Global Banks at a Strategic Crossroad

In Q1 and early Q2 2014, SSgA actively engaged with 15 global banks ahead of the proxy voting season. These engagements were conducted jointly with members of SSgA’s investment and governance teams. Our engagement addressed specific governance issues at each bank and also encompassed a wider discussion on the changing regulatory landscape and its impact on business strategy, capital requirements, operations and risk management, and the bank’s global footprint. Below we have provided the perspectives and insights gleaned from our engagement activities with banks this year.

SSgA’s Active Engagement with Global Banks in 2014: Challenges and Perspectives

Impact of Divergent Regulatory Frameworks on Strategy, Talent Retention and Pay Structures

2013 was a watershed year in terms of the plethora of rules and guidance that were finalized by bank regulators on a variety of topics. These ranged from capital structure to governance around pay disclosure for banks. As a result, while the fog of regulatory uncertainty is lifting for banks, it has also required bank boards to reassess their existing business strategy in light of the new requirements and its impact on future capital adequacy ratios, outlined under the Basel III regime. Rules that seek to reduce the systemic importance of banks have also placed limitations on the scope of a bank’s business and in some instances have required a bank to raise additional capital.

In addition, routine stress tests by central banks have added an additional dimension to the reputational risks facing banks.

Contrary to coordinated actions taken by regulators during the financial crisis, some of the new regulations are not harmonized. This has resulted in banks facing different regulatory requirements in different markets. From a governance perspective, regulation on pay is one of the biggest areas where geographic difference has had an impact upon the structure and limits on executive compensation and senior employees deemed to impact the risk profile of the bank. For example, under the Capital Requirements Directive, variable pay at banks operating in the EU is capped at one times fixed pay for certain types of staff such as senior management and risk takers. This ratio can be increased to two times fixed pay if approved by shareholders. As a result, several EU banks have had to increase base salary and enhance pay disclosure while also going to shareholders to get higher compensation thresholds approved. In contrast, US and Asian banks are less regulated with respect to compensation issues. This dichotomy in regulation has created an uneven playing field for European Banks, heightening the challenges of talent retention within critical business divisions.

Engagement Perspectives

As part of our engagement with the Chairmen of banks, we delved deeper into the long-term strategic plans that the boards had developed for their companies. Based on our analysis, global banks fall into two categories:

• 1. Banks that believe that the current environment is part of a cyclical pattern, which requires them to manage their existing business through the current challenging cycle; and
• 2. Banks that believe that the industry is undergoing structural change, which requires them to reassess their overall strategy, realign market expectation with regard to future earnings, and undertake significant structural changes to their business operations and scope.

Banks that fall in the first category have focused their strategy on cost cutting, margin expansion, and retention or growth of market share or the strengthening of their position in certain market segments. On the other hand, banks that fall in the second category are more focused on restructuring their overall business by divesting certain business divisions and strengthening their product offering in others. In some cases, these business changes are designed to help transition these banks into becoming higher dividend paying companies.

With regards to remuneration matters, we find that regional regulation—and more importantly, the social and political discussions around bankers’ pay—have a significant influence on the structure and quantum of senior executive pay at these companies.

While SSgA is sympathetic to the need to protect bank franchises which are highly dependent upon retention of key talent, we also recognize that pay models previously adopted within the industry were flawed and continuing to operate on a business-as-usual basis is not an option. As part of our analysis on remuneration reports and policies, SSgA evaluates each pay proposal on a case-by-case basis. When making our voting decision, we consider regional regulation and sensitivities around pay in the context of a bank’s global positioning. We also evaluate the quantum of pay, the drivers for short-term and long-term remuneration in the context of competitive pressures and need for talent retention, particularly at the time of restructuring. Importantly, SSgA will look at trends in the ratio of profits distribution and the extent to which the bank is able to deliver on their return on equity targets.

Mitigating Reputational Risk from Ongoing Investigations and Litigation

With increased regulatory scrutiny, bank boards have been constantly challenged by investigations into business practices at their institutions. Several board members have cited reputational risk as an ongoing concern during engagement. Furthermore, the recent spate of multi-billion dollar settlements has focused the market on the serious financial consequences of unethical practices and breaches of international codes. As a result, bank board directors have reported increased interaction with regulators, particularly when it comes to ongoing investigations and litigation settlements.

Engagement Perspectives

Investor concerns persist regarding robustness of internal controls in light of continuously emerging regulatory investigations. In addition, reports of fraud or questionable practices in bank subsidiaries located in emerging or non-core markets raise further concerns on the overall culture and ethics within an institution.

SSgA engages with banks to assess the level of board involvement in understanding and molding company culture. We believe that culture and ethics in organizations is driven by the ‘tone at the top’ and that the board plays a vital role in influencing the prevailing culture in a bank. We expect banks to have robust disclosure of their policies and code of conduct. We assess practices such as ongoing ethics training, and level of board oversight on compliance matters. In the current environment, SSgA has also been inquiring about the board’s supervision of ongoing regulatory investigations and litigation settlements. We believe that non-executive directors should be involved in and updated on all open investigation and ligation settlement matters on a frequent basis. At banks where the positions of chairman and CEO are combined, we expect that the lead director be made responsible for the oversight of these issues.

Further, the high quantum of fines and settlements has brought additional focus on the need for well-developed malice and claw back provisions in senior executive pay. However, these provisions are applicable on a forward looking basis and do not apply to past practices. While analyzing senior management compensation at banks that have agreed to large multi-billion dollar settlements, SSgA evaluates if the current management was in place at the time the alleged malpractices were perpetuated. SSgA believes that managements which were responsible for past governance failures should not be additionally rewarded for reaching a settlement with regulators.

Steering Banks Through the Uncertain Economic Environment and Complex Geopolitical Risks

A continuing challenge for bank boards is developing long-term strategies in an uncertain global economic environment. The global economic and financial system, still recovering from the 2008–09 financial crises, is facing additional uncertainty from various developing geopolitical risks such as increased risk of action by the US and EU against Russian banks and companies, skirmishes among Asian countries on border issues, and political unrest in the Middle East. In addition, growing competition from a shadow banking sector which is minimally regulated and the continuing possibility of cyber security attacks, compound the business complexity facing global financial institutions.

Engagement Perspectives

In order to gain confidence in a board’s ability to lead a business through an uncertain environment, SSgA analyzes and evaluates a board’s composition. We assess the diversity of skills, gender and expertise on the board, in the context of the risks and challenges facing a bank. SSgA also assesses the oversight provided by the board and its board committees, and engage with companies to discuss board evaluation processes in place. We try to understand the mechanisms though which a company plans for the long-term succession of its directors and executives.

Finally, SSgA also analyzes a board’s governance structure, particularly the checks and balances in place to limit concentration of power among one or few individuals on the board. While evaluating proposals on separation of chairman and CEO positions, SSgA engages with the company’s Lead Independent Director, to assess if the individual and responsibilities assigned to the position adequately serve as a counterpoint to the combined chairman/CEO position. We also consider other factors such as company performance, board structure, director’s skills, duties and tenure, shareholder rights, executive compensation, CEO succession policies, and historical board and board committee performance in making our voting decisions on such proposals.

Conclusion

As part of our stewardship responsibilities, SSgA engages with banks to discuss a wide range of business issues. Our engagement informs our voting decisions and helps us analyze specific governance concerns through the prism of macroeconomic, regulatory and competitive challenges facing banks, which have a significant impact on the long-term strategy and performance of these institutions. Finally, our voting decision is based on our overall assessment of the nature of collective actions taken by boards, the willingness of non-executive directors to engage with large institutional investors, and a board’s receptiveness and responsiveness to investor concerns.

The complete publication is available here.