I am spending a lot of time at the moment reviewing the various global approaches on remuneration regulation. It suddenly struck me, in a Homer Simpson moment, to ask a basic question. Does more remuneration regulation lead to better reward outcomes? It turns out not. In fact, regulation is a poor solution to a low level problem that will throw up more issues than it resolves. The real reasons behind the regulatory assault appears to be more to do with political expediency and an easy target rather than resolving issues of market failure.
Few would argue that shareholders and remuneration committees are closer to the issues of executive remuneration than regulators and shareholder advocacy groups taking a generic tick box approach could ever be. The regulations not only fail to discourage the behaviour that they believe, incorrectly, led to the financial crisis but they are storing up problems for organisations over the next few years just when the focus should be on economic and organisational recovery.
Does regulation solve the problem?
Professor Ian Tonks of Bath University argues persuasively that statistically, pay performance sensitivity in banks is actually no higher than other sectors and overall is quite low. The relatively small performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector is dependent on short term financial performance. He notes that as Conhon et at (2010) shows that the role of compensation in promoting excessive risk taking prior to the crisis was dwarfed by the roles of lose monetary policy, social housing policies and financial innovation – which of course falls largely under the very politicians and regulators that now endeavour to regulate on pay. As Weight (2012) notes the key determinate of levels of executive pay is organisational size.
So the evidence points to the fact that executive pay in banking had very little to do with market failure and thus regulating it will have a very limited, if any, impact on the probability of further market issues – as if the current LIBOR issues did not prove that fact with greater eloquence that this commentator could hope to achieve.
Does it work?
So does the regulation of pay work? The answer is not really. The CIPD submission to the UK Government’s banking inquiry showed that the issue is mostly around culture; a view greatly supported by the actions of the new CEO of Barclays who is attempting a massive transformation of the Bank’s culture in response to its multiple failings. Reward is but one small part of a much bigger issue. But the FSA in the UK, the FCIC in the US and the EU capital requirements directive all link remuneration structures to market failure; with surprisingly little robust evidence to support this assumption.
In general the approach is to defer large parts of the bonus payment in to the future and also that a large part of the deferred portion must be paid in equity or similar instruments. The deferred part of the bonus is subject to malus and claw back. What is worse is the EU proposal that bonuses be no more than one times base salary.
It is all downside for the employer
The most interesting and critical part of this analysis is what will the results of these limitations? First of all the approach to limit bonus payments to one times salary. At its most simple level it is going to mean large hikes in base salary. We have already seen this occurring in response to regulators demands for a greater balance between fixed and variable remuneration. For employers increasing fixed salary has a very large down side. It massively increases fixed costs at the same time as the same regulators are demanding greater capital holdings – doh! The benefit of having a flexible bonus system is that you can pay out when times are good and not pay when cash is tight. In addition salary payments are not performance driven or risk adjusted; so you are undermining the very strategy on which the assumption of market failure is based.
This leads on to a second issue for employers that are closely linked to the first point. If you defer large parts of the bonus over multiple years you are forcing employers to pay cash out when they may have much better uses for this resource – including building capital reserves or returning cash to shareholders. Thus the regulations on pay are hampering the very important role of management in managing the cash resources of their business. Oh, of course shareholder advocacy groups say do not dilute share capital – the regulators say pay bonuses in equity instruments – doh!
It is largely (but not completely) downside for the employee
The regulators seem to be ignoring two very important financial concepts when introducing regulations on pay; as are shareholder advocacy groups such as ISS when making similar demands on executive pay. These are the time value of money and the fact that the risker the financial vehicle the more return it has to generate. (Although this is a double edged sword as we will see later). A cash bonus of £500 today is worth more than £500 paid next year or the year after. To give the equivalent in today’s money of £500 in two years’ time would mean paying out perhaps £535 – and that is using quite a modest discount rate. You then say to your employee I promise to pay you £535 in two years’ time; BUT if we do not perform well, or if someone in the organisation misbehaves and we lose money we reserve the right to reduce or not to pay the bonus. An intelligent employee will look at her organisation and what is happening in other organisations and say “well, I think there is a 10% chance each year over the next three years that I will lose my bonus”. So the deferred bonus is not worth £500 to me in three years’ time; it is worth £432. So the employee can either accept a lower value, uncertain payment in the future or look to her employer to increase the bonus to make up the lower future value. Not an ideal employee engagement scenario.
The double edged sword of equity
Regulators and shareholder advocacy groups are insisting that a large percentage of deferred bonuses are paid in equity or similar instruments such as cocos. (Broadly, conditional bonds). For the employee this is a double edged sword. On one side, equity levels can produce very good results. For example, Goldman Sachs share price has had an annual increase of around 23% over the last three years. So if your bonus was deferred in to stock it would have doubled over three and a half years with little or no effort by you. For the regulators and the politicians this means that stock based bonus pay-outs have the possibility of being very much higher than originally forecast. Not exactly the policy outcome that was hoped for. The other side of the sword for employees is the uncertainty factor. Goldman Sachs shares may have increased; but many organisations share prices will not have risen; or given share price volatility have a high probability of being at a lower level at the very point of vesting. Uncertainty, as noted above, reduces value. In the eyes of a rational employee a bonus deferred in to stock over say three years must be discounted to a much lower level that the actual value awarded. (Although the concept of “actual value” here is quite nebulous). Some traders that I know have discounted future equity based deferred bonuses to close to zero due to the risk (and perhaps their own financial time horizons). Thus the deferred bonus in to equity ceases to be a retention tool unless you have to be one of the lucky Goldman Sachs employees – but then you do not know if you are going to be in a job in three years….doh!
The other arguable point about deferring bonuses in to equity is that it actually increases risky behaviour. Why? A deferred bonus in equity cannot drop in value below zero for the employee so there is a limited downside. However, if taking a business risk increases the probability of equity upside then there is no rational reason for an employee or a director for that matter, not to take that risk. So, instead of regulators and politicians providing policy that reduces financial risk the current approach appears to increase the risk, reduce flexibility and increase fixed costs; not an ideal policy outcome with no clear winners and the potential for everyone to lose – doh!
The evidence points to the efforts by regulators to provide prescriptive regulation on pay and bonuses; particularly in the banking sector, to be deeply flawed. They are trying to solve a problem which played only a small part in the near global market failure. They would be better to focus on the more important issues of lose monetary policy, culture and poor financial regulation of complex financial instruments. The pay regulations are counterproductive and have a high probability of not delivering the desired policy outcomes but making the situation worse and more risky than it was before – doh!
I believe the time is right for evidence based, principled regulation around high pay. Not for any reasons to do with market failure but because we must at least start to take heed of the arguments around social justice while appreciating that in a demand driven market economy the concept of “fair pay” is, like Plato’s table, something of an unobtainable but delightful concept.