The Interim Report of the Hayne Royal Commission suggested that incentives tied to profit were part of the cause for misconduct (see HERE) .

Therefore, by implication, the Commissioner asks:

• should profit be removed as a measure for incentives, or
• should incentives be removed entirely?

Guerdon Associates’ submission to the Commission’s Interim Report maintains that this is impossible.

With or without incentives, profit will always drive employee behaviour

The pursuit of profit is the foundation of a modern market economy. This was described in the work of the Scottish economist, Adam Smith. In the “Wealth of Nations”, and other later works, Smith expounded upon how rational self-interest and competition can lead to economic prosperity. His idea of “rational self-interest” has endured to this day.

Rational self-interest drives investors to provide capital to companies that can deliver them the most profit for the provision of that capital. Rational self-interest drives employees to work for companies that deliver them the most pay (i.e. profit) for the provision of their labour. Employees are employed and rewarded in line with their contribution to company, and hence investor, profit.

It would be disingenuous or naïve to suggest that profit is not the raison d’etre of senior management employment, and by extension, all employees in private enterprise.

Incentives can be explicit via direct monetary reward for achieving required profit outcomes. They can also be implicit, as in continued employment, promotion, and career development opportunities. In one way or another, an employee’s contribution to profit will be recognised.

Removing the explicit will do nothing to hinder the effect of the implicit rewards. And rewards for profit there must be, otherwise profit will not be pursued by employees, capital will be withdrawn, and banks will fail.

So, if:

• The Hayne report contends that incentives tied to profit are partly responsible for banking misconduct, and yet

• The pursuit of profit is the raison d’etre of private enterprise, employment and reward such that removing explicit incentives will only increase the link between profit and implicit incentives,

is there a way to use remuneration as a lever to reduce misconduct rather than exacerbate it?

Incentives are the answer, as well as the problem

Guerdon Associates’ submission to the Royal Commission suggests that employee incentives have a key role in reducing misconduct, but only if misconduct is related to loss of profit.

Until relatively recently, bank and insurer misconduct did not impact profit. Now it has. It is likely the recommendations of the Hayne Royal Commission will ensure that future misconduct will impact bank and insurer profit, mainly through an improvement in regulator effectiveness.

Given that misconduct will continue to impact their ongoing profits if it is not minimised, how can banks and insurers better configure rewards to minimise misconduct, and better align with profit?

As the banks’ submissions have already indicated, they have implemented changes by introducing various measures of misconduct or misconduct supervision into balanced scorecards. All of the banks have deferral of incentive pay, such that incentive pay can be reduced if misconduct is discovered after the fact.

But, improvements can be made:

• None have automatic, or formulaic reductions of deferred remuneration for each and every instance of misconduct. At senior management levels, malus is applied on a discretionary basis. This reduces the incidence and consistency of malus application.

• All retain LTIs that are heavily influenced by the last financial year’s measure of TSR or profit, fostering a short term mentality.

They have also been compelled to retain counterproductive LTI plans to receive proxy adviser and investor support, despite the absence of any research indicating they can be effective. Long term deferred ownership would be one possible solution, but unlikely to be acceptable to a large proportion of investors if it replaces ineffective LTIs.

Banks and insurers have also been compelled to retain malus discretion, rather than regular formulaic reductions, because of competitive pressures to retain key employees.

While not removing discretion, malus is more likely to be applied if it is a prescribed action. This will cause a change in what is known as “choice architecture” – a concept recognising that the most likely choice will often be the default choice.  There is less likelihood that companies will exercise discretion not to apply malus if its use is otherwise prescribed.

Assuming it is prescribed that every instance of misconduct results in malus, then malus would, initially, be more frequently applied, and more consistently. This more frequent application of a “negative reward” will cause rational self-interest to focus management and employees on reducing misconduct.

So, what should he Royal Commission consider recommending?

Recognising that the Federal Government will probably respond to the Hayne Royal Commision with additional pay regulation via the BEAR, Guerdon Associates has suggested that any such regulation should recognise that incentives are part of the fabric of a capitalist system, and that they be put to use to achieve better outcomes by:

• Requiring a more formulaic, automatic reduction of deferred remuneration. Discretion can be retained, but applied to remove the discount, rather than the present practice of discretion being used to apply the discount. This suggestion recognises that a “nudge” to apply malus more evenly and uniformly may be required.
• LTIs be replaced by longer vesting equity ownership grants not subject to short term year end financial or market measures. They remain incentives because malus can still be applied to reduce reward. This is similar to the system advocated by major investor groups in the UK and partially endorsed by the UK government. (See HERE). This suggestion recognises that change to unwieldy and ineffective LTIs will not otherwise come about because of investor and proxy adviser guidelines.

See the Guerdon Associates submission to the Royal Commission HERE

Others’ submissions can be found HERE

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