Time, value and a bonus

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Introduction

I was at a City lunch in a conversation with a senior executive of an American bank and her partner, a gifted financial analyst.  We discussed the impact of bonus accrual accounting standards on balance sheets.  Then she made a startling statement.  “The accruals cost us millions, but the executives value their bonus at a fraction of its face value.”   We then spent two hours discussing that statement.

In both women’s eyes the issues are the trends in executive compensation to long deferral periods, bonuses held in stock and the potential value reduction through future downward adjustment and claw back. The issue for executives is economics 101.  A dollar has less value tomorrow than today and uncertainty over the number of tomorrow’s dollars reduce the value still further.  Yet, the increasing costs of executive incentives weigh heavy on the corporate balance sheet and in the eyes of the shareholder advocacy groups.

Pressures on bonus structures

The demand for longer bonus deferral periods reflects the perceived risk horizon of the impact of executive decisions.  The driver for deferral into stock is to increase executive alignment with shareholder interests.  Increasing conditionality around claw back of bonuses paid and value reduction of unvested payments is a reaction to executive misdemeanors.  All of these are worthy objectives – but they come with unintended consequences.

Impact

The cumulative impact of these changes is that the face value of the incentives becomes close to meaningless to the recipients.  Future value becomes unknowable.  Long deferral periods lead to great uncertainty as to value (the very basis of the Black Sholes calculation).  Stock value is heavily impacted by external events such as market crashes. Decisions made in good faith can, with several years’ hindsight; look wrong if not negligent, leading to high levels of management risk aversion.  The cash flows on which an executive has to base her future become smoke and mirrors.

Organisational penalties

The core of a reward strategy is to attract, retain and motivate.  If the recipient of a reward does not value the payment at the same level as the cost to the organisation, the strategy fails. Motivation and retention is reduced if lower value than the cost is attached to the award.  Yet, the balance sheet, P&L and share dilution have heavy organisational effects in both dollar and reputational terms.

The impact on the individual executive’s behavior is also meaningful.  Risk aversion becomes important to avoid penalty.  Capital protection rather that appreciation becomes a driver to reduce future uncertainty.  As we have seen in some labor markets, upward pressure on base salary and thus dollar certainty is increasing.

Unintended consequences – lose lose…

We are at a tipping point.  Remuneration costs are rising, for executives value is falling; external criticism is increasing rapidly as is remuneration regulation. There is a vicious circle of increasing face value to make future value meaningful; something of a tail chasing strategy. The system is broken.  Not yet beyond repair, but the longer the malaise festers the more painful the eventual solution.

A root and branch review is needed and needed now.  Executive compensation has always been complex and opaque.  Its death rattle is now being sounded – at least in its current form.  The reward profession needs to move contemplation from its navel to this vexed subject before it is too late; although what the alternatives are I shudder to contemplate.

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Epidemic of thieving bankers

Photo-by-Ian-Davidson

Introduction
Why have so many well paid, highly educated men (and it is almost entirely men) working in financial services caught the disease of fraud and theft? There is manipulation of LIBOR and FX rates, alleged dubious dealings in derivatives, insider trading; even down to evasion of train fares. Is the infection caused by greed, hubris, poor leadership or a corrupting culture? What is to be done?
Environment
Financial services is one of the most heavily regulated, monitored and controlled environments. Yet, even allowing for the gross incompetence of the regulators, the level of wrongdoing is breath-taking. It is essential, for the survival of the already low levels of trust in financial services, that the infection of thievery and self-enrichment is tacked with the vigor of attacking an epidemic.
Are societal norms to blame? Over the last few years we have seen enormous growth in tax evasion, expense fiddling and influence peddling (and that is only the politicians). It is arguable that the environment among the well off and those who should be setting an example in society is that obedience to the rules, both the spirit and the letter is for the little people. Even when caught the response is often that nothing wrong has been done; it is the rules that are at fault or that the regulations are to be gamed to the highest extent to the advantage of the individual. In that context I guess that a little rate manipulation is seen as quite acceptable. Informal sub cultures have developed, despite all the regulatory training and people development: where criminal or near criminal behavior is not just acceptable but encouraged. The disease spreads tenaciously, secretively, hidden from the cleansing light of day until it is too late. Certainly Human Resources appear to have lacked any form of X-Ray vision to detect the wrongdoing not just at an early stage but at any stage at all.
The Epidemiological approach
It is time that an epidemiological approach to the problem is taken. Examination of the causes, spread, transmission and monitoring of the disease in the hope of finding a cure or eliminating the causes of this epidemic is necessary and timely. We have big data tools, masses of data, specific examples and outbreak centers’ – perhaps even a patient zero or two. Trying to kill the diseases by punishing the host (in this case by large fines on the banks paid for, ultimately by the shareholders) is akin to killing the dog in order to get rid of the fleas.
Consequences
If we do not take the epidemiological approach now we risk simply driving the behavior underground making it harder to find and with even more painful consequences for the bank customers and the little people who always seem to carry the cost burden be it via higher taxes, austerity or erosion of personal wealth. This is the winter of our discontent, it is time to let lose the weapons of disease control before it turns in to a cancer that destroys the entire body of financial services.

Rewarding Reward Podcast http://www.idavidson.podbean.com/

Ian Davidson Reward podcast

I have produced the fourth podcast in the series “Views over the City”  http://www.idavidson.podbean.com This podcast covers pay and reward issues on a global basis.  This podcast includes:

For more on Banking remuneration see: https://iandavidson.me/2013/06/12/rebuilding-trust-in-the-city-of-london/

“I was at a recent meeting in the City of London to launch the document “Focus on rebuilding trust in the City” a Chartered Institute of Personnel and Development (CIPD) survey of staff in financial services in the City of London on trust and their employment relationship”

For more on Executive pay https://iandavidson.me/2013/06/18/balance-of-power-executive-pay-and-shareholders/

“There is considerable controversy over levels of executive pay.  There are a multitude of stakeholders or would be stakeholders pugnaciously striving for influence.  Remuneration committees are supposed to control executive remuneration.  However, as the MM&K recent survey shows, FTSE CEO Remuneration increased, on average, by 10% in 2012.  Why are shareholders allowing this to happen?”

For more on strong analytics:

https://iandavidson.me/2013/05/30/strong-analytics-3/

“As a reward specialist I am asked questions like, what is our pay inflation going to be next year?  I used to go away, do research and say 2.4% – having used the historic average.  Of course it was never exactly 2.4% so my boss would turn round and say – “but Ian, you said it was going to be 2.4%, you’re fired”.  If asked the same question now, I respond with an answer; “there is a 50% probability that it will be 2.4%; but there is as 10% probability it could be 4%, so we should factor that in to our budget.”

My new reward podcast give a wide view over the reward landscape as well as a fascinating conversation with innovation guru and author Peter Cook.

http://www.idavidson.podbean.com

If you would like a guest blog post or to guest blog post on this influential reward blog please get in touch.

blog@mauritius.demon.co.uk

Balance of power – Executive pay and shareholders

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Introduction

There is considerable controversy over levels of executive pay.  There are a multitude of stakeholders or would be stakeholders pugnaciously striving for influence.  Remuneration committees are supposed to control executive remuneration.  However, as the MM&K recent survey shows, FTSE CEO Remuneration increased, on average, by 10% in 2012.  Why are shareholders allowing this to happen?

Balance of power argument

I had a fascinating discussion with the executive pay guru Cliff Weight on the subject of the balance of power argument (although the discussion below is entirely mine) when looking at executive pay. 

The Executive’s power

Most of the time the executives hold the balance of power because:

  • Changes in executive board members, unless well managed, tends to lead to a fall in share price
  • Changes in senior management generally signals a failure of strategy or strategic uncertainties – which lead to a fall in share price
  • A lack of good succession planning by the Board so there is no immediate, obvious internal or external replacement.
  • A shortage of good candidates with the relevant experience and willingness to take high profile roles.  This tends to mean organisations can be without a CEO or Finance Director for six to nine months; which leads to a fall in share price.

No Board or Remuneration Committee wants to be seen to be acting in a way that damages shareholder returns. 

The Stephen Hester debacle

A good example of how NOT to carry out changes in senior management is shown by the apparent decision of the UK Treasury to replace Stephen Hester, the CEO of RBS.  The announcement seemed to take the markets by surprise – leading at one point to a 7% drop in RBS share price.  Further, the lack of any successor or allegedly any succession planning by HM Treasury means there is something of a leadership vacuum in RBS (even with their excellent senior management team) that causes great uncertainty to both investors and employees.  This, just at the point when RBS had turned around and had a clear and compelling vision of its mission and future.

The Shareholder’s power

Shareholders have limited power over executives; they have the upper hand mainly when:

  • There are downside earnings surprises
  • Takeover or mergers are under discussion
  • There is a strategy dislocation – a disruptive technology or social trend; look at Smartphones impact on the traditional phone manufactures
  • The market loses confidence in the management of an organisation

These tend to be seminal points in an organisation’s existence that hopefully do not occur too often.

Important issues for Remuneration Committees and Executive management

Both parties to pay discussions need to think about the balance of power issues and how they influence the reward dynamic.  Strategy needs to be owned and driven by the entire executive team; hopefully mitigating the effect of the departure of any executive.

Good management of shareholder relations and open communication will help reduce any share price “shocks” when changes do take place.  Good financial PR will again mitigate both the shock and share price impact.

The paradox of succession planning

One of the potential failings of Boards when considering the balance of power argument is succession planning.  In an ideal world a replacement for the CEO would have been identified and prepared for the new role well in advance of the change.  Unfortunately there is a paradox here.  A CEO could perceive that work by the Board to identify her successor was a signal of their imminent departure.  As invariably such issues leak, so the market would view it in much the same way.  Dammed if you do and dammed if you don’t.  There is also the issue that the heir apparent may become impatient with the wait and either go elsewhere or worse actively seek to undermine the existing CEO with the Board.

There is no easy or obvious answer to the succession paradox; but clearly it is an issue that must be taken on board in the balance of power debates.

Conclusion

The balance of power approach is a useful framework to view trends in executive pay.  I can see no immediate answer to how or even if, the balance of power should be more equally distributed.  Like any good explanatory framework, the balance of power debate asks more questions than it answers.

 

 

 

Rebuilding trust in the City of London

 

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Introduction

I was at a recent meeting in the City of London to launch the document “Focus on rebuilding trust in the City” a Chartered Institute of Personnel and Development (CIPD) survey of staff in financial services in the City of London on trust and their employment relationship.  (I tweeted from the meeting #rebuildtrust )  The keynote speakers to an invited audience of senior City HR people and journalists were:

 

It was an informative meeting presenting both the survey results and material on initiatives taking place to build trust after the calamities, errors, poor judgement and near criminal activity in the City over the last few years, which has badly eroded trust in what was once a gold standard for honesty and integrity.

Both Peter Cheese and Andrea Eccles gave particularly good presentations from different ends of the initiative spectrum.  Peter spoke on the big picture and in particular the role that HR has to play in leading the changes.  Andrea spoke of the very important key initiatives at grass roots level that City HR are taking, working with the Lord Mayor’s City Values forum.

The key themes during the meeting were:

Each of these themes is explored below.

Culture

Culture has been identified by the CIPD in earlier work as being fundamental to the required changes in the City.  The survey indicated clearly that the existing culture is a long way from being what is needed.  45% of the participants said their employer put profit before values.  Only 47% of staff saw customers as their key stakeholder.  As one of the speakers said, “What is required is a return to the core values of caring for customers and caring for employees”. 

One interesting take on the subject was the suggestion that financial services organisations need to focus more on recruiting “ethical” people.  My own experience, backed up by the survey results, is that a lot of people join financial services to make money.  In order to be seen as successful and to make the big bucks you need to be aggressive and egotistical; otherwise how would you make deals worth millions of pounds?  Unfortunately, aggression and egotism are not good indicators of ethical behaviour.  This goes to the heart of the matter; it is very difficult to make lots of money in an ethical and customer focused way.  The demands on one hand, by shareholders and analyst to make shed loads of money on one hand, and on the other, regulators, politicians (especially the European Union) and media on the other trying to stop profitable activity.

The role of HR in leading the changes was highlighted several times.  Again the paradox between this approach and the role of HR in supporting the business to carry out its activities was evident.  A good example was a comment about the morality of HR being involved in compromise agreements in financial services.  It was alleged that these compromise agreements can (as in the case of the NHS) be used to gag whistle blowers.  The reality is that compromise agreements are an essential part of the HR toolkit.  It allows for the amicable separation between employer and employee, normally on a “no fault” basis.  In the fast paced and rapidly changing environment like financial services, there will be differences of opinion, strategy and personality clashes.  Compromise agreements lead to a civilised and low cost way of managing these situations.  The suggestion that HR should stop using them is really throwing the baby out with the bathwater.  HR has far more important tasks in providing the frameworks for culture change than worrying about compromise agreements.  It is getting tied up in the detail rather than working on the big strategic picture that often leads to HR being perceived as a barrier rather than an enabler.

There was some good news.  RBS, the largely state owned bank in the UK, was singled out for praise for its work in introducing a much more ethical and customer centred approach – something of which I have some personal experience. (And would like to have more if Rory Tapner is reading this).  Sadly examples of good practice are few and far between. 

Values

Part of the discussion on culture must include values.  City HR is leading a lot of work on the development of toolkits to help.  The presentation by Simon Thompson went in to detail on the work of the Institute of Bankers on professional standards and many big employers in the City have signed up to these standards and the educational and training frameworks that support these approaches. 

Professionalism

This was a key theme in the presentations.  Raising the level of professionalism is very important in defeating the current broken culture.  What do I mean by broken culture?  It is the behaviours that allowed the manipulation of LIBOR rates for profit; that mis-sold products including PPI and, perhaps, some derivative products for gain rather than the good of the customer.

The survey showed that only 30% of staff are in professional bodies with standards.

To work in HR in the City you need to be CIPD qualified, yet to work as a banker you need no qualifications at all

That quote summed up for me the entire issue around professionalism.  One can argue about professionalism and its meaning.  It does normally provide a framework of acceptable (and unacceptable) behaviour that can form the basis of reward on one hand and disciplinary action on the other.

There was a comment that there are a vast number of codes of practice, regulations, laws, (domestic and foreign) and guidance – some of which is in direct contradiction.  True, but no one said it was going to be easy.

I must again praise the work of City HR in providing structure and good practice for professionals in the City.  This slow drip drip drip of information, tools and frameworks are, over the long term, likely to prove to be a bigger boost to professionalism than grand culture change initiatives by those embedded in the current City ideology. 

Leadership

One of the more disappointing results from the survey was that 41% of the participants said that there was one rule for senior management and another of other staff.   Given that nearly all the speakers emphasized the key role of senior management and CEO’s in leading the culture change; there is still a big mountain to be climbed.  The fact that only 36% of “other ranks” are aware of their organisations values indicate that organisational leadership has a large communications issue on their hands; and what is leadership if it is not communication of the vision.

Risk Management

A key theme during the presentation and during the Q&A session that followed was risk management.  It is clear that the framework to support culture changes needs good human capital measures and strong analytics.  Why?  Two major reasons were discussed.  First, it is difficult to discuss change if it cannot be properly measured.  Second, in the world of financial services number crunching and risk analysis are part of the bread and butter of daily activity.  To have credibility, the change activity, particularly if led by HR, needs to adopt this approach.  When I worked in investment banking I sat on the Operational Risk committee and that experience led directly to my design and implementation of a reward risk framework.     Exactly the same type of approach can be used when thinking about risk and culture in the financial services environment.  It is this sort of fundamental change in thinking that is going to provide the scaffold for the success of the work in culture change.  HR does, on occasion, shy away from people metrics; yet they are an essential framework for designing interventions and supporting our businesses. 

Role of HR

There was a lot of discussion on the role of HR.  Here I must depart from the gospel according to the panel speakers.  There are two places the pressure for change will come; the first is from senior management.  There is a bit of an issue with this one.  Senior management got where they are by supporting and encouraging the status quo.  Much of this has been made in management literature; the ideology of management has support for the status quo deeply imbedded within it.  Asking senior management to support massive cultural change may be like expecting turkeys to vote for Christmas….  The second place is from the employees within the organisation.    It is possible, as history has shown, for small but articulate groups of people to push for change from within the organisation.  Given the above mentioned ideology that is a possibility but not a strong probability. 

If culture change becomes another HR intervention it has the possibility to be marginalised and not become part of mainstream business thinking.  The survey showed that a number of culture change initiatives have not worked so far.  Only 17% of participants saw the culture change in their organisation as being very effective.

Clearly HR does have a role in providing the toolkits, interventions, training and development necessary to carry out the culture change; but leading it is not, in my view, going to happen and if it does it is more likely to lead to a marginalisation of the change on the business agenda as so often happens with HR led initiatives.

HR does have a key role in modelling and supporting behavioural change as well as ensuring that the new generation of bankers coming through at least start with an ethical mind-set. 

Reward issues

Reward is at the heart both of what is “bad” in the City and what will help drive change.  But,

  • 73% of staff think that some people in financial services are overpaid
  • 67% say there is secrecy around pay for senior mangers
  • Only 36% see reward as being “fair”.

As reward professionals we have to stand up and be counted.  Discussion needs to take place on what is “fair” pay.  Pay systems have to be somewhat more open so there is a greater understanding of what people are being paid for,

Key tasks include:

  • Better advocacy of pay levels and differentials in organisations
  • Development of incentives to encourage professionalism
  • Development of reward and performance management that encourage thinking about how an objective is reached as well as the measure of the objective.
  • Being as open as is appropriate to stakeholders on our reward approaches and outcomes
  • Being an advocate both internally and externally for the reward systems and outcomes.
  • To bring measured, data led, rational debate to politicians, the media and other commentators to prevent or at least moderate the near hysteria around financial services and senior executive pay

Conclusion

The CIPD report is a timely looking glass in to the views of those who work in financial services as to issues of trust and reward.  It is well written and influential; I would recommend it to you. (Disclosure note; I undertook some analysis of the raw data in the report for the CIPD).  Both the CIPD and CityHR are clearly thought leaders in this field and their activities are to be applauded.  The report is an important part and input to the on-going discussion on this subject.

The report is also timely.  The results from the Banking Standards Inquiry by the UK’s House of Commons are due to be produced very soon.  Unfortunately it may be argued by some that it has been badly tainted even before release because:

  • The standards of politicians in the UK are at an all-time low and lecturing other people on ethics and standards is at best the pot calling the kettle black and at worst rank hypocrisy.
  • A lack of understanding of the world and work of financial services by MP’s who have seldom operated in the real world and those who have did so via the playing fields of Eaton (an elite fee paying school in England  attended by many of the UK cabinet and their advisors).
  • A large part of the problems with the collapse of trust in financial services is due to inaction by politicians and regulators who believed that light touch and not actually understanding what was going on was a good way to regulate a very complex, risky, global business.
  • A potential perception that there is a lot of band-standing and jealousy going on at Westminster village that does not aid credibility

I hope I am wrong and wait to read the report with interest.  However, the weight of history is against them; since when have politicians made anything better?

Failure is not an option unless we do want the politicians to bring their incredibly costly sledge hammers to smash some nuts that, it turns out on closer inspection, actually have nothing to do with the problem.

It is only by hard work based on sound data such as the CIPD report; and not taking some moral high ground and seeking to apportion blame; that will make the very necessary changes.  HR and reward in particular do have key roles to play.  At the end of the day there must be the drive and will in the Board room to make the required culture change a reality. 

#reward #rebuildtrust #CityHR #RBS #trust #financialservices #cipd #cityoflondon #stronganalytics #rewardmanagement #risk #riskinhr #hrblogs

 

 

 

More pay regulation – Doh!

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Photo copyright Ian Davidson Police and protesters outside the Bank of England

Introduction

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.

Potential outcomes

 

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!

Conclusion

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.