Does malus for executive pay and risk management work?
04/04/2019
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Procee­­­ding the global financial crisis, there has been a raft of changes to the compensation regulation schemes and practices for bankers. The European Union regulated an ‘incentive cap’ and ‘malus’. In addition, UK regulators implemented clawback provisions into regulation. Locally, malus features in most ASX 100 executive pay plans, although with limited application in most cases. APRA, ASIC and institutional investors are seeking, in various degrees, to beef up applications of malus.

The purported aim of incentive caps and malus is to avoid the excessive risk-taking and inappropriate behaviour.

A lab experiment by Qun Harris, Analise Mercieca, Emma Soane and Misa Tanaka from the Bank of England observed how risk taking and effort differ for various incentive structures.

They found that a proportional incentive with no malus for negative returns resulted in excessive risk taking. Malus and the implementation of a incentive cap (as it required in the EU for bankers) helped reduce risk taking behaviour, but this could be undermined by imposing minimum, but high, earnings targets. Meanwhile, there was some reduction on effort when an incentive cap scheme was used.

The outcomes of this work should be of interest to every ASX 200 board as they wrestle with risk management and absolute performance for an optimal risk adjusted return.

Experiment

The researchers conducted ‘lab experiments’ on 392 master’s students from the London School of Economics. They considered that the field experiment on ‘material risk takers’ would be too expensive, although they did not mention that a real world experiment would use other people’s money.

The students’ reward was based on investment returns on a portfolio they achieved relative to a benchmark return.

The control group was an unregulated incentive proportional  with profit (in this case investment returns above an established asset return benchmark). The control group only receives an incentive if there is profit. The schemes for other groups included either an incentive cap (applicable under EU rules) or a malus provision.

The experiment tried to answer the following specific questions:

  1. Does proportional-with-profit incentive, which pays proportionally to realised investment returns when the returns are positive but pays nothing when the returns are negative, encourage individuals to take greater risks than they would take if they had to invest their own money?
  2. Do incentive cap and malus mitigate risk-taking, relative to proportional bonus?
  3. Does the risk-mitigating effect of bonus cap and malus change when incentive is conditional on meeting an absolute or relative performance target?
  4. Finally, how do incentive cap and malus affect incentives to engage in project search effort?

Findings

First, a greater proportion of the participants in the control group chose to invest in higher risk assets when offered a proportional to profit incentive, than they did when asked to invest their own money (i.e. when they have some personal downside risk). This suggests that, consistent with the consensus in the regulatory community, the proportional incentive can indeed encourage excessive risk-taking.

Second, the incentive cap and malus treatment groups tended to choose lower risk assets than the control group, suggesting that, other things equal, such regulations on pay could help mitigate risk-taking.

Third, the difference in risk-taking between the incentive cap and malus treatment groups and the proportional incentive group weakened significantly when participants’ incentive was conditional on hitting a high absolute targets, or they have a relative performance target. This could suggest that the risk-mitigating effect of incentive regulations could be undermined through tweaks to parameters that are under banks’ control. That is, there is evidence to support APRA’s and the FSB’s contention that relative TSR incentives encourage excessive risk taking. Setting lower absolute performance bars for incentive purposes may also do wonders for risk management, but will not, however, be received well by many investors.

Finally, there was some evidence that the incentive cap group exerted less effort than the control group, although this was not the case for the malus group. That is, higher incentive opportunities do impact on effort.

Conclusions from research

Incentive caps reduce effort. Malus does not. Malus moderates risk-taking.

Relative performance targets increases risk taking. High absolute performance targets increase risk taking.

If incentives are linked to any high or relative performance targets any control on remuneration becomes less relevant. Employees will strive to meet the unrealistic targets instead. Hence regulators, boards and shareholders have to ensure that the targets set do not lead to a culture of excessive risk-taking. The regulators already think this way, and are about to act (see HERE). Investors do not act this way (see HERE). Boards, alas, need investors to support their companies, and are caught in the middle.

The paper can be viewed HERE .

© Guerdon Associates 2019
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