Is a reminder needed to incorporate risk management into executive pay?

Long before the credit crisis we wrote that boards should take account of risk in setting incentive plan metrics.

Unfortunately some overseas banks did not subscribe to our newsletters.  UBS is a case in point. The “conservative” Swiss banking giant wrote down a previously unimaginable US$37 billion dollars. With assistance from KPMG, they have put together a 50 page report detailing the hows and whys UBS took such a huge hit.

For what you would expect to be a dry report, it is compelling reading. It explains much more than the sub prime fiasco. The report implies that management did not really understand what they were getting into (especially with their purchases of Warburg/Dillon Read Capital Management. This unit eventually became UBS’ internal hedge fund). 

Of interest is that they attributed much of the cause to their executive compensation system.  Here is an excerpt:

“UBS has identified the following contributory factors related to compensation and incentives:

• Structural incentives to implement carry trades: The UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha (i.e., return in excess of a defined expectation) versus the creation of return based on a low cost of funding.
• Asymmetric risk / reward compensation: The compensation structure generally made little recognition of risk issues or adjustment for risk / other qualitative indicators (e.g. for Group Internal Audit ratings, operational risk indicators, compliance issues, etc.). For example, there were incentives for the collaterallised debt obligations (CDO) structuring desk to pursue concentrations in Mezzanine CDOs, which had a significantly higher fee structure (approximately 125-150 basis points) than High-Grade CDOs (approximately 30-50 bp).
• Insufficient incentives to protect the UBS franchise long-term: Under UBS’ principles for compensation, deferred equity forms a component of compensation that generally increases with seniority. Essentially, bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings.”

The full 50 page report can be found HERE.

UBS was not, unfortunately, alone in both suffering significant write-downs and attributing cause at least in part to the compensation system (see our article HERE).

That executive pay was a contributor to the global credit squeeze was acknowledged recently by Reserve Bank Governor Glenn Stevens.  He gave the keynote address at the 150th birthday dinner for Bendigo Bank on 9 July 2008 (see HERE).  It was interesting (at least to us) because he recited the views of his overseas counterparts on the causes of the credit crises now engulfing the world and what needs to be done. 

There were four.

In setting out what needs to be done to repair major international financial institutions, Stevens listed loss recognition, risk assessment and capital adequacy, and then added that managerial incentives need to be “more carefully structured”.  He is referring to incentive pay that for the most part was based on short term earnings results, with little or no balance being provided by clawback arrangements, long term incentives, or risk management.  
Before the credit crisis we had pointed these things out, and urged companies and boards to consider these (e.g. see one of our clawback articles HERE, and the need to incorporate risk as well as return into executive incentives HERE).

In Australia, for the most part, our bankers have not been subject to incentives driven primarily by short term earnings, unlike the US.

When David Crawford completes his report on the ANZ-Opes affair it will be interesting to see what sort of conclusions, if any, he reaches on the reward system used by the bank.

Nevertheless the management reward systems adopted by Australian banks helped them avoid US-style excesses.

Conversely, it could be argued that the rewards at Australian listed property trusts were often driven off increasing the size of the assets managed.  So for property trusts that had incentive plans based on earnings growth without adequate attention to their capital base there was motivation to increase the size of a fund with very little regard to the impact of gearing levels on long term performance. This has contributed to the mark down in value of these local trusts.  Just as inappropriate reward systems have been a disaster in the US, they have had their presence felt in Australia to an extent.

While it may be too late for many industries, we note that some sectors of the economy are still healthy. In particular the mining industry is booming.  But while the boom probably has a while to run we suggest that even mining company boards may need to consider incorporating risk management into their remuneration structures more effectively, given that: 

• Commodity prices are currently about twice their previous cyclical peaks.  As commodities underpin almost everything sold, this is having an impact on inflation.  As a result, commodity prices are now directly reducing demand and consumer confidence.
• When the clerk at the post office dispenses free investment advice by telling us that mining stock prices can only go higher it suggests that the market has almost run its course.
• The world’s economy is slowing.  Commodity prices follow economic outcomes.  Right now, the economic forecasts are all pointing the wrong way.
• Lastly, there is burgeoning supply.  Infrastructure bottlenecks are being overcome, new production resources are on stream.

So, not even the booming sectors of the economy can be complacent. 

If boards do not get compensation structures right, some companies even in boom industries could be a train wreck waiting to happen. 

Articles we wrote on incorporating risk management into reward frameworks are just as prescient now as when we wrote them before the credit squeeze.  See some of them again for example HERE and HERE.

There are many methods for incorporating risk management into executive incentive plans.  We urge boards to actively consider these.

© Guerdon Associates 2021
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