Has banks’ bonus culture really changed?
Today’s the big day at Goldman Sachs. Employees of the so-called Vampire Squid will find out whether they’re getting a bonus for last year’s performance and, if so, how much. For what it’s worth I’ve heard rumors from the firm’s own employees that 40% of staff will not be getting bonuses this year.
Here’s how the compensation picture looks to be shaping up so far for the major Wall Street houses.
And since JPMorgan Chase releases division-specific information on compensation and staffing levels, we can see how the average pay for an investment banker stacks up to the average pay for all the other kinds of employees:
Remember early 2009, when the air was heavy with the fear created by the collapse of Lehman Brothers, the near-collapse of AIG, the fire sales of Bear Sterns and Merrill Lynch, the worst week in history for the U.S. stock market’s Dow Jones average, the banking-induced collapse of Iceland, the failure of Northern Rock the year prior and the persistent worries about the health of all major banks everywhere? Well it was in these tense times that leaders of the Group of 20 nations met in London and endorsed, among other things, the Financial Stability Forum’s (FSF) Principles for Sound Compensation Practices. Why? Because all of the leaders of the most important countries in the world agreed that “compensation practices at large financial institutions were a key contributing factor to the global financial crisis.”
The G20 endorsed 9 principles to encourage “prudent risk-taking”:
- Compensation should not be controlled by the chief executive officer and management team. Boards of directors with independence and expertise in risk management and compensation should call the shots.
- The boards should regularly review the compensation system to make sure that it operates as intended.
- Financial and risk control staff must be empowered and also compensated generously and in a manner independent of the business areas they oversee.
- Compensation must be adjusted for all types of risk. For example, 2 employees who generate the same profit but take different amounts of risk should not be treated the same. And risk adjustments should account for all types of risk, including things liquidity risk, reputation risk and cost of capital, which are more difficult to measure.
- Bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.
- Payouts should be sensitive to the time horizon of risks. Final payments should not be made for short periods where risks are realized over long periods. Payouts for income that cannot be realized or whose likelihood of realization remains uncertain at the time of payout should be questioned.
- The mix of cash, equity and other forms of compensation must be consistent with risk alignment and driven by clear rationale.
- Banking supervisors should include compensation practices in their risk assessment of firms.
- Firms must disclose clear, comprehensive and timely information about their compensation practices to facilitate constructive engagement by all stakeholders.
There’s nothing earth-shattering here. In fact, it’s hard to believe that these principles were not already in force prior to the crisis.
Last October — two years and six months after the principles were first endorsed — the FSB issued its second report card on the progress made by supervisors and banks in implementing them. It based its assessment on the responses to a survey it gave to the banks and banking supervisors. The following is quoted verbatim.
- Only a few firms […] provided detailed information on the expertise and experience of the members of the remuneration committee.
- The vast majority of respondents indicated that the remuneration for employees in the risk and function is determined independently. However, the [survey] responses are not always clear with respect to their ability to override decisions or pressure from the revenue producing functions.
- Firms vary in the extent to which they use flexibility offered under accounting rules to limit recognition of revenue for purposes of incentive compensation until the payment is received.
- The determination of individual employees’ performance and compensation at large internationally active firms is largely a discretionary process, although the level of discretion varies significantly.
- Although good progress has been made by the large internationally active firms, some existing practices and circumstances may potentially undermine the effectiveness of measures for aligning compensation with risk and performance.
- First, some firms allow a relatively high level of discretion for performance adjustments of both the current bonus pools and individual pay awards. In these cases it is not always clear if the criteria for discretionary decisions are determined at the beginning of a bonus season so that these criteria could have a positive effect on staffs’ behaviour and if there is transparency of the decision-making processes to ensure an effective and consistent performance adjustment.
- Second, some firms have implemented malus and/or clawback arrangements with high activation barriers for adjusting deferred compensation with risk outcome. These provisions are only triggered in the event of material losses, limiting the necessary sensitivity of compensation with risk outcomes.
The report makes it clear that the process by which bonuses are awarded are still something of a black box.
Overall, the practices of the 20 large internationally active firms for aligning compensation with performance and risk outcomes can be considered as generally consistent with Principle 5 and Standard 5. However, few details were provided in respect of the decision-making process and the exact linkage between the performance results of the firm, the different business units and the pay awards for the individual employees.
We’re more than 3 years out from a crisis caused in part by these very same decision-making processes on compensation. So why is it that we don’t fully understand them yet?