Promising Steps on Bank Pay Reforms

Despite greater regulatory oversight and smaller payouts, compensation in the financial sector continues to attract scrutiny and criticism. Yet, an examination of pay reforms at some banks suggests a strengthening alignment of interest among executives, their firms, and wider society.

First, owing to new regulations, a greater proportion of bankers’ pay is exposed to longerterm performance outcomes of their firms. Last December, the Committee of European Banking Supervisors (‘CEBS’) finalised rules requiring 40-60 per cent of executives’ variable pay to be deferred for three to five years and at least 50 per cent of it to be in stock. Equally, CEBS regulations limit upfront cash payments to 20-30 per cent of total remuneration.

Although US regulators have historically been reticent to regulate executive pay, the Federal Deposit Insurance Corporation is proposing to introduce similar requirements at US financial institutions.

Importantly, some banks are going further. Whereas share awards at North American and Western European financial institutions typically vest over three years, one European bank has proposed lengthening the vesting period for restricted stock to the later of five years or an employee’s retirement from the firm.

Across the Atlantic, JP Morgan has raised the proportion of deferred compensation paid in equity from 50 per cent to 75 per cent or more for top management. It also requires these executives to retain 75 per cent of vested shares.

In explaining their decision to defer a greater proportion of variable pay than is legally required, the remuneration committee chairman of a UK bank declared that ‘the goal is to make people think long-term’.

Second, there is a greater emphasis on evaluating performance and payouts through a multi-year lens. At one global European bank, the compensation committee takes into account the firm’s performance over the past three years when awarding restricted shares to executives.

Furthermore, under European regulations, bankers’ deferred pay is subject to adjustment (‘clawback’) if there is subsequent deterioration of firm or business unit performance, discovery of misbehaviour or serious employee error, risk management failure or other adverse developments.

In terms of policy, some bank boards have given themselves discretion to reduce bonuses all the way to zero.

At some financial institutions, employees who leave the firm will continue to have a portion of their pay at risk. At UBS, deferred cash bonuses for departing executives will remain subject to forfeiture – for such reasons as material restatement of financial results or harm to UBS’s reputation – for up to two years after the end of their employment. At Canadian Imperial Bank of Commerce, the CEO’s unvested share awards will not pay out if, after his retirement, there is a significant financial restatement pertaining to the period in which he served as CEO.

Third, risk considerations are now better incorporated into compensation arrangements. This exercise, however, remains challenging and imprecise.

Operationally, many bank boards are spending more time linking pay to risk appetite and outcomes. At a European financial conglomerate, the risk function has a more direct input into the remuneration process. Its staff participate regularly in compensation discussions and produce a separate risk report for the remuneration committee. The committee chair noted recently that ‘the degree of oversight and depth of analysis on risk is much greater today’.

At a Canadian bank, the chief risk officer helps the compensation committee to calibrate annual bonuses by presenting a report at year-end comparing risks taken during the year to the risk appetite approved by the board and identifying future risks that may arise from decisions taken that year.

In addition, risk-related metrics – for example, return on risk-weighted assets – appear to be employed more widely to determine the size of variable pay and extent to which restricted shares will vest.

Notably, a few European banks are discarding the performance measures most favoured by institutional investors – total shareholder return (‘TSR’) and earnings per share (‘EPS’) – because they believe these metrics are less appropriate for the financial sector and may induce undesirable behaviour. One remuneration committee chair has complained that TSR tends to reward volatile performance but not consistently good results and EPS does not take into account risk.

Due to the high leverage of banks, a few institutions are considering paying executives with non-equity instruments – including contingent capital bonds – to incentivise executives to preserve enterprise, rather than solely shareholder, value.

To be sure, problematic remuneration practices remain. For example, revenue is still used to determine annual bonuses at some banks. Moreover, contrary to European practice, restricted stock awards at most US financial institutions are not subject to performance-based vesting conditions, such as a minimum level of economic profits.

It also remains to be seen whether bank boards will have the courage to preemptively adjust pay when risk concerns arise, particularly at the top of the business cycle when the pressure to compensate competitively is greatest. Given the moral hazard and excess profits arising from implicit government support of large banks, pay caps may be needed to temper excessive risk-taking.

While their ultimate effectiveness will not be known for years, the progressive steps taken by some financial institutions provide a reason for optimism that their compensation arrangements will not pose the same danger to systemic stability as in years past. Other banks should take note.