Restructuring Executive Pay

Over the past months, shareholders have rebelled against company executives at annual meetings, forcing the reevaluation and restructuring of payment strategies.  On top of this, many banks are planning to claw back bonuses. HSBC, for instance, will rescind bonuses to pay fines associated with money laundering. JP Morgan will take away bonus payments from the London Whale to make up for trading losses.  

Compensation methodologies are currently being reformed. Ideally, the altered compensation strategies will ensure proper motivation for top executives; ensure a long-term perspective for investment/innovation/risk-taking; not adopt a simplistic view of how people will respond to financial incentives; and be simple enough for outsiders to understand.

Remuneration typically has three parts, a fixed salary, a cash bonus based on the year’s performance and a component based on long-term performance and incentives. In its current form, the annual bonus of FTSE 350 companies is typically around 200% of base pay salary. Bonuses are normally paid if certain benchmarks are met. Bonuses of this nature have also been criticized for encouraging risky behaviour in the short term, in order to meet or exceed benchmarks.

There are several strategies being considered to alter remuneration methodologies. 

1. The Kay review, a paper examining short-terminism in asset management, suggests that annual cash bonuses be abolished. Instead, companies should provide long term performance incentives and base pay only. Long term incentives should be given when leaving the company.
2. The European Commission has proposed limiting the bonus pay to 100% of base pay. 
3. Publish a single figure encompassing all forms of pay. 
4. Making shareholder votes more binding, such that shareholders must be consulted if a majority votes against the pay policy  

The problem with number one is that will likely lead to higher base pay.  If annual bonuses are 200%, base pay would be tripled in order to substitute what is lost. Yet, this option would at least increase transparency. Shareholders would vote on base salary and long-term incentives only.  By deferring long-term bonuses, companies would also align payouts with the overall results of a bank, rather than a single person’s track record (ideally).

The European Commission’s suggestion would likely have similar repercussions; base pay would increase to make up for the bonus limitation. It is also possible that companies paying out a bonus less than 100% of base pay would increase the bonus amount, as it would act as a form of anchoring.

Option three, which would increase transparency, could potentially hide the nuances associated with remuneration, and make it more difficult to determine the reasonableness of the pay. Yet, shareholders would have more power, which could be beneficial long term.

None of these options seems to be perfect. Perhaps the best option is a combination of the various strategies. For instance, a binding vote on policy, together with increasing transparency by requiring companies to publish bonus-to-salary pay ratios, while eliminating short-term bonuses for the sake of long-term compensation, is worthy of consideration. It would increase transparency and shareholder power and help eliminate short-term incentives. 

The psychology of executive remuneration

Executive pay across industries is facing criticism surrounding high salaries. This condemnation is especially true in the financial services, both in wake of the financial crisis and in light of an increase in their share of the wage bill. Indeed, the pay gap in the UK has widened significantly over the past thirty years. Someone in the 90th percentile in 1979 earned 2.5 times more than someone in the 10th percentile, now he earns 3.7 times more. 60% of the increase among the top 10% of earners is accrued to those working in the financial sector.

Much of this increase takes the form of a bonus. Originally, bonuses (performance pay) were designed to align the incentives of the executive with that of shareholders. It was meant to eliminate the principal-agent problem by aligning executive incentives to increasing company value. By reaching a certain benchmark, executives were given additional remuneration. This bonus was often given in the form of stock options or shares, which was meant to further goal alignment. Yet, this has not necessarily worked as meant. Performance pay has led executives to take unnecessary risks. Bonuses have been continuously paid even when institutions are failing. Salaries became a way for executives to judge themselves against their peers, rather than used as a judgment of company performance. 

There are two main problems with this theory, however. One stems from an incorrect view of human motivation. The second problem is associated with payment relativity.

Money is not the only motivation for workers. While bonuses have long been used to incentivize performance, large bonuses when performing cognitive tasks are actually counter-productive to performance. Research has shown that while financial incentives can motivate people to work, very large bonuses can hinder performance by causing stress involved in attaining it, the fear of not receiving the bonus and focusing attention on the bonus rather than the job at hand. 

The problem of compensation relativity is two fold. First of all, executives judge themselves against one another, and compete for highest salary. This leads to higher compensation demands, without the performance to back it up; meaning there is sometimes inconsistency between economic value added and pay. Payment relativity is also problematic when peer group comparisons are used to determine pay. Pay groupings are meant to provide information on appropriate salaries, providing boards with benchmarks, but often result in the inflation of executive compensation when peer groups with higher salaries are chosen. 

A third issue surrounding performance surrounds the idea of crowding out. Monetary incentives have been found to impact the intrinsic motivation of people, as motivation now comes from something external. As a result, people perform less well after monetary incentives are given. This is true regardless of the form of the remuneration (base pay versus bonus).

The regulation of executive compensation is an area currently being considered by regulators, central bankers and more. While regulators are focusing on the structure of pay packages from an economic perspective, they must also be careful to consider the psychology and utility of remuneration before altering the structure of executive payment. 

Social media and the stock market

The most significant trend affecting the financial services industry currently is increasing regulation. One of the main purpose of these new regulations (and new regulatory bodies) is to restore confidence in the market place. Social Media is the best way to reach investors, especially a new generation of investors, who are accustomed to receiving information faster, in different media platforms, and who are currently cynical of the financial industry. How can, will and should regulatory bodies and exchanges capitalize on this movement in 2012? The TSX already has a twitter page, for instance. What about an FSA Blog on upcoming regulations?

Consider, for instance, how online sentiment is already being used to predict market trends and stock prices. Social media can show attitudes “towards certain things and disdain for others, all the while displaying the overall appeal of a company.” As it turns out, this information can be incredibly influential in determining share prices. For example, the number of “followers” a company has is predictive of its valuation. More generally, the number and type of emotional words on Twitter can predict daily moves in the DJIA with almost 90% accuracy. (Personally, I’m curious how an analysis of facebook or blogs -- professional and laypersons -- would hold up). “Tweet” analysis is already being used by several companies. But, if companies begin mining for information online in order to conduct sentiment analyses, the likelihood of impulsive (or fraudulent) posts to have a meaningful (and potentially wrongful) impact is high. With social media increasingly prevalent in the world today, this risk is growing.

While one of the advantages of social media is the immediacy of information, the opportunity for mistaken stories to have a significant impact on a company’s stock is highly probable. What if major funds instantly relate to readers the trades they make?  Share prices have the potential to change drastically in a short period of time. This begs the question if social media, as it relates to the financial industry, should be regulated.  Won’t regulations of this nature have a negative impact on transparency and investor confidence… the reason for increased regulation in the first place? Clearly we’ve come full circle. Regardless, there are certainly ways for institutions and investors to further capitalize on this trend going forward.

What to expect from Solvency II

Demos meets with MPs Steve Baker and Matthew Hancock today to discuss Solvency II, new EU legislation providing a unified set of rules for insurance companies operating in the Europe. It aims to increase capital requirements and risk management standards across the EU, making the financial system more secure, increasing capital efficiency and improving the ease of doing business. Solvency II also aims to instill risk awareness into governance, operations and decision-making of the EU insurance and reinsurance businesses. It’s estimated that this will affect over 3,600 companies across 27 countries when this legislation comes into force in 2014. But while this means big changes for the whole sector, it will affect some countries more than others.

Major changes to international financial architecture do not come without costs.  A study by Accenture revealed that 30 per cent of insurance companies surveyed expect the cost of implementation to exceed €26m in the short term. Industry consolidation, another likely result of these regulations, is likely to harm UK consumers in the long run. Solvency II regulations may also negatively impact the revenues of insurance companies operating in the UK, as the new requirements make them less competitive against insurance companies abroad. 

Jackie Hunt, finance director at Standard Life, considers Solvency II changes to be “manageable.” Yet, Ms Hunt has also stated concerns that Solvency II is creating an environment where “European insurers are effectively disadvantaged” compared to those operating out of North America.

Insurers based in the EU may have to apply new regulations to their non-EU operations.  Specifically, the amount of capital required will be increased relative to underwritten risk, altering a company’s operational ability and how the company is able to use its deployable capital. Companies such as Axon, Aegon, Aviva, ING, Allianz and Prudential, which have large operations internationally could reasonably move their business outside the EU if regulations are too demanding. Prudential’s chief executive Tidjane Thiam stated he would consider moving Prudential’s headquarters abroad (probably to Hong Kong) depending on the particulars of Solvency II. Thiam specified that Prudential “wouldn’t be having this debate” without Solvency II. While “supportive in principle” of the regulations, the detrimental impact (including to invest in corporate bonds beyond a five year window) may be too much for the company to continue to head operations in the UK.

Even if insurance companies remain in the UK, the assets they purchase and the products they provide to consumers will be affected. For instance, Solvency II regulations will make Asset Backed Securities (ABS) less attractive. A movement away from ABS, will cause a reduction in market liquidity, and a widening of trading spreads in financial markets. More importantly, Solvency II limits the ability for banks to transfer risk through securitisation. 

While the Solvency II regulations are focused on insurance providers, they may have a spillover affect to pension companies.  Increasing regulation will increase the cost of holding extra capital. It is likely that these costs will be passed onto annuity pricing and force prices up. According to Delloitte, 36 per cent of insurers plan to re-price their products before Solvency II is implemented. Twenty six per cent of life insurance companies and 8 per cent of non-life insurance companies are planning on altering their product mix.

Many worry that Solvency II is stricter towards UK insurers. Over the years, European regulators have developed individually. One of the goals of Solvency II, is to combat these differences and increase coordination among regulators. Unfortunately, continental bodies tend to be more similar in their regulatory practices, as such Solvency II may hit UK companies particularly hard.

These negative effects may cause significant harm to the UK economy generally. According to the Association of British Insurers, the UK insurance industry contributes around £10.4 billion in taxes to the UK government, and employs around 290,000 people in the UK alone. The UK insurance industry is responsible for investments of £1.7 trillion (equivalent to approximately 25 per cent of the UK’s total net worth). 

As Britain continues to move towards isolation from the rest of the EU, any power the UK has is decreasing. Consider, for instance, Cameron’s veto of December 2011 EU treaty. This aligned many European leaders against Britain, leaving them to develop a new accord without input from the UK.  Last December Cameron also clarified that Britain's membership in the EU is based on its own interests.

While Cameron’s December 2011 veto of the EU treaty created a precedent for Britain to say “no” to the EU, many argue that it left the UK with less bargaining power. One industry insider stated that the veto created “a heightened sense of not wanting to do any special favours for the UK.” This creates increasing difficulty for Britain to influence the Solvency II capital regime.

Solvency II means big change, but the sector has yet to decide whether it will be wholly good or bad.  Some of the questions Demos will seek to answer in the APPG on Economics, Money and Banking meeting today are:

Are these potential negatives of Solvency II regulation enough for the UK to take action?

Is Britain focusing too much on potential negatives, and forgetting about the improved risk management and the safety effects of the regulation? (Solvency II aims, after all, to protect policyholders.)

Is Britain failing to protect the individual, choosing instead to protect big business? 

And what will happen to the UK if regulators and companies fail to apply EU law?

The truth about LIBOR

Last week, Barclays was fined £290m for its manipulation of Libor rates. While Barclays was the first bank fined, many have been implicated in the scandal. In an ongoing debate surrounding the trustworthiness of Banks and financial institutions, the recent rate manipulation by several banks provides evidence of a ‘culture of market manipulation’, which many argue exists in big banks. Indeed, this most recent scandal has pushed many over the edge, causing outrage and questions as to whether the financial system has become a ‘sewer of systematically amoral dishonesty.’

Libor is the London Interbank Offered Rate, or in more comprehensible terms, the rate banks charge one another for loans. In essence, it reflects the price a bank pays for money. The rate is calculated daily, based on reports from member banks. Barclays, as well as other institutions, manipulated this by submitting rates lower than the numbers they were actually using. Libor has the capacity to impact over $350tn worth of financial products globally, as it is commonly used as a benchmark rate for several products including home mortgages, corporate loans and interest rates on credit cards.

The manipulation made the banks appear more solvent during a time of crisis, making it look like they were paying less to borrow more and covering up the true level of the bank’s financial distress. Actual costs of the manipulation are yet unknown, but the FSA stated the bank’s actions ‘could have caused serious harm’ to other institutions and individuals.

The £290m fine given to Barclays by regulators in the UK and US is a record amount. RBS is expected to receive a £150m fine. HSBC, Deutsche Bank and Credit Suisse have disclosed they are ‘co-operating with regulators’ requests’, and over 20 banks (of the 40 banks that submit rates) have received subpoenas from regulators. RBS has already let go 10 traders involved in the scandal, and at least a dozen other institutions have fired or suspended employees.

Given a lack of information as to the actual costs, if any, of the scandal, the uproar surrounding the manipulation seems to be more a comment on a lack of confidence in, and a mistrust of, the financial services industry. The manipulation shows the bankers’ callous attitude. E-mails were exchanged promising champagne for the misreporting. That traders did not think they would be caught shows disregard for regulatory bodies and the internal systems of the banks. That they were willing to do it in the first place suggests a disregard for the Libor system.

Politicians and regulators alike have responded strongly. Labour leader Ed Miliband has called for a public inquiry into banking culture and practices and has pushed for a new code of conduct criminalising bankers’ abuse of the system. George Osborne has highlighted the inability of the FSA to prosecute the bankers for manipulating rates.

Yet, most responses seem to ignore the fact that information regarding Libor manipulation was known several years ago. Between 2007 and 2008, Barclays failed to act on three separate internal warnings surrounding false submissions. In 2008, the Wall Street Journal published an article alleging banks were submitting lowered rates influencing Libor downwards. Where was the uproar then? Who knew, and when? This Wednesday, Paul Tucker, deputy governor of the Bank of England, will appear in front of the Treasury Select Committee to answer questions along these lines, specifically regarding a telephone conversation ‘during which the external perceptions of Barclays' Libor submissions were discussed.’

So far, senior executives are not being forced to resign, although they will need to face questioning. Should they be forced to resign? Should they face criminal charges? And looking to the long-term, how can Libor, and indeed the financial system, be reformed so something like this does not happen again?