Last Thursday 26 February 2009 the UK’s FSA presented its code of practice for Britain’s bankers. On 16 March 2009, at the Remuneration Forum we sponsor in association with CGI Glass Lewis, Senator Nick Sherry will discuss the pay regulation changes proposed for the Corporations Act, while Mr. John Trowbridge will provide more information on the APRA pay code that is yet to be released.

It is likely that the two sets of regulations will be complementary, and not replicative. However, this does not preclude non-financial sector companies from being pressured to provide remuneration arrangements similar to those of their banking peers, and over the next two to three years, we expect this to be the case.

This could be a problem if all industries are expected to adopt a “lower-risk” focus, derived from commercial banking industry concepts. Just as there was an under-estimation of risk (noted by us in our past articles), the pendulum could swing to an over-emphasis on constraining risk in executive pay.

The financial crisis has in some ways resulted in a welcome focus on how the behaviour of executives is affected by the way they are remunerated in financial sector firms. But there has been little analysis of the impact this has on the non financial sector. This needs to be considered, as there is a danger that what is good for the goose, is not applicable to the gander.

In this article we provide a perspective on risk and reward, and why incentive plans can skew behaviour in the wrong direction.

Stock options (and other leveraged equity incentive plans) generate a strong incentive to increase the share price of a firm by whatever means. This includes not only achieving genuine growth, but also undesirable behaviour such as accounting fraud, which was at the heart of the financial scandal surrounding the collapse of Enron, WorldCom and others.

But the current financial crisis is not primarily about firms engaging in fraudulent or criminal behaviour (notwithstanding the actions of some sub-prime mortgage lenders). It’s really about excessive risk-taking at (overseas) financial firms that perhaps cross the line into unethical conduct.

To understand why the structure of the compensation financial services executives received may have led to their taking great risks, think about a company as a hierarchy in which executives compete to get to the top. They win bonuses and promotions if they outperform their colleagues by, for example, earning a higher return than others at an investment bank on the funds they manage.

Now imagine a competition such as diving, in which you can choose how risky a strategy to take, ranging from a fairly safe dive you can reliably execute for a decent score to a very risky dive that will yield a terrific score if you hit it but could also turn out very badly. Suppose you are equally matched against all your competitors, and everyone faces the same choice.

If you care only about winning, what should you do?

The answer is, you should perform a highly risky dive, as should all your competitors, even if by doing so there’s a good chance you will blow it. The reason is that taking a big risk increases the probability of your ranking both at the top and at the bottom (while reducing the probability of a middling result), but all that matters is the probability of ranking first.

By the way, this is one of the problems with using relative TSR.

If you play it safe, you are very unlikely to win, because chances are at least one competitor who takes a big risk will get lucky. So all competitors will take big risks even if this means that scores will be lower on average. The fact the payoffs are asymmetric — there’s a prize for ranking first but no penalty for ranking last — creates this incentive for all competitors to take big risks.

If executives are rewarded in this way they will behave just like other competitors. Stock options similarly pay off when things go very well but yield no penalty when things go very wrong. They are a giant carrot with no offsetting stick. This is an aspect of overseas banker remuneration that was addressed in our recent article on UBS (see HERE).

In some settings, it certainly may be desirable for executive compensation to encourage taking big risks — for example, in an innovative technology firm or advertising agency. But if bankers and insurers approach risk like venture capitalists, that is a problem. And if non-bankers adopt practices which relate to banking industry risk and performance measurement, they could get it badly wrong in terms of incentives.

Then there are shareholders’ interests. These are not the same as the interests of the managers hired to manage the company. Shareholders, as investors, tend to diversify their risk. Their returns are greatest if the companies across their portfolio take risks. But the manager paid mainly in company stock will be overly risk averse, while a manager paid all in cash will be indifferent to stock price. That is why executive remuneration is usually based on a mix of fixed cash, bonus and equity. Exact alignment is impossible.

Overall, in many industries, it may be in shareholders’ interests to encourage more risk taking (within parameters understood and agreed by the board), not less. So, as the regulation is enacted and the next few years’ remuneration reports are received, we urge all stakeholders to reflect on the nature of risk and reward for the unique circumstances of each company, and not blindly follow the new trend towards risk aversion.

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