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A Contemporary Banking Issue Essay Online For Free

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Bankers' remuneration is perceived amongst the core recession triggers, which lured top bankers to engage into socially wasteful investments. Society perceives bonuses as the main drivers of "greed and irresponsibly short-sighted behavior" (pp. 1). From an economic point of view, the central critiques about bonuses are concerned with risk-taking and short-term orientation. Nonetheless, it is noteworthy that the design of the overall compensation package appears to have generated bankers' myopia rather than the bonus system per se. In fact, most banks now concur that, preceding the crisis, their systems were excessively short-sighted, and are currently striving to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods (Gehrig & Menkhoff, 2009). Bonuses have stirred widespread aversion feelings because of their asymmetric payoff structure which invites risk-taking by bankers. As such, should the risky investment have succeeded, the manager would have been granted a hefty compensation; whereas even in the unfavourable scenario, he still satisfied with a comfortable fixed salary incurring no further repercussions. Put differently, a bonus-based compensation package fails to penalise accordingly the various outcomes of jeopardising investments and consequently encourages them (Gehrig & Menkhoff, 2009). Remuneration is defined as the payment that generally comprises the base salary topped with any bonuses or other economic benefits which an employee or executive receives during employment in exchange for professional services. This term often refers to the total compensation which includes the base salary plus shares or share options, bonuses, pension benefits, and other perks or forms of compensation (Investopedia, 2011). Thus, remuneration can be divided into fixed based pay (payments or benefits not depending on any criteria) or variable (whereby additional payments or benefits are function of performance or various contractual agreements such as depending on sales, profits, return on assets). The above are correlated with the output of the accounting system but may also reward in line with market price of the firm's shares. Both these components may include monetary payments or benefits (such as cash, shares, options, pension contributions) or non-monetary benefits such as health insurance, discounts, fringe benefits or special allowances for car, mobile phone (CEBS, 2010). Regulatory bodies, (i.e. G20, Committee of European Banking Supervisors), seem to concur that the inappropriate remuneration structures of some financial institutions have been a contributory factor towards the failure of individual financial institutions and systemic problems in the European Union Member States and worldwide. Remuneration policies that offered incentives and encouraged risk-taking above a certain tolerable degree at institution level undermined sound and effective risk management and exacerbated such behaviour. It was admitted that excessive remuneration in the banking industry fuelled a risk appetite disproportionate with the loss-absorption capacity of the sector (CEBS, 2010). The remuneration of bankers situates at the very centre of moral outrage succeeding the financial crisis. While regulators are mostly concerned with the remuneration structure which incentivised undue risk-taking, society sternly blames the pay-offs to senior executives of failed banks and large bonuses which 'rewarded' bankers whose activities were entangled with the crisis triggering mechanism. The protest is greatly about the perversity of apparently mischievous prizes for blatantly imposing such costs on other stakeholders. The mainstream analysis of moral hazard (information asymmetry) assumes behaviour to be rational with respect to self-interest, in other words opportunistic in the sense that it takes advantage of chances to achieve personal benefit regardless whether that may happen at the others' expense (Dow, 2010). The remuneration policy should be in line with the business strategy, objectives, values and long-term interests of the credit institution. Otherwise, if the variable part of the remuneration consists predominantly of remuneration instruments that are paid out immediately, without any deferral or ex post risk adjustment mechanisms, based on a formula that links variable remuneration to current year revenues rather than risk-adjusted profit, there are strong incentives for managers to shy away from conservative valuation policies, strong incentives to ignore concentration risks, strong incentives to rig the internal transfer pricing system in their favour and strong incentives to ignore risk factors, such as liquidity risk and concentration risk, that could place the institution under stress at some point in the future (CEBS, 2010). The Principal-Agent theory implies that executive compensation should be correlated with the total return to shareholders, commonly by granting ownership of the firm through stock or options. However, despite this framework's compelling logic, existing empirical support contradicts the effectiveness of the agency theory when applied to executive compensation (Kakabadse et al, 2004). They are also meant to serve as an effective retention tool for talent in the long term, meaning they should motivate loyalty in successful bankers. However, stock options reward success, but normally do not penalize failure (Branca and Imelmann, 2009). Frabotta (2000a) argued that short-term strategies may in fact achieve differing outcomes to those actually sought, as they may not be congruent with the long-term profitability of an organization (Taylor and Davies, 2004, pp. 468). As such, bankers might seek to maximize short-run profits by employing creative accounting. This comprises methods such as discretionary costs management (i.e. reduction in allowance for doubtful clients with a view to increase net accounts receivable), sales and expenses adjustment, or non-operational profits e.g. asset disposals. Furthermore, medium-term behaviour might encompass income smoothing to reduce earnings volatility and ensure less variable flow of benefits for the more loss-averse directors. According to Prasad (2008), evidence shows that executives contractually entitled to receive exhilarating pensions, tend to pursue corporate strategies which aim to reduce the overall risk of the firm. As such, these executives embark on fewer risky investment projects, reduce dividends, avoid excess debt or expand the average maturity of corporate debt. Likewise a CEO is more likely to retire voluntarily his pension has vested and is immediately payable. Besancenot & Vranceanu (2007) based their study of compensations plans on game theory. The purpose was to analyse whether such structures incentivized managers to engage in fraudulent activities. Their model rendered that under perverse incentive plans managers eluded regulations and committed fraud.

Walker's Review

Sir David Walker's Review of corporate governance in UK banks and other financial industry entities was requested by the UK government in order to evaluate what prompted the financial crisis and how its recurrence could be prevented in the future. The final report suggests a series of reforms to improve the quality of boards, strengthen the role of shareholders, and increase transparency of pay and bonus structures. At the core of the recommendations lies the clear link which the author identifies between board behaviour deficiencies and poor business performance (Gill, 2009). The Review hints at the idea that some banking groups managed to survive the crisis and in relative terms have prospered, whereas others failed to do so and pleaded mercy from governmental bailouts. This situation indicates the gap in the quality of corporate governance between the two categories (Slaughter and May, 2009). One of the most important and controversial themes in Walker's (2009) Review is the remuneration policy of financial institutions. The recommendations in this respect emphasize that substantial enhancement is needed in board level oversight of remuneration policies, in particular in respect of variable pay, and in associated disclosures. Besides, the responsibility of board remuneration committees should be extended to cover the entire entity's remuneration framework especially executives whose remunerations exceed the median level throughout the board - 'high end category'. The term depicts employees who perform a 'significant influence function' and who can have a 'material impact on the risk profile of the firm'. Through deliberate insistence on long-term focus, they should be stand as a major countervailing force against any short-term pressure from shareholders or the executive. Furthermore, with a view to ensuring better alignment of interests, performance conditions and deferment of variable payments for executives should be materially more demanding than anterior industry norms. In other words, it is advised that at least half of expected variable remuneration should be on a long-term incentive basis with vesting, subject to performance conditions, deferred for up to five years. As to the short-term bonus, which rewards the executive for performance in the current year, the proposal is that payments under any award should be phased over a three-year period, with no more than one-third in the first year. The 'high end' pay executives bracket should be expected to maintain a shareholding or retain a portion of vested awards in an amount at least equal to their total compensation on a historic or expected basis, to be built up over a period at the discretion of the remuneration committee. Vesting of stock for this group should not normally be accelerated on cessation of employment other than on compassionate grounds. Despite being convincing at first sight, the Report's main recommendations concerning financiers remuneration mask a more fundamental issue of principle: that the current 'bonus problem' is a creation of accounting fictions of reliance on accrual accounting recognition of profit instead of economic profit. Focusing on earned or realised profit as the basis for bonus entitlement would eliminate many of the highlighted problems. The result of such a change in perspective would be similar to the intent of the Report; however it would possess the advantage of returning the debate to a focus on principles (Paradigm Risk, 2009). What is more, other critics such as Barker (2009) assess the recommendations regarding remuneration to be rather prescriptive or specialised for implementation in the non-financial sector. The Walker Review does not seek to define the quantum of remuneration that should be awarded to board members or other "high-end" employees. However, it delivers several proposals which target the improvement of the remuneration structure in terms of links with risk taking and performance. An interesting proposal advocated in the Review is that the Chairman of the remuneration committee should stand for re-election if the issued report receives fewer than 75% of votes cast at the AGM. This would serve to increase the accountability of the remuneration committee vis-à-vis shareholders. Remuneration packages of banks directors are made up of the basic salary and benefits which are topped by several cascading layers of rewards such as pension provisions and various bonuses. Barclays claimed that it had shown restraint on pay as it revealed that its chief executive, Bob Diamond, was paid a bonus of £6.5m for 2010. He also earned a £250,000 salary and was awarded a £2.25m long-term payment based on future performance. As chief executive he will be paid a £1.35m salary. Fred Goodwin from RBS was granted £9m in salary, £14m bonuses, and £276,000 extras (relocation expenses, school fees) - totaling over £23m in the past 9 years of employment for the state-aided financial giant. Skeptics would catalogue these obscene amounts as enormous rewards for failure. What is more, this former CEO gathered a sufficiently high pension pot to allow him the comfort of withdrawing £703,000 a year pension. Specialist lawyers infer that his contract was wisely and tightly drafted in his favour and very well negotiated. Moreover, the expenses incurred by the company to keep its executives pleased also included lavish benefits such as a permanent luxurious Savoy hotel suite; fleets of cars available at all times, special food, uncalled for refurbishment of floors, use of own corporate jets on regular bases (Dispatches, 2009). Yet results of a study (Fahlenbrach and Stulz, 2011) show that no evidence exists that banks with a better alignment of the CEO's interests with those of the shareholders had higher stock returns during the crisis. Some evidence shows that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity.
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