have incentives to keep the world and national economies healthy and prosperous in the long term. Comparative performance measures certainly work against this. Defined Contribution Pension Schemes for executive directors would help here - see Performance and Reward 138-9.

Conclusion

It is very clear to me that Executive Pay is an extremely important issue that can either support or frustrate efforts to improve Corporate Responsibility. In fact my personal suspicion is that the bad practice on executive pay since the mid 1980s has been a big factor leading to the problems in Corporate Responsibility that we have seen in more recent years.

Paul Myners on Moral Hazard in banking

2007-12-06T20:50:00.000Z

Following my recent entry on the moral hazard in banking, I was very interested to read Paul Myners comments on a similar theme. These comments were made in a substantial interview reported on ft.com 4th December 2007.
The full interview can be found at (subscription maybe required):
http://www.ft.com/cms/s/0/7272fc1c-a28b-11dc-81c4-0000779fd2ac.html

Specifically on the moral hazard point Mr Myners said:

"I think there’s an inbuilt moral hazard in banking. I think that isn’t just confined to banking. I think it includes private equity and other forms of investment in which the incentives to take on risk in pursuit of reward are not symmetrical to the consequences of getting that wrong. So there’s a natural inclination to stay with risk for too long. Chuck Prince embraced this in his famous statement about the music’s still playing, but I think that’s true to some extent to equity investors as well. While the market is rising, it is better to stay in than to seek to anticipate a fall, get that wrong for a short period of time, underperform against an index and benchmark and other managers, and run the risk of losing the account. So, the economic rationality that should lie behind equity and other forms of investment, doesn’t always work in the way that the economist assumes because the economist has not factored in the agency risk for the agent underperforming against expectation."

It seems to me that the problem that Mr Myners describes is not so much "inbuilt" but rather a direct consequence of the way fund managers are paid and of performance being measured over too short a timescale.

If I had my own money invested in a market that was still rising, but expected to fall significantly at some point in the next year, then I would clearly be looking to sell [Interestingly I did move significant personal money out of equities in June 2007!].

Surely then if I employ a fund manager to look after my interests then the fund manager should also be looking to sell my assets for me in this scenario. But Mr Myners points out that this strategy does not work for the fund manager because, if the market continues to rise for several months then the funds performance will look poor over this period, and the fund manager will lose his bonuses.

[I do worry that American stock values are currently propped up by fund managers looking at each others behaviour and all desperately hoping that they can get through to year end without a big fall. Should we expect a big fall early in the new year?]

It seems top me that there are two possible ways round this problem:
1) Stop all performance related pay for fund managers. They could be paid a flat salary and encouraged to take seriously their fiduciary duty to the underlying owners of the assets.
or
2) Require all performance related pay for fund managers to be linked to long term (five years?) performance measures, using a structure similar to the FILLIP described in Performance and Reward.

Obviously it is important that the people who hire fund managers also restrict their attention to long term performance. If they move their money too often they undermine the long term thinking of the fund manager. Mr Myners comments about developing the expertise of Pension Fund Trustees are important in this respect. However it is important that any "professionalism" in pension fund trustees stops short of giving them a vested interest in outcomes, or does anything to undermine their duties to the underlying owners of the funds.

Angela Merkel on executive pay

2007-12-04T13:36:00.000Z

Following Mangela Merkel's complaints about excessive executive pay, ft.com ran a discussion, "Are top executives paid too much?" This was my contribution:

Executive Pay by Patrick Gerard 03 Dec 2007 09:24 PM
Yes, top executives are paid far to much. As the FT front page and leader reported on 15th October, even US Corporate Leaders think they are paid too much. How have we got into this situation? There are several factors:
- conflicts of interest within a unitary board
- lack of focus on fiduciary duty
- the temptation to see salary as a quantifyable (but utterly flawed) measure of business success
- Remuneration consultancies who find it easier to sell services if they promote high rewards
- Increasing professionalisation and complexity in the pay setting process, preventing outsiders from making effectively comments
- The practice of comparing salaries and seeking to pay above median
- institutional investors being so well paid themselves that they can't complain about excessive pay in management

In the UK regulatory problems have also contributed:
- Almost all the top people in the Financial Reporting Council are people who have benefited from high executive pay
- A concenus approach to the definition of the Combined Code has forced it to collude with high executive pay
- A government too dependent on support from business to raise issues that business finds difficult

Is excessive executive pay really a big problem? Absolutely yes! It creates an environment in which a manager has to "play the game" of prioritising personal rewards over the financial health of the nation. Pay (specifically stock options) was a huge factor in the dot.com crisis and short term rewards were a big factor in the credit crunch. How long before top earners are allowed to distroy our economy?Angela Merkel is absolutely right to call for intelligent regulation of these matters. Business leaders should put their own house in order before the blunt instrument of regulation does it for them.

This appeared on ft.com at:
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?a=tpc&s=646099322&f=386092324&m=1781098751&r=1781098751
(subscription may be required)