BNAs

Banking Report

Reproduced with permission from BNAs Banking Report, 98 BBR 733, 4/24/12, 04/24/2012. Copyright The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

2012 by

C O M P E N S AT I O N

Banking Compensation: Have The Regulators Gone in the Right Direction?

BY MIKE CURRAN TOWERS WATSON
AND

PETER GUNDY

n recent years, regulatory and political actions have forced a change in the banking business model and therefore its pay model as well. While the context for these changes is evident, what bears examination is whether these fixes are the right ones. Are they appropriate given business conditions? Are we better off for them? What might we do differently? And regardless, what are the short term and long term implications? This three-part series of articles will examine risk and its downstream implications from both a historical and a forward-looking perspective. Well examine how we ended up with the risk and reward model that was in place during the financial meltdown. Well also explore how companies have identified and mitigated negative aspects of their reward programs, and what best practices emerged as a result. And finally, well consider to what extent government reform has been successful and whether we are better off today than we were four years ago. Who are the winners and who stands to lose? Throughout, well examine how risk factors have contributed to a crisis around the attraction and retention for needed talent. For those who have come to this field with the promise of significant pay opportunities, times have changed (at least for now) and organizations need to take both a short- and long-term view on solving recent challenges to define their present and future workforce.

2011: The Year in Review

The compensation season has come to a close and the 2011 bonuses have been paid. Overall pay levels are Peter Gundy and Mike Curran are senior consultants with Towers Watson, a global professional services company.

down substantially after a tumultuous year that was punctuated by the continued debt crisis in the Eurozone. In 2011, financial performance for banks was mixed, but for most the year was generally mediocre for profits and stock prices. While as reported profits were up somewhat, most banks viewed operating profits as down relative to 2010 when taking into accounting adjustments, such as debt value adjustments. (See Exhibit 1 for a summary of banking industry performance.) In the run up to year-end 2011, much attention was focused on how the structure of incentive compensation is different than in years past, particularly in terms of how much of the incentive pool was going to be paid in cash versus deferred in stock or other vehicles. Some banks placed caps on the total amount that could be paid in cash. In most banks, at least 50 percent (and sometimes all) of a senior executives incentive was deferred and will be paid out over time. The structure of todays bonuses is the product of an intensive effort by banks to comply with the massive regulatory and legislative changes the industry has seen over the past three years. The regulations and legislation in the U.S. ranging from the Federal Reserve Guidelines on Incentive Compensation, FDIC regulations, and the DoddFrank Act have led to sweeping pay changes at all of the largest banks. These regulations have also been extended to regional banks in the U.S, and recent guidance suggests that 2012 may be the beginning of new pay requirements for selected insurance and asset management firms (so called Systemically Important Financial Institutions or SIFIs). While less proscriptive than some of regulations seen in the U.K. and the E.U., the U.S. regulations have pushed banks to assess the degree to which incentive plans reinforced excessive risk-taking; incorporate features into incentive plans that balance risk-taking and financial results; and incorporate risk-management and other control processes to support balanced incentive arrangements, including corporate governance policies and procedures (see sidebar on the current global regulations governing compensation).

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ISSN 0891-0634

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Exhibit 1: Performance Summary (2007 2011) Composite of 14 Leading U.S. Banks (2007 = 100)

Source: Bloomberg

The Banking Pay Model: An Historical Perspective

In our view, historians will look back on the changes that have occurred to the banking compensation model over the past three years as a significant marker for the industry. The evolution of the pay model in banking has followed key changes in the industry, accelerating with the repeal of the Glass-Steagall Act in 1999. The repeal of Glass-Steagall gave way to the Universal Bank (or vice-versa, as some industry observers believe that the creation of Citigroup forced politicians toward the practical abolition of Glass-Steagall). Clearly, the combination of previously separated institutions and the ongoing consolidation in the banking industry set in motion the concern that some institutions were indeed too big to fail. In any case, this chain of events created a regulatory and business environment ripe for accelerated change. How does this come to bear on pay? Prior to the 1980s, there were effectively two separate compensation models in play one for commercial banks and the other for investment banks. The traditional commercial banking pay model relied largely on base salary and very little on incentive compensation, steering prescribed and arguably more conservative behaviors. Investment banks, in contrast, maintained a highly leveraged partnership model that was based on allowing for significant rewards during the boom years and low rewards during the bust years. This was a commonly accepted risk scenario and understood to be part of the value proposition of working in this environment. DLJs public offering in 1970 set off a wave of IPOs for securities firms like Merrill Lynch and investment banks like Morgan Stanley. With these IPOs came an even more highly leveraged compensation model that
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included stock-based pay. As regulatory obstacles related to equity and corporate bond underwriting and trading were lifted, banks sought to compete head-on with investment banks for business and talent. This led them to adapt their pay models to be more competitive in structure and quantum with the investment banks. In doing so, competition for talent was further heightened, and the pay opportunities grew even higher for those with the most sought after skills. Given the contemporaneous business shift towards more structured and complex products, the professionals with the most desired skills were heavily concentrated in areas such as securitization and derivatives. The compensation system is/has been a reflection of the labor market for talent: There has been a high degree of willingness to provide large rewards for those who can generate significant current revenues as well as for those who create new products that will generate tomorrows revenues. This was a key element of the value proposition of working in this field and remains so today. While executive pay in the banking sector is well below several other industries such as energy and technology, compensation for staff below the executive suite is generally higher than in any other sector. Given the huge profit opportunities (at least historically) and the impact that a small number of employees can have on firm profits, it is no surprise that the labor market has been extremely competitive. Since employment costs are by far the largest expense item for every firm and since the average employee is so expensive, it should come as no surprise that in tough times the industry is quick to reduce head count even letting go productive well-trained employees knowing they will need to be replaced when the market environment improves. Paradoxically, the value (which quickly translates into cost) of these employees is so high that they
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2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC.

3 must be terminated in order to limit losses and show investors that management is doing something to address the expense side of the equation. This creates a riskpremium on compensation, since employees know that they are potentially here today, gone tomorrow. Finally, the investment banking industry historically lacked or made limited use of benefits such as pension programs in order to avoid building up deferred costs. Similarly, the lack of these benefits meant that no employee was wedded to their current employer in order to vest or accumulate a large pension. While this partly explains the higher incentive compensation levels, it does not of course square with the significant deferred expenses associated with stock programs (unless you consider three- to four-year year overlapping vesting programs to be less of a future drag on earnings and financial flexibility than a thirty-year pension obligation). politicians. The situation provided ample fodder for populist stump speeches that made villains out of the top 1% of income earners. While TARP (Troubled Asset Relief Program) provided liquidity for the banking system and signaled that the system was backed by the full faith and credit of the U.S. Government thus preventing a financial meltdown, it let politicians put their nose inside the tent on the issue of pay and more broadly on corporate governance in banks. The financial support brought with it immediate restrictions on compensation, including de facto pay caps for executives at the companies that were participating in the TARP fund. The ensuing regulations and legislation focused heavily on protecting taxpayers and, to a lesser degree (primarily through the Dodd-Frank Act) on protecting consumers. It also had the ancillary effect of helping quell the outrage that members of the public felt regarding these perceived excesses. It is less clear that the shareholders of the more stable banking institutions have benefited from the new rules. Indeed these shareholders may stand the most to lose going forward, both in terms of the incremental restrictions on business activities and from the reduction in the focus on shareholder alignment in pay programs. From a shareholder perspective, there is little in the regulations or legislation that speaks to the fiscal alignment of compensation relative to revenue, profits, or shareholder returns on a firm or individual basis. In fact, many regulators have identified equity awards awards that clearly align interests of employees with those of shareholders as accelerants poured on the fire of inappropriately designed incentive plans. They have viewed stock as having too much upside (particularly short- or mid-term) in relation to the longer-term downside risk to the financial system of taking on inappropriate and excessive risk. To summarize, the perfect storm is far from over.

Creating a Perfect Storm

Given the intense competition for the best talent, there has been little incentive for companies to rein in compensation due to the first-mover disadvantage of doing so. The best employees have proven that they will accept a modest pay cut or negative change in pay delivery mechanisms, but that they will quickly flee a firm that is out-of-line with its key competitors on either pay levels or vehicle. The attempts to revise Salomon Brothers pay programs in the early 1990s to align unit pay with unit performance was quickly abandoned as key staff showed their resistance to the change by joining competitors willing to offer new hire guarantees. Clearly, the overall market environment enables more or less of such movement at any given time, but the lack of true handcuffs in either a practical or psychological sense has limited any firms ability to retain key staff with pay programs much below market regardless of the firms near-term ability to afford those pay levels. All of these factors converged to create a perfect storm for risk and rewards. At the time of the financial crisis, banks and investment banks were more leveraged than ever before in both their business and pay profiles. On the pay side, overall pay levels increased from a few hundred thousand for a typical Managing Director in 1982 to multiple millions of dollars for the typical Managing Director in 2007. However, the fixed component (i.e., base salary) only increased from $100,000 to $200,000 in that same 25-year time period. On the business front, income from principal activities (primarily trading, but also private equity efforts) was overwhelming in relation to fee income and agency trading revenues at most organizations. Firms were becoming increasingly more leveraged right up until the beginning of the financial crisis in 2008. This model was not sustainable, and weve seen the fallout over the past several years.

Fast Forward to Today

In the past three years, banks have made significant structural changes to their incentive plans and control processes. s Bonus pools are funded in relation to risk adjusted performance metrics and, in many banks, can be further adjusted based on a qualitative assessment of the risks taken to achieve results; s Banks, at regulators behest, have identified material risk takers and designed special features for their incentive pay including minimum deferral rates and claw back or forfeiture provisions if future events/results show that risk was not appropriately considered; s Total compensation is down relative to pre-crisis levels and even down from 2010 levels and more incentive compensation is deferred, approximately twice as much relative to pre-crisis plan designs (see Exhibit 2 for five-year trend in compensation); s Governance and oversight has improved at both the management and Board of Director levels; and s The overall culture within banking organizations has evolved and is more attuned to risk management.
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Pay: The Smoking Gun

The beginning of the end of the industrys pay model can be traced almost to the day Lehman Brothers failed (Bear Stearns had been purchased by JPMorgan Chase months before). Almost simultaneously with the government stepping in to assist the banking industry, political sights were set on compensation. The fat bonus checks, the millions spent on lavish office remodeling and other perceived excesses were an easy target for
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Exhibit 2: Declining Pay Levels and Less Paid in Cash Total Compensation Trend for Managing Directors Pay Levels and Cash vs. Deferral Split (2007 = 100)

Covers Capital Markets functions (i.e., investment banking, fixed income, equity sales & trading, equity finance, equity research) at eleven global universal banks. Source: Towers Watson

At the same time, due to higher capital charges and liquidity requirements, there are noticeable changes to the banking business model. These changes include a shift toward businesses with lower capital requirements such as private banking; a substantial reduction in proprietary risk-taking due to both regulatory and capital considerations; shifts in revenue mix away from the investment banking segment to consumer and wealth management segments; lower returns as measured by ROE; and reductions in head count and other costs particularly in the impacted business units.

Have The Regulators Gone In the Right Direction?

Some politicians, economists, and bankers have argued that there was no need for regulation and that the market should have been left to work including the inevitably failure of weaker institutions. However, it is hard to imagine that we would have emerged from the financial crisis which created substantial damage to the global economy and seemed to threaten a complete melt down without any regulation at all. Others argued that intervention (both immediately and through regulation) was necessary, but not to the extent seen. As might be expected, many in the banking industry have identified issues with the specific form of regulation and wonder whether they truly address the stated concerns associated with incentive plans (i.e., that they incent inappropriate or excessive risk taking). Over the last forty years, the typical cycle in the banking industry has been that the business model changes first and the compensation model adapts to the new
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business model. In this crisis, undoubtedly due to the political influence of the bailout, changes to compensation programs have been contemporaneous with or even preceded changes to the business model. What unintended consequences can we expect from this shift in the normal evolution of pay models? Do we have a mismatch of pay model versus business model? Was it wise to have changed the pay model without understanding the impact of the changes to the business model? Our perspective is that we dont see this as a sea change in the way business gets done but then again, companies have responded to this crisis differently than from others in the past. This case is unique; its not fully clear whats been fixed. Time will be the best judge. In the next article in this series, well look at how this climate has impacted several aspects of companies reward programs, how theyve dealt with those challenges, and what best practices have emerged as a result.

Sidebar: Compensation Regulations An Overview

In the wake of the financial crisis, numerous agencies around the world began to consider how compensation should be regulated. Today, each country has adopted their own regulatory requirements using selected portions of the different guidance that has emerged over the past several years and there are indeed differences by country. For organizations that operate in multiple countries, as all major banks do, this has made for a complex exercise in compliance. Banks must follow the
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Country Switzerland Authority/Legislation FinMa-circular 1 0/1 (Oct. 21 2009) Key Provisions Principle-based approach that follows the guidance of the FSB

Germany

Instituts Vergtungsverordnung (Oct. 13, 2010)

France

Enacted CRD III

Spain

Enacted CRD III

Follows the approach developed by CEBS in the Capital Requirements Directive III (July 2010) Must identify material-risk-takers (Identified Staff) Incentive plans for Identified Staff must include: Risk adjusted performance measures taking into account the cost of capital Payment awards in prescribed proportions of cash and instruments Prescribed minimum deferral and retention periods and vesting schedule Claw back policies Formal policies on caps A requirement of a fully flexible bonus policy (i.e., no minimum bonus levels) Additional rules apply to the composition of the Remuneration Committee, personal hedging policies, severance, and pension design

United Kingdom

FSA Remuneration Code (Dec. 17, 2010)

U.S.A.

Dodd-Frank Act (Jul. 10 2010) FDIC Proposed Rules (Mar. 2011)

Principle-based approach that follows the guidance of the FSB Dodd-Frank Act limits the types of performance measures that can be used for mortgage originators FDIC rules propose a mandatory three-year deferral for executives and key employees of organizations with over $50 billion in consolidated assets

regulations of their headquarters location primarily, but must also comply with local regulations of the countries in which they operate. The Financial Stability Board, created in 2009 as the successor of the Financial Stability Forum, provided the initial public influence of the current regulations when it adopted the Principles for Sound Compensation Practices in April of that year (and later that year with its Implementation Standards). In essence, the FSB Principles for Sound Compensation Practice engendered three broad concepts: 1. Effective governance of compensation: s A firms board of directors must oversee the design and operation of the compensation system. s A firms board of directors must monitor and review the compensation system to ensure the system operates as intended. s Staff engaged in financial and risk control must be independent, have appropriate authority, and be
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compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm. 2. Effective alignment of compensation with prudent risk taking: s Compensation must be adjusted for all types of risk. s Compensation outcomes must be symmetric with risk outcomes. s Compensation payout schedules must be sensitive to the time horizon of risks. s The mix of cash, equity and other forms of compensation must be consistent with risk alignment. 3. Effective supervisory oversight and engagement by stakeholders s Supervisory review of compensation practices must be rigorous and sustained, and deficiencies
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6 must be addressed promptly with supervisory action. s Firms must disclose clear, comprehensive and timely information about their compensation practices to facilitate constructive engagement by all stakeholders. The FSB principles were considered by local agencies such as the Financial Services Authority in the UK, the Federal Reserve Board in the U.S., and the Committee of European Banking Supervisors in the Eurozone as they developed specific regulatory guidance in the years that followed. What has set the regulatory standards in different countries apart from one another is the degree to which they provide a principles versus rules-based standard for compensation or not. In general, the regulatory standards of North America and Asia have been principles based and not overly proscriptive (although recent agency proposals have introduced specific mandates for pay deferrals for executive officers and key employees and the Dodd-Frank Act does prohibit the use of certain performance measures for mortgage originators). In contrast, U.K. and E.U. regulations have been heavily laden with rules prescribing the manner in which incentive compensation may be delivered (i.e., cash versus deferred, types of deferral vehicles). The table below highlights the regulations in force in selected countries, along with some of the pay-related provisions. There is a continued effort to reform compensation in banking, much of it building on the existing legislation (as seen in proposals such as CRD IV). However, much of the action these days seems to be on extending these rules to other sectors of financial services. In late 2011, the U.S. Financial Stability Oversight Council outlined six categories that would be used to determine which other systemically important financial institutions (SIFIs), such as insurance companies and asset managers, would be subject to similar compensation regulations as banks. Proposals in Europe are also setting their sights on other financial sectors, such as Solvency II (target insurers and reinsurers) and AIFMD (targeting alternative investment fund managers). As yet, none of these new proposals introduces substantially new limitations on compensation not seen in banking. It may well be that we have seen the extent of regulatory intervention on the structure of compensation.

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2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC.

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ISSN 0891-0634