Executive Compensation in the Danish Bank Sector

Transcription

1 MSc. in Strategy, Organization and Leadership Master Thesis Authors Silas Mygind Flytkjær Thomas Kornum Academic Advisor Hans Bent Martinsen Executive Compensation in the Danish Bank Sector - From a Board Perspective Aarhus School of Business Aarhus University September 2010

2 Executive Summary The authors motivation for writing a thesis, from a corporate governance point of view, comes from a drive to solve problems on the highest organizational level. The interest in the banking sector in general, and executive remuneration in particular, has evolved over the last couple of years parallel with an extensive media coverage. The central idea of the thesis is that a well-designed compensation plan will provide the executives with a strong guidance to achieve the vision of the company as well as fulfilling the special role of banks in the society in a satisfactory way. The key findings in the thesis are: The bank sector is a unique industry in the society with a special responsibility that must be considered when designing executive compensation plans. In the banks the executives have a high level of managerial power, rooted in the special governance structure of the industry. To better align the interests of the bank sector and the interests of society a new model has been developed in this paper. The new model is addressing the additional complexity of the bank sector with regards to the agency problem. The new model has become the foundation of recommendations on the compensational design and includes elements such as: stakeholder approval of compensation schemes, long(er) term oriented stock options, and performance indicators that include both company goals and the societal responsibility. One of the future perspectives of the paper is if this new tie between banks and society, on the highest organizational level, can better provide a better development and stability to the bank sector as well as the economy in general. This develops a prospect for many new studies. How does the new model affect the culture in banks and does this potential new culture have an effect on the way variable remuneration elements are designed for all bank employees. Another future perspective is that if the bank sector needs specific guidelines, maybe the whole financial sector needs it as well. Page 2 of 100

3 Contents at a Glance 1. Introduction Theoretical Background The Danish Bank Sector Compensation Guidelines for Remuneration Criticism of Compensation Packages in General and for the Danish Bank Sector Discussion Conclusion References Page 3 of 100

4 Table of Contents 1. Introduction Problem Statement Delimitation Scientific Approach and Methodology Structure of the Thesis Theoretical Background Defining Corporate Governance General Danish Corporate Governance Structure Responsibilities of Managers/Directors Key Committees Audit committee Remuneration Committee Nomination Committee Agency Theory Positive Theory of Agency Theory of Principal and Agent Agency Problem Moral Hazard Adverse Selection Optimal Contracting Approach Managerial Power Approach The Danish Bank Sector Historical Development Market Structure Page 4 of 100

5 3.3. Corporate Governance Characteristics in Banks Compensation Compensation as a De-motivating Factor Types of Compensation External Governance Influence Law/Regulation Danish law Markets Alignment of Interests Shareholder vs. Stakeholder interests Setting up Performance Indicators Goal Setting Theory The Balanced Scorecard Triple Bottom Line Problems with Performance Indicators Ethics and Fairness The Trinity of Control, Effectiveness and Stakeholder Consideration The Trinity from a Corporate Governance View Agency Theory Review of the Trinity The Traditional Compensation Plan Model Guidelines for Remuneration OECD Lessons from the Financial Crisis European Union Denmark Page 5 of 100

6 6. Criticism of Compensation Packages in General and for the Danish Bank Sector Agency Problem in the Danish Bank Sector Criticism of Performance Pay Effects of Incentives on Behavior Cheating when Setting Performance Indicators Criticism of Corporate Governance in the Danish Bank Sector Discussion Re-Thinking the Framework of Guidelines Re-Thinking the Corporate Governance Framework Re-Thinking How to Grant Stock Options Re-Thinking Performance Indicators and Bonuses Conclusion Possible Further Studies References Page 6 of 100

7 1. Introduction After the last couple of years with a financial crisis, the executive remuneration debate has become a hot topic in the media. Different compensation schemes have been increasingly criticized with regard to bonuses and stock options. The media have focused a lot on the compensation of executives, especially in the world of banking. In the last time, primarily during the period of the publication of financial statements, where the compensation schemes have been presented, there have been different examples of ways that the media, companies and executives have dealt with the compensation question. In the UK and US there have even been examples of CEO's not accepting their bonuses, as a result of primarily outside pressure from the public and shareholders. The bank sector is an interesting industry to take a look at, because in the period before the financial crisis it seemed like executives in banks could not do anything wrong. Almost every bank in Denmark was doing really well before the crisis and came out every year with high turnovers and profits. At this time there was not much debate about CEO's of Danish banks being paid too much, because everything was just getting better and better. After this wave of success, as the crisis arose, these compensation packages that were created for the executives were no longer viewed as fair in the eyes of the broader public. One of the reasons for this perception of unfairness is that the government had to bail out banks using taxpayers money, while the top executives had been receiving high bonuses in the preceding years. This made the top executives and directors look greedy in the eyes of the general public Problem Statement In the above mentioned context, this paper will have its basis on the following problem statement: Page 7 of 100

8 We would like to examine the framework for executive compensation in the Danish bank sector from a board perspective, in order to find out how shareholder and stakeholder interests can be effectively balanced when the directors of the board are determining executive remuneration. This should provide a better foundation for developing specific recommendations to boards. In order to investigate this, the paper will be answering the following research questions: In which ways can top executives receive their remuneration? What are the interests of shareholders? What are the interests of stakeholders? How does one effectively relate compensation to performance? What are the current guidelines for executive compensation? Should companies discuss compensation more openly? Regarding the ways of compensating CEO's - Are unhealthy incentives created? This thesis will be interesting for a small group of people in the Danish banking industry. The group of people will consist of the parties dealing with the designing of the compensation package for the top executives in the banks, comprising executives, the board of directors and the shareholders who have the final decision on a compensation plan. Also different stakeholder groups would have an interest in the thesis, as they, per definition, have a stake in the banks. Among the stakeholders would be organizations and governmental institutions that issue guidelines on corporate governance in general. For this group of people the thesis will become a good starting when reviewing the current guidelines Delimitation The thesis is focusing on the executive compensation in the Danish bank sector. The reason the authors have chosen to focus on the Danish bank sector is that there are differences Page 8 of 100

9 internationally regarding corporate structure, legal systems, governance processes, ownership tendencies, history etc. By limiting the focus on the Danish based banks the thesis will be better able to handle the areas within the problem statement in depth. This, however, does not mean that the thesis will deny the existence of international markets, mutual international dependence or global currents. Therefore examples from other countries will also be used, but only where it makes sense for the Danish bank sector. The main point of the thesis is not how to motivate executives as a superior goal. The focal point is how to compensate the executives. Whereas many researchers focus on compensation as a tool of motivation, as well as there are many researchers working toward disproving compensation as being a motivational factor, this thesis will rather have its basis on compensation as a tool of direction. This does not mean that the motivational side of remuneration is not acknowledged, just that the thesis will not be based on motivational theories. The thesis is not about how much executives should be paid, as the exact amount will be viewed upon as set through negotiation between the top executives and the board of directors in the individual company. With regards to the current legislative process there is much debate going on at the moment and both the Danish parliament and the parliament of the European Union are discussing, passing and adopting legislation. As this is a present ongoing process that develops parallel to the composition of this thesis, it will not be possible to cover this area with full accuracy in full detail Scientific Approach and Methodology The theoretical foundation of this paper will work on two different levels: A scientific theoretical level and a more specific, concrete disciplinary level. The latter will revolve around theories within or related to the corporate governance area, with a special emphasis on the prevailing agency theory framework which will be discussed later in this paper. Page 9 of 100

10 The scientific theoretical level, on the other hand, has to do with the paradigm forming the thesis and the methodological approach. Regarding the scientific paradigms Guba (1990) identifies four different dimensions: Positivism Postpositivism (or neopositivism) Critical theory Constructivism For the purpose of this paper the authors have assessed the postpositivistic approach to be the most appropriate. On an ontological level postpositivism, as well as positivism, assumes that reality is out there, however, the two dimensions differ in the way that postpositivism does not see it as possible for humans to fully perceive and understand the world, even though it is driven by real cause and effect relations. On an epistemological level postpositivism differentiates itself from the subjectivistic nature of critical theory and constructivism although it does not adopt the fundamental objectivity of positivism, which requires the inquirer to be in an absolute distance from what is being inquired, thereby rejecting any occurrence of values and other biases from the outcome of the research. Instead postpositivism keeps objectivity as a goal, but acknowledges through its modified objectivity that it can only be approximated. On the methodological level the authors will follow the postpositivistic approach of concluding on the basis of theoretical generalizations about reality s objective nature through deductive thinking, which on the basis of the previously mentioned modified objectivity can only become an approximate depiction of reality (Heldbjerg, 1997). Having determined the basic scientific approach through ontology and epistemology, the methodology has also been touched upon. Arbnor and Bjerke (1997) further deals with the methodology, by splitting the subject in three points of views: The analytical view The systems view The actors view Page 10 of 100

11 Describing these approaches Arbnor and Bjerke (1997) defines methodology as a set of ultimate ideas about the constitution of reality, the structure of science, that is important to methods, that is, to guiding principles for creating knowledge. Basically, methodology is concerned with how something can be done and includes the methods, procedures, and techniques used to collect and analyze information and the unraveling of concepts and approaches should in this way help the reader to understand the author s concept of reality when writing the paper. The three methodological approaches relate to paradigmatic categories, shown in the figure 1.1 below. Figure 1.1: Reality and the Approaches Source: Arbnor and Bjerke (1997:44) These approaches should be read with Guba s previously mentioned dimensions in mind, which will reveal that the systems approach is one of the approaches which continue the line of thought from postpositivism. The analytical approach is more in line with positivism and the actor s approach follows the constructivist paradigm. Still, however, as it can be seen from the model, the systems approach overlaps the analytical approach as this paper will also do on different aspects. Unlike a typical quantitatively oriented analytical study, the authors of this thesis will not gather empirical data to answer the problem statement, Page 11 of 100

12 they will, however, use empirical data from other researchers to support theories and hypotheses in line with the more pragmatic approach of the systems line of thought. This leads to a data collection based on secondary data such as; Articles Journals Books Laws and Guidelines Websites Naturally the list above is by no means an exhaustive list. They are however the primary sources (of secondary data) of this paper Structure of the Thesis The structure of the whole thesis is focusing on getting a theoretical understanding of the problems, so the authors will become able to conclude with some theoretical recommendations on getting a more balance alignment between shareholder and stakeholder interests through bank executives compensation packages. The first focus point in the thesis is the angle from which the problem is viewed; this is done by looking at relevant literature around corporate governance, hereby creating a foundation for the board perspective used throughout the thesis. Next, the thesis goes through the agency theory, which is one of the basic assumptions behind the whole problem statement. Typically, when discussing compensation plans from the view of the shareholders it has its roots in agency theory. This makes the agency theory a natural central starting point of this thesis for the discussion on how better to design a bank executive s pay in order to give him direction that more effectively aligns stakeholder and shareholder interests. After establishing the core theoretical understanding of the problem, the next part in the thesis will focus on literature that sheds light on other parameters to understand which theories and components can be used to answer the problem statement. Page 12 of 100

13 First the authors will investigate literature about the bank sector in Denmark. This is done in order to find out if the industry creates some delimitations on what can be used from the general literature about compensation and to get a better understanding of the banking industry. The next part focuses on the literature on compensation as mentioned earlier. This gives a feel for what compensational tools can be used to design a compensation plan that provides direction to the executives. At the end of this part the authors will sum up the first four parts to create a model on how compensation packages are traditionally being designed in the bank world today. After having designed a model on how compensation plans are designed the authors move on to look at some of the guidelines that already exist, both national and internationally. This section will help the authors to find different areas where the literature on compensation can be improved. At the end, all of the above mentioned parts will have created a basis for a discussion to find areas where the current guidelines on the topic can be improved. This leads to a model developed by the authors in order to better align stakeholder and shareholder interest through executive compensation plans in the Danish bank sector. Page 13 of 100

14 2. Theoretical Background The report will start off with a review of theories, definitions and other information which is fundamental to gain a deeper understanding of the remuneration debate in the context which has just been outlined. This background section will elaborate on the perspective of the thesis, i.e. the board perspective, but also on the framework in which it is embedded Defining Corporate Governance According to the business writer O'Donovan (2003), corporate governance is an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders by directing and controlling management activities with good business savvy, objectivity and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes. (O'Donovan, 2003). In this citation O'Donovan refers both to the different players in corporate governance: shareholders, stakeholders and management, and what elements corporate governance includes. In this project we focus on three different aspects of corporate governance, control, effectiveness and stakeholder consideration as beacons for the board in terms of directing the management of a corporation in a remuneration setting context. This direction has often only been focusing on the shareholder interests, because corporate governance to a high extent deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment (Shleifer, Vishny, 1997). Here, agency theory is introduced, which will be examined later. A concept that is relevant for all three parts is agency theory. How do the principals ensure that the agent will act effectively on their behalf and in their interest and not in the agent's own? One of the elements that can also be related to these areas is the question of how proper compensation should be determined. The role/responsibility of corporate governance is taken on by the board of directors. The board of directors consists of two types of members; independent and dependent. Page 14 of 100

15 Independent directors are those serving on the board that had no relationship to the company before they joined the board. Dependent directors are people from inside the company who gets on the board (Shultz, 2008). According to Bowen (2008) a properly functioning board provides corporate governance by adding layers of judgment and protection against abuse of power, self-dealing, favoritism, and just plain foolishness. The board serves also as a valuable connection between the work of the company and the external environment that conditions the success or failure of the corporation in so many ways (Bowen, 2008). The responsibilities of the board of directors will be described later in this part, where both the responsibility of executives and the board of directors will be investigated General Danish Corporate Governance Structure In order to investigate and understand corporate governance in a Danish context, it would be beneficial to examine this exact context. In many ways the Danish corporate governance structure is similar to that of other European countries, however there are some differences. One of the main characteristics is the structure of the actual board. Whereas the UK and the USA operate with a unitary board that comprises both executives and non-executives, Danish companies operate with a dual board structure with a supervisory board and an executive board of management 1. Traditionally in the dual board structure the supervisory board has a monitoring responsibility and oversees the direction of the board of management, whereas the board of management (or executive board) is responsible for the running of the company (Mallin, 2007). In Denmark, however, there is not such a clear distinction between management and control because the so-called supervisory board also takes part in strategic decisions for the company as well as because of the fact that the Danish law permits executives to serve on the so-called supervisory board. In this way the Danish model is somewhat of a hybrid of 1 In Danish the supervisory board is called bestyrelsen and the board of management is called direktionen Page 15 of 100

16 the one-tier unitary board and the two-tier dual board (Knudsen, 2005). The ownership structure is also a factor that differentiates Denmark from other countries. Ownership is very concentrated in Denmark and foundation ownership plays a vital and significant role (Rose, Mejer, 2003). Institutional ownership also plays an important part with institutional investors owning approximately 35 percent of market value of Danish equity (Mallin, 2007). Traditionally Danish corporate governance has had somewhat of a stakeholder orientation, illustrated by legal requirements such as the demand for employee representation at the board. However, before the financial crisis there has been more pressure on Danish firms for increasing its focus on shareholder value. A consequence of this has been an increase in stock-related incentive contracts (Rose, Mejer, 2003) Responsibilities of Managers/Directors When discussing the responsibilities of directors of the board some distinctions should be made. First of all there is, on the one hand, the legal aspect, and on the other, different guidelines that provide guidance to both what directors should do and to a certain extent how they should do it. Whereas the thesis will later handle the question of how the board should take action concerning the determination of executive compensation Bowen (2008:21) sums up the overall responsibilities of the directors of the board as divided into the following categories: 1. Select, encourage, advise, evaluate, compensate, and, if need be, replace the CEO 2. Discuss, review, and approve strategic directions 3. Monitor performance 4. Ensure that the organization operates responsibly as well as effectively 5. Act on specific policy recommendations and mobilize support for decisions taken. 6. Provide a buffer for the president or CEO in the vernacular, take some heat 7. Ensure that the necessary resources, both human and financial, will be available to pursue the organization s strategies and achieve its objectives Page 16 of 100

17 8. Nominate suitable candidates for election to the board, and establish and carry out an effective system of governance at the board level From these areas it is obvious that this thesis will have its focal point on the compensation part of the first category, but actually compensation can also be a factor that supports several of the other categories. For example, a compensation plan can help guide strategic direction (2), it can encourage both responsibility and efficiency (4), it can be a buffer for the executives regarding the compensation debate (6) etc. The Danish Law also determines certain responsibilities for directors, whether they serve on a management board or a supervisory board. Besides maintaining the overall and strategic direction, as well as securing a reasonable organization of the company, the Danish company law 2 (Økonomi- og Erhvervsministeriet, 2009b) specifies demands on the board regarding (1) a satisfying conduction of audit, (2) necessary procedures for risk management and internal controls, (3) proper financial reporting, (4) that the management conducts its duties in a proper way, and (5) that the company s available cash resources and funds are at a reasonable level at all times Key Committees Boards will most often have appointed various sub-committees. These sub-committees will then report to the board on specific areas. There can be several reasons for this, but the main purpose is that a smaller group can focus on a matter and consider it in more detail than would be convenient for the whole board. Another purpose is to increase the objectivity of decision-making to avoid conflicts of interest, for instance when determining executive remuneration, or to discipline personal preferences as in the exercise of patronage (Charkham, 2008). However, it is important to remember that even though various tasks 2 Selskabsloven Page 17 of 100

18 may be delegated to sub-committees, it is still the board as a whole that remains responsible for the areas covered by these committees. Many independent corporate governance codes recommend that specific committees should be formed. The British Cadbury Report (1992) recommends that as a minimum an audit committee and a remuneration committee should be formed. This is also stated in the British Combined Code (2006), which emphasizes the need of a nomination committee as well. According to the Higgs (2003) most listed companies have both an audit and a remuneration committee. In fact, just one FTSE company did not have any of the two committees, while app. 15% of companies outside the FTSE 350 did not have an audit committee, whereas as much as 71% did not have a nomination committee. Of the FTSE 100 companies however, only 6 companies did not have nomination committees. These most common sub-committees will be described briefly below Audit committee The audit committee is one of the most central committees. The Smith (2004) review, a group appointed by the British Financial Reporting Council, defined the role of the audit committee as revolving around the terms oversight, review and assessment. These signify that the committee should not be engaged with specific monitoring themselves, but rather focus on having an effective system of controls in the company and ensure that the actual auditors are objective. In this way the committee is supposed to be a strong representative for the shareholders and a useful link between internal and external auditing, but also as a unit that provides relevant information to the board. Therefore it is important that the committee is comprised of independent non-executive directors, so that the right questions can be asked and so that the occurrence of conflicts of interest can be minimized (Spira, 2002). 3 FTSE 100 is the 100 largest UK firms listed on the London Stock Exchange, based on market capitalization Page 18 of 100

19 Remuneration Committee The Combined Code (2006) suggests that the board should establish a remuneration committee of at least three, or in the case of smaller companies, two, members, who should all be independent non-executive directors. This is similar to the recommendations of the Danish Committee on Corporate Governance, which will be elaborated on in a later section. The non-executive part is important to prevent executives from setting their own remuneration level and the independency of the members should prevent a situation where they themselves could have something to gain by overpaying executives. Besides making suggestions to the board regarding the remuneration level the committee should also determine appropriate targets for any payment-for-performance schemes Nomination Committee Years ago the normal procedure for employing new directors to the board was through the connections of existing board members. This has led to friends of the current directors to be employed. This procedure has implications as it will lead to an imbalance of the board, in terms of a lack of independent non-executive directors that are appointed on the basis of their relevant knowledge and professional skills. The answer to this problem has been the nomination committee (Mallin, 2007). The nomination committee should, on a continuous basis, evaluate what skills, as well as knowledge and experience, are needed on the board. With these factors in mind the committee should engage in succession planning and search for appropriate candidates. The Combined Code (2006) sums up that there should be a nomination committee which should lead the process for board appointments and make recommendations to the board. A majority of members of the nomination committee should be independent non-executive directors (Financial Reporting Council, 2006:A.4.1.). Page 19 of 100

20 2.3. Agency Theory Agency theory in its simplest form concerns the relationship between a principal and an agent who makes decisions on behalf of the principles (Douma, Schreuder, 2002). In corporate governance agent theory is one of the major theories because it deals with the topic of self-interest, bounded rationality 4 and risk aversion from both parties (Eisenhardt, 1989). The CEO is an agent making decisions on behalf of the corporate board. Corporate boards are controlling the company on behalf of the shareholders. Therefore it could be said that the CEO is an agent on behalf of the shareholders. This alignment between CEO, corporate boards and shareholders creates an important research question: On whose behalf is the CEO making the daily decisions in the organization? Another reason why agency theory is really important is that it deals with the issue of separation of ownership and control. Agency theory argues that in companies, where share ownership is broadly held, management actions diverge from those required to maximize shareholders returns (Berle, Means, 1932). This separation of ownership and control is important for the decisions of executive compensation because the actions of one party affect both his welfare and that of another party. This relationship between shareholders and executives cause an agency loss which is the amount to which returns to the shareholders fall below what they could receive if the shareholders had exercise direct control over the company according to Jensen & Meckling (1976) and Donaldson & Davis (1991). Narrowly defined an agency relationship is a contract in which one or more persons (principals) engage another person (agent) to take actions on behalf of the principals, which involves the delegation of some decision-making authority to the agent. In an agency relation, the principals want the agent to act in the principals best interest. On the other hand, the agent is expected to also have his own interest and if both parties in the 4 The bounded-rationality framework views individuals as attempting to make rational decisions, it acknowledges that decision makers often lack important information on the definition of the problem, the relevant criteria, and so on (Bazerman, 2006: S. 6) Page 20 of 100

21 relationship are utility maximizes, there is a good reason to believe that the agent will not always act in the best interest of the principals (Jensen, Meckling, 1976). If this was their only interest to consider the only problem is to design an incentive contact that induces the agent to undertake actions that will maximize the principals welfare. When the contact includes only the interest of the shareholders, to maximize profit, the design of executive compensation do not take into consideration the interest of stakeholders in the organization. The attention devoted to developing a theory of agency has resulted in two approaches; 1) Positive theory of agency and the 2) Principal-agent theory. Although they differ in many respects, both theories address the contracting problem among self-interested individuals and assume that in any contracting relationship total agency costs are minimized. The principal-agent theory is generally mathematical and non-empirically oriented, whereas the positive theory of agency is generally non-mathematical and empirically oriented (Eisenhardt, 1989:6) Positive Theory of Agency The main research questions in the positive theory of agency are: how do contracts affect the behavior of participants, and why do we observe certain organizational forms in the real world (Douma, Schreuder, 2002). The positivist agency theory investigates the principal and agent when having conflicting goals. The main focus here has been on the governance mechanisms that limits the agent's self-serving behavior. These governance mechanisms that solve the agency problem have been the main theoretical perspective in positivist agency theory. According to Eisenhardt (1989) there have been three influential articles: (Jensen, Meckling, 1976; Fama, 1980; Fama, Jensen, 1983). From these influential articles Eisenhardt has created two propositions: When the contract between the principal and agent is outcome based, the agent is more likely to behave in the interests of the principal. Page 21 of 100

22 When the principal has information to verify agent behavior, the agent is more likely to behave in the interests of the principal. These propositions assume that the principals are the shareholders but nowadays we see a three party having a big influence on both the relationship and how the agent behaves. This new party is stakeholders. One research question would be: Does this new party have any influence Eisenhardt's two propositions? And if yes: How is this new complexity of the relationship taken into consideration when designing executive compensation? Theory of Principal and Agent According to Douma & Schreuder (2002) the central research question in the principalagent theory is; how the principal should design the agent's reward structure. As mentioned earlier the principal-agent theory follows mathematical and logical deduction of the assumptions. This focus helps on determining the optimal contract between principal and agent, with special focus on behavior versus outcome. With this general focus principalagent theory can be applied to employer-employee, lawyer-client, buyer-supplier, and other agency relationships (Eisenhardt, 1989). The simplest model of the theory assumes goal conflict between principal and agent. This conflict exist because the agent is more risk averse than the principal. The simple model can easily be described by two cases. The first case, a simple case of complete information, is when the principal knows what the agent has done. Given that the principal is buying the agent's behavior, then a contract that is based on behavior is most efficient. An outcome-based contract would needlessly transfer risk to the agent, who is assumed to be more risk averse than the principal. The second case is when the principal does not know exactly what the agent has done. Given the self-interest of the agent, the agent may or may not have behaved as agreed. (Eisenhardt, 1989:6). The second case is the reason why the agency problem arises. Page 22 of 100

23 Agency Problem Almost all contractual relationships are potential subjects to an agency problem, where one party promises to perform on the behalf of a second party. The agency problem almost always exists in a relationship between shareholders and top executives. Here the top management (agent) is performing on the behalf of the shareholder's (principal) welfare. The relationship between shareholder and top executives is a typical example of the second case, where the agent has better information than the principal about the relevant facts. This advantage of information can lead to opportunistic behavior on behalf of the agent. This creates a situation, where the value of the agent's performance to the principal will be reduced. For the principal to assure that the agent does not under perform, he must engage in costly monitoring of the agent. The monitoring of the top executives is also done by the compensation committee under the board of directors (Bowen, 2008). Commonly, it is also the compensation committee which designs the executives compensation plan, where it has to be approved by the shareholders. Even with the monitoring board of directors there still is an agency problem, but the board of directors decrease the information advantage of the agent (The Economist, 2010). According to Hansmann and Kraakman (2004) there are three generic agency problems which arise in companies. The first involves a conflict between owners and managers; second a conflict between majority and minority shareholders; and third, a conflict between the company itself (including, its shareholders) and the other parties with whom the company has dealings with, such as creditors, employees, and customers. For the purpose of this project only the generic agency problem number one and three will be focused on. Again this is focus on the second case (from the last paragraph), where the problem lies in aligning the shareholders interest with top executives interest and not the executive s personal interest. This situation between agent and principal develops a state of uncertainty and asymmetric information, which imposes certain constraints that generate two kinds of problems, a moral hazard and adverse selection. Page 23 of 100

24 Moral Hazard The moral hazard problem has a big influence on the executive compensation discussion. A moral hazard problem arises when the shareholders cannot observe the top executives actions. In the case of observing the top executives action is one of the tasks of the board of directors. A moral hazard problem can arise because (1) there is a positive cost of monitoring agent's actions and (2) the board of directors is not even able to perfectly infer agents actions by observing the outcome because the agent s actions do not completely determine the outcome (Padilla, 2002). Moral hazard may be defined as actions of economic agents in maximizing their own utility to the detriment of others, in situations where they do not bear the full consequences or, equivalently, do not enjoy the full benefits of their actions due to uncertainty and incomplete or restricted contracts which prevent the assignment of full damages (benefits) to the agent responsible (Padilla, 2002:6). This moral hazard problem gives the principal two difficulties when designing a contract. First, he cannot design a contract based on his observation of the agent's actions. The total cost of monitoring the top executives is prohibitive. Second, it is hard for the principal to design the contract with a focus on outcome for two reasons: There is uncertain between the agent's action and the outcome of his actions. An agent would not sign a contract that is predicated by the principals observation because the agent is risk neutral 5. Therefore the principal cannot assign the full consequences of the agent s action in a contract. This makes the agent able to engage in discretionary behavior. Where the agent makes decisions against the interest of the principal. Agency theory literature focuses on the contracting process and how information aspects of moral hazard are integrated in a contract. This is done to minimize the cost of moral hazard problems. The key elements in the principal-agent literature are the structure of preferences 5 Risk neutral is the behaviour between risk aversion and risk seeking. Page 24 of 100

25 of the parties to contract, the nature of uncertainty, and the informational structure in the environment. Therefore a general conclusion to the agent problem is to design a contract which has a carrot and sticks format to maximize the principal utility. This is done by balancing incentives and risk sharing as well as rewards and punishments. The idea is that if the agent meets the desired outcome he is reward and punished when not. Agency literature also focused on another agency problem: adverse selection Adverse Selection The adverse selection problem has to do with asymmetric-information. Here the agent has information that the principal does not know he has, which may be useful for the agent's decision-making. In a case of an adverse-selection problem, the costs of monitoring an agent's actions are not at stake insofar as the principal is not in possession of the information held by the agent; consequently, he is not able to know if the agent's actions were appropriate (Padilla, 2002) Optimal Contracting Approach Optimal contracting deals with the agency problem that executives not automatically seek to maximize shareholder welfare. Under optimal contracting the board is aligning the interest between shareholders and executives with adequate incentives. Here we have to remember that the board is working in favor of the shareholders interest (Bebchuk, Fried, 2003). According to Bebchuk & Fried (2003) there are two ways an optimal compensation contract can result with: effective arm's length bargaining between the board and the executives or from market constraints that induce these parties to adopt a contract. Page 25 of 100

26 One problem with the optimal contracting approach is that it cannot be assumed that the board seeks to maximize shareholders welfare more than it could be assumed for the executives. The behavior of the directors is also subject to the agency problem Managerial Power Approach The managerial power approach is one way of explaining why executives get more favorable compensation than what they should have with arm's length bargaining (Bebchuk, Fried, 2003). Bebchuk and Fried (2003) suggest that with the more power the executives have, the greater is their ability to get a better compensation package. The managerial power approach also builds on: outrage and camouflage. First outrage ; consist of costs and constraints. The tightness of the constraints managers and directors confront depends, in part, on how much outrage a proposed arrangement is expected to generate among relevant outsiders. (Bebchuk, Fried, 2003:75). The outrage of these outsiders might cause embarrassment or reputational harm to directors and executives and this might decrease support from shareholders. Therefore acceptance of a compensation package will depend on how it is perceived by the outsiders. Second camouflage ; To avoid or minimize the outrage that results from outsiders' recognition of rent extraction, managers have a substantial incentive to obscure and try to legitimize or, more generally, to camouflage their extraction of rents. (Bebchuk, Fried, 2003:76). Many times the adoption of camouflaged compensation plans leads to an inefficient compensation structure, which hurt managerial incentives and firm performance. The managerial power approach can help explain four patterns and practices by power and camouflage: Power-Pay Relationships; Compensation Consultants; Stealth Compensation and Gratuitous Goodbye Payments (Bebchuk, Fried, 2003). 1. Power-Pay Relationships; Within this relationship the executives pay will be higher or less sensitive to the performance of the company relative to have much power the Page 26 of 100

27 top executives have. The more power the less sensitive to performance. There are four pattern's where the top executives tend to have more power, with other things being equal: i) the board is relatively weak or ineffectual; ii) there is no large outside shareholder; iii) there are fewer institutional shareholders; or iv) managers are protected by antitakeover arrangements. 2. Compensation Consultants; Are taken in to help design a compensation package that under the optimal contracting framework is fair to both parties. Often these compensation consultants end up having the role of justifying executive pay rather than optimizing it. A consultant is hired by the human resource department (HRD) which is under the CEO (top executives). This link between HRD and CEO has a negative impact on the consultant's goal of making an optimal contract because a consultant that hurts the top executive s pocketbook would have a harder time being hired by the same company again, or indeed by any other firms. 3. Stealth Compensation; Are arrangement used by companies to camouflage compensation and make them insensitive to performance. Stealth compensation includes: pension plans, deferred compensation, postretirements perk and consulting contracts. 4. Gratuitous Goodbye Payments; Are severance arrangements that go beyond what is specified in the contract, so gratuitous payments are what the company pays on top of a CEO's contract to replace them. The gratuitous goodbye payments are commonly used when a board has to replace a CEO for poor performance. This creates insurance for the CEO against being fired for poor performance. The signal this insurance sends to the next CEO and top executives will only weaken their incentive to perform. Page 27 of 100

28 3. The Danish Bank Sector The Danish bank sector is a part of the financial sector in Denmark. This sector encompasses financial institutions, mortgage lenders, insurance companies, pension funds, etc. (Pedersen, 2002). A strong financial sector is a key catalyst for growth and welfare in a country and therefore a country is in need of efficient, transparent and competitive financial markets, but also because the financial sector intermediates savings into investments and deals with risks that can both benefit and harm economic activity (Økonomi- og Erhvervsministeriet, 2002). The role of competition in the banking sector is of particular importance, given the central role played by commercial banks in the economy. By resolving the problems of information asymmetries, banks are able to efficiently intermediate the funds from depositors to borrowers, contributing to economic growth (International Monetary Fund, 2007). The roles that the banks have in a society today have a great deal of importance for citizens, companies and public authorities. According to Finansrådet 6 (2010a) these roles are: The banks role in companies daily business: The banks are there when entrepreneurs start up new ventures, when companies expand, sell or buy. They are there when it goes up and when it goes down. Therefore banks are entities that constitute an important factor for a country s competitiveness. Banks in the citizens daily life: The banks are there when people buy dinner, pay rent and other bills. They help when people save up for holidays or need to borrow money for a new house, car etc. Banks and growth: Banks are an important part of a country s economy and have a great impact on the financial development. Countries with a well-functioning financial sector experience more growth and welfare than other countries. Banks as companies: Here the banks have the same role as other companies in a country by contributing to the country's economy in a traditional sense. This is done 6 The Danish Bankers Association Page 28 of 100

29 through employment, tax payments, education, innovation, research and development. Banks take a social responsibility: The banks do this by involving themselves and supporting the local sports clubs and charitable organizations. They also provide voluntary debt advice. After the review of the role the bank sector plays in the Danish society a small description of the development in the Danish bank sector will be made Historical Development The Danish bank sector has traditionally consisted of two different types of banks: banks and saving banks. The saving banks were not allowed to do all of the banking business as the banks. Saving banks could not conduct trade with stocks, provisions of securities and foreign businesses. This however changed in 1988 where savings banks where fully allowed to both conduct business as the normal banks and get capital by issuing stocks (Baldvinsson et al., 2005). Shortly after giving the saving banks the same rights as normal banks the Danish banks started merger wave. In 1990 there were two major mergers: the first merger was between Den Danske Bank, Handelsbanken and Provinsbanken; the second were between Privatbanken, Andelsbanken and Sparekassen SDS under the name Unibank. In 2000 Unibank merged with banks from Sweden, Norway and Finland in The Nordic Baltic Holding later Nordea. The same year Den Danske Bank merged with Kapital Holding and became the biggest financial institution in Denmark under the name Danske Bank. This history of bank mergers across the borders of the Scandinavian countries has changed the view of what the big banks in these countries see as their home market to a view where Scandinavia is seen as one big home market (Baldvinsson et al., 2005). The trend that the Danish bank sector is becoming more of a Scandinavian bank sector is not the only change there has been in the bank sector. In 2000 for the first time in the Page 29 of 100

30 Danish banking history the loans were bigger than the total deposits in the bank sector (Baldvinsson et al., 2005). This development has continued until today 7. The difference between loans and deposits has increased until 2008 where it topped with a deposit deficit of more than DKK 500 billion (Bechmann, Raaballe, 2009a). Figure 3.1 Developments of Deposits and Loans, Quarterly Source: (Danmarks Nationalbank, 2010) By looking at figure 3.1 one can see that the difference has decreased between loans and deposits within the groups 1 and 2 8 in the Danish bank sector after the economic crisis started (2008). 7 Today in this case is Group 1: Dansk Bank, FIH Erhvervsbank, Jyske Bank, Nordea Bank Danmark, Nykredit Bank and Sydbank (working capital above 50 billion). Group 2: Alm. Brand Bank, Amagerbanken, Arbejdernes Landbosbank, Forstædernes Bank, Ringkjæbing Landbosbank, Spar Nord Bank, Sparbank, Sparekassen Sjælland and Vestjysk Bank (working capital above 10 billion). Source: (Danmarks Nationalbank, 2010:12) Page 30 of 100