Are forces gathering to regulate banker pay?

The ingredients for the “perfect storm” may be gathering as a result of the global financial fallout and local concerns.

Usually we pass over media reports of more pay regulation as just another way to sell newspapers. However recent media reports of banker pay regulation have come from very authoritative international sources that include Australian regulator representation. Given Prime Minister Kevin Rudd’s recent support for Australia’s participation in better global financial regulation, as well as several other factors detailed in this article, we think it prudent, in this case, to highlight the debate and suggestions with our readers. We have also been influenced by indications that Australia’s Treasury is reviewing executive pay disclosure laws in response to a government initiative.

The first major indication that banker executive remuneration could be set for a rethink was first brought up by the European Commissioner for Internal Markets, Charlie McCreevy, over 2 months ago.

He commented at an after-dinner speech to the Chartered Institute of Insurers that executive remuneration structures – especially in the banking and insurance sectors – ‘front-load’ much of the reward while costs related to risk underwriting and bad debts are back-loaded. The bonuses are paid out before the losses are clocked up. He said that nobody could claim that this has served either shareholders or taxpayers well.

While he recognised that it is a complex issue because of the competition for talent in the market place, he insisted that a balance has to be found, preferably by industry itself. If it is not found, he warned, political reality could well make calls for a more interventionist approach difficult to resist. Perhaps this is a matter that needs to be looked at in the context of revisions to corporate governance codes.

Since his speech, a great deal of back room consultation seems to have happened. In a move that may foreshadow new legislation, government ministers meeting in Washington last week (including our Treasurer Wayne Swan (see HERE)), supported a report that said banks’ generous compensation structures were partly to blame for the credit crisis. Judging from Mr. Swan’s media comments after his trip, it would be fair to say that he was very concerned at the state of the world financial system and the implications for the world and Australia’s economy.

The Financial Stability Forum, representing G7 and other regulators from around the world, produced the report. It said the current system needed urgent reform. Amid a raft of other recommendations, including an overhaul of the way ratings agencies work and a beefing up of the Basel rules on banks’ accounts, the FSF said remuneration should be tied to performance over credit cycles, which last five or more years. Specifically:

“One of the striking features of recent events has been firms’ sizeable payouts to staff in areas in which the firms have subsequently incurred very large losses as risks materialised. Compensation arrangements often encouraged disproportionate risk-taking with insufficient regard to longer-term risks. This problem can be mitigated if firms closely relate the incentives in their compensation model to long-term, firm-wide profitability. In addition, regulators and supervisors will work with market participants to identify means by which risk management policies and controls can mitigate risks associated with these incentives. “

Perhaps they should have read our article on pay clawbacks last month (see HERE)

Their specific recommendation was:

“The financial industry should align compensation models with long-term, firm-wide profitability. Regulators and supervisors should work with market participants to mitigate the risks arising from inappropriate incentive structures.”

The full report can be found HERE.

This could raise the prospect of bankers having to wait many years for bonuses, or even being forced to forfeit them if the bank’s performance later disappoints. The report said that while many of the recommendations could be achieved without heavy regulation, some would require regulation.

The types of bonus plans criticised are just as typical in Australia as in New York or London. In particular, the creators and consumers of derivative products are paid annual bonuses on a “carried interest” basis, which in effect is the unrealised profit of the asset values carried in a portfolio. These bonuses are not clawed back when these profits turn to losses in the following period, or upon eventual realisation by investors who invested their money in the bank’s products.

Outside of the investment bankers are the mass distributors of the products. These are typically retail bankers, insurance companies and brokers with extensive branch and financial planning networks. These bankers, insurers and brokers typically receive bonuses related to fee income earned.

So, in effect, Australia’s remuneration practices could contribute to the same outcomes now being experienced in the US and Europe. To date, Australia’s problems seem to have been confined to some rogue brokers. That Australia did not suffer to the same extent is a credit to the risk management practiced from the boards of these companies down.

But it only takes one lemming….

While the report was aimed squarely at the causes of the sub-prime liquidity mess created by US investment bankers and supported by their European counterparts, the outcome of discussions between the regulators and companies in those markets could have real consequences for bankers in Australia. Nick Sherry’s and Treasury’s “remuneration and company performance” review (see our article HERE), Wayne Swan’s heightened concerns, and the traditional Labor Party constituency’s distaste for “overpaid” bankers could be the ingredients for a “perfect storm” on reactive pay legislation.

© Guerdon Associates 2024
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