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| Pay in the spotlight (September 2009) |
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Page 2 of 3
The four-letter word that colors the compensation debate Everywhere one looks in the fight over executive compensation in banks and investment banks, lurks risk. Broadly, the worry is that there has been a disconnect between financial services compensation practices and risk management practices. H.L. Mencken once said that Puritans live in fear that someone, somewhere, was having a good time. And so it is that those lined up for restrictions on compensation fear (with some justification) that untrammeled compensation will plant the seeds for a future crisis while the present one is still being worked out. It’s been a rough battle for banks and their representatives to fight, because it’s more than a battle of headlines, op-eds, and congressional floor statements taking great umbrage, like Captain Renault in “Casablanca,” at what’s been going on. “Excess risk taking, based on perverse incentives, did happen,” says consultant Dan Borge. “And it contributed to the mess that we’re in now.” It’s a matter of moving on, and getting on with corrective measures, but in a logical and appropriate way. Finding the middle way Borge, a director in the New York offices of the LECG consulting firm, was principal developer of the industry’s first enterprise risk management program, at Bankers Trust. But while he sees the need for improved correlation between executive compensation and risk, he insists that there are no simple solutions. He adds that much of the current debate isn’t helping: “Anger is not a strategy.” Setting the current agenda was a June statement by Treasury Secretary Timothy Geithner. (See “Pillars of compensation”.) Geithner’s opening included this sharp declaration: “This financial crisis had many significant causes, but executive compensation practices were a contributing factor. Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.” The questions underlying the debate include: How well will what is in place, or in the wings, work? What will be missing from the equation? “When people start digging into this matter, things become harder still,” says Dan Borge, “because there are so many complexities involved.” A key issue, he feels, is whether an institution has an enterprise risk management viewpoint and mechanism in place. The board has to be on top of ERM, says Borge, before a compensation committee can really be doing its new job on the risk front. The unanswerable question A key issue in Geithner’s points is for banks to develop the ability to align compensation philosophy and strategy with “the time horizon of risk.” The concept here makes a lot of sense, says Borge. “You don’t want to pay people until the party is over.” But the tough part is making that concept work in a real-world banking organization. It all comes down to who is responsible for what, says Borge. “In the ideal world, you’d want to pay an individual no more than the individual’s actual contribution to the corporation,” and you’d want to do it on a timely basis—timely for the recipient and also timely for the corporation in terms of when it realized income from the person’s activities. But the higher up the food chain, the more problematic that would be. For the person who runs a business unit, compensation could be based on a portfolio approach—performance of a group of assets or accounts, could be measured, with a risk factor included. “But it’s the exception, not the rule,” he says. Another problem is that risk doesn’t get defined or identified. What do different people looking at a bank define as risks? asks Brian Dunn, president of McLagan, a subsidiary of AON Corp., and CEO of Global Compensation. “It’s a lot like pornography,” he adds, in that people can know it when they see it, but may not be able to explain beforehand. “Risk is inherently subjective,” agrees Borge. “Risk is a forecast of what may happen in the future. It’s an unanswerable question. There will be nobody who gets it right because you won’t know when you get it right. But the journey will be valuable.” Compensation in a vacuum Another key point enumerated by Secretary Geithner is alignment of compensation practices with sound risk management practices. Borge says that he understands the logic of this principle. “You don’t want the compensation committee off in a corner, drawing up approaches to compensation, while somewhere in the company, someone is doing something that no one knows anything about,” he explains. Not knowing what risks are being taken, and who is taking them, leaves the bank flying blind, and leaves the compensation committee more or less in the dark. Typically, he adds, the compensation consultants who work with banks tend to work in something of a vacuum, designing plans based, traditionally, on peer tracking data. And “the risk guys,” if the bank has any, are typically not asked about compensation schemes. This will have to change, says Borge, if much of what’s being discussed in Congress and among regulators goes through. TARP rules: Shape of things to come? Banks coming under TARP confront the potential shape of the future for banks in this context. Treasury issued interim final rules restricting aspects of executive compensation in mid-June. Over the summer Treasury accepted comments on the rule. (In its comment, ABA pointed out that in many details, the interim final regulation oversteps the requirements of the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009 that it implements.) Numerous provisions apply, but in the risk management context, several stand out. One is the requirement that TARP recipients maintain, or create, a board compensation committee consisting solely of independent directors. This committee is to meet, at least twice a year, to “review, discuss, and evaluate employee compensation plans in light of any assessment of any risks these plans pose to the TARP recipients.” Further, the committee is to “discuss, evaluate, and review” senior executive officer (SEO) and employee plans “to ensure that the SEO compensation plans do not encourage the SEOs to take unnecessary and excessive risks that threaten the value of the TARP recipient.” Compensation committees are also required to provide an annual narrative description of what actions were taken to limit unnecessary and excessive risk taking in SEO and other employee compensation. And they must also certify that they have completed all required reviews. Among the criticisms that ABA’s Sarah Miller, senior vice-president, Center for Securities, Trust and Investments, leveled at the interim final rule in the association’s Aug. 14 comment letter was a section concerning excess burden levied on community bank TARP recipients: “While larger firms have long had board compensation committees responsible for overseeing company compensation plans, many community banks, particularly closely held institutions, have not had the need for these committees, particularly as community bank compensation plans are modest and not structured so as to reward excessive risk taking. Clearly, the added burdens associated with establishing a compensation committee will fall disproportionately on the community bank.” Indeed, Susan O’Donnell, Boston-based managing director for the Pearl Meyer & Partners compensation consultancy, and a specialist in community banking compensation, points out that assessing risk is a very time-consuming task for a board of outsiders who usually lack detailed banking expertise. And the TARP requirements demand this exercise at least twice a year. Cut bonus, raise salary McCall Wilson, president and CEO of The Bank of Fayette County, Moscow, Tenn., heads a bank that took $6 million in TARP Capital Purchase Program funds at the urging of its regulators, though it has yet had any need or special opportunity to deploy it. But nevertheless, the $254 million-assets bank has the obligations that come with the purchase. Wilson says his board is local. He doesn’t have any directors with experience in advanced concepts such as corporate-owned life insurance or deferred compensation. Facing TARP restrictions on Wilson’s performance bonus, the simplest approach was to eliminate the bonus and raise Wilson’s salary. With the help of compensation consultants, boards may be able to lick that kind of challenge, says Aon’s Brian Dunn. “It’s easy to design a plan and figure out what the magnitude of pay levels ought to be,” says Dunn. “But what you ought to be paying for, that is a very different question.” Moreover, says Dunn, when the compensation committee is called on to balance pay and risk issues, and the government encroaches on the decision process by setting specific numbers, as the interim final regulation does, “then that’s a complete trip down the rabbit hole.” In a recent ABA telephone briefing, ABA’s Miller summarized much of what’s going on in bank compensation legislation and regulation and made a prediction: In time, much of what applies to TARP banks now—and to public banks after passage of pending legislation—could filter down to all banks in some fashion.
—Steve Cocheo, executive editor
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0909/index.php?startid=22
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