The future of banker compensation

The compensation landscape at financial institutions is undergoing dramatic change. New approaches to remuneration are being implemented to comply with changing regulations and drive long-term business success.

In recent years, banker compensation has been under unprecedented scrutiny. While few believe that compensation was a major cause of the global financial crisis in 2009, banker bonuses continue to be widely debated.

Two key forces are driving the change in the landscape for banker compensation. Firstly, regulators are focused on the structure of rewards and want to ensure that excessive risk-taking is not rewarded. Regulators note that broad risk reform must be supported through compensation plans.

Secondly, politicians are focused on finding ways to rein in what they, and the general public, consider to be excessive pay levels. In particular, high pay is not tolerated in the wake of the global financial crisis, considering the huge cost to the public treasury to underwrite banks that they had to save.

Financial institutions (FIs) face challenges in achieving the right balance between profit, growth and risk management. They need to define their risk appetite and work with employees to maximize growth and profit within this framework.

Historically, there has been very little awareness among employees of how individual decisions could impact the organization. Most would not get actively involved in risk management.

Post-crisis, there is awareness that everyone in the organization has a role to play. New ways of thinking are required to take advantage of all possible synergies. One key synergy is compensation. An FI’s compensation approach must support its risk control processes.

As the Basel Committee on Banking Supervision said, “For a broad and deep risk management culture to develop and be maintained over time, compensation policies must not be unduly linked to short-term accounting profit generation.” To do so, FIs must ensure that bonus pools reflect the cost of capital used to generate returns and pay practices support smart risk-taking.

Capital-charging business and bonus pool

Profits earned through high-risk activities are less favorable than those earned from low-risk activities. However, in many incentive plans, all profits are treated equal.

The Financial Stability Board (FSB) regulations require performance measurements to include risk adjustments that reflect the cost and quantity of capital consumption and liquidity risk. FIs implement this through a risk-adjusted profit measure or a discretionary overlay to adjust bonus pools.

Regardless which performance measure is selected, boards are retaining more discretion in bonus payout.

Pay practices that support smarter risk-taking

The FSB principles and implementation standards are changing the rules on compensation globally.

Fixed remuneration

There is now pressure to ensure a right level of remuneration mix between fix and variable components. New restrictions on variable remuneration require higher levels of deferral. This, together with bonus reduction in 2009, has made many FIs relook at their remuneration mix.

Short-term incentives

The biggest change to short-term incentive plan structures is the requirement for clawback or malus clauses. Clawback policies vary between companies, but most allow for discretionary adjustments to reflect significant financial misstatements and some forms of ethical misbehavior. In addition, many FIs provide deferred compensation in the form of equity.

Long-term incentives

The introduction of deferred compensation through equity has allowed the provision of long-term incentives to management through annual bonus. Companies also make sure that all awards in shares or share-linked instruments are subject to an appropriate share retention policy.

Guaranteed payments, sign-on bonuses and buyouts

Previously, guaranteed bonus was used by most companies to attract and retain key talent, but global regulators now realize that this is not a prudent practice. Companies with such policies are limiting guarantees to 12 months or using alternative options. Similarly, sign-on bonuses now often include performance conditions and clawback clauses.

Post-employment contractual payments

Lavish post-employment compensation is also under the spotlight. Companies have started re-examining their arrangements to ensure alignment with long-term value creation and prudent risk-taking. Such payment should be related to long-term performance and does not reward failure.

Is pay too high?
Much of the political debate is centered on the issue of “excessive compensation”. Many FI directors share this view. The two factors that are pushing pay levels high are:
► Overpaying the middle 80%. Most directors agree that the issue is not paying the top talent. Rather, it is in overpaying the middle 80% that didn’t perform to justify high bonuses.
► Excessive dependence on lateral hires. Most replacements are sourced from other FI firms resulting in a pay premium. It becomes a game of musical chairs where there is little emphasis on growing and retaining talent. A culture shift is required for managers to invest more time in developing people.

Effective board oversight
Today, FI compensation committees spend more time on pay matters and look more broadly at pay. A focus on top executives is no longer sufficient. Compensation committees dig deeper into the organization’s pay philosophy, actual remuneration for the top groups of employees who take on significant risk, pay mix, and design of various incentive plans.

For many FIs, this is the first time risk professionals are formally called upon to evaluate and comment on the “riskiness” of pay structures.

Alignment with customer value
While there has been focus to ensure compensation does not encourage excessive risk-taking, there is a strong business case for broader change. By simply modifying compensation plans to comply with the new regulations, FIs are not implementing practices that influence customer loyalty.

In reality, what the customer wants is often different from the messages sent to employees through compensation programs. Commission plans are a prime example -- they reward product-pushing and churn.

HR should relook at how value can be realized through people by
► Thinking outside the box on who’s hired
► Innovating how capability is built
► Sending the right messages and driving critical behaviors through compensation

Moving forward
FIs continue to face challenges in reviewing and adapting their remuneration practices. These challenges include having to satisfy local regulatory requirements, support the strategic goals of the business and continuing to keep remuneration affordable.

The challenge for FIs is to go beyond the compliance-only mindset to building compensation programs that drive true competitive advantage. This takes the organization from simply being able to pay to beating the competition and win.