Incentive design for banks
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1 Incentive design for banks Professor Rüdiger Fahlenbrach Swiss Finance Institute and Ecole Polytechnique Fédérale de Lausanne (EPFL) Professor Alexander Wagner Swiss Finance Institute and Universität Zürich SFI Annual Meeting 2014 November 13, 2014
2 Agenda Compensation and incentives of top bankers and traders prior to the 2007/2008 crisis (Fahlenbrach) The evolution of non-executive bankers compensation over the last decades (Fahlenbrach) Recent settlements and its consequences for incentive design and HR (Fahlenbrach) Seven challenges and opportunities in pay design in banks today (Wagner) Outlook for the future and discussion (Fahlenbrach and Wagner) R. Fahlenbrach and A. Wagner : Incentive design for banks
3 Level and structure of pay of top U.S. bankers prior to the crisis of 2007/2008
4 2006 Compensation for a top US banker Compensation for the year 2006: Salary: $ Car, driver, tax counsel: $ Option grants: $ Restricted stock grants: $ Cash bonus: $ Total: $54,238,000
5 The debate on top banker s compensation can really be summarized in one slide Richard Fuld, former CEO of Lehman Brothers $ $
6 Top executive compensation in the financial industry post crisis Regulatory bodies are convinced that compensation contracts for executives and traders created too many incentives for risk taking Short-term bonus arrangements and equity grants that vested too quickly were identified as the main culprits (essentially, the $522 million on the previous slide) But it ignores that many CEOs and executives held on to their shares and lost substantial amounts of money Large debate on claw-back provisions, longer vesting periods for equity, and outright caps on bonus and variable compensation; partially implemented in many countries Problem of high compensation for traders partly solved by Volcker rule that bans proprietary trading Big question: Will these restrictions have an impact on retention of top talent?
7 Evolution of non-executive pay and its relation to the skill of employees and financial regulation
8 Wages in finance long term trends and determinants Thomas Philippon and Ariel Reshef have analyzed wages of all finance employees in the U.S. financial industry between Analysis is relative to wages in the non-financial sector A relative wage larger than 1 means finance employees are better paid than employees in the non-financial sector Source: Philippon, T., and A. Reshef, 2012, Wages and Human Capital in the U.S. Financial Industry: , Quarterly Journal of Economics, 127, R. Fahlenbrach and A. Wagner : Incentive design for banks
9 Jobs in the financial sector required more education, and were more highly paid both before 1930 and after 1980 R. Fahlenbrach and A. Wagner : Incentive design for banks
10 Relative pay and skill correlates strongly and negatively with the degree of regulation R. Fahlenbrach and A. Wagner : Incentive design for banks
11 Which subsector in finance is responsible for the large increases in wages? R. Fahlenbrach and A. Wagner : Incentive design for banks
12 Since approximately 1990, people in finance make more money than other people with the same education level Has led many observers to ask whether this leads to an inefficient allocation of talent: Should the physics Ph.D. be on the trading desk of a bank instead of researching new renewable energy sources? R. Fahlenbrach and A. Wagner : Incentive design for banks
13 Excess wages are controversial because they may lead to misallocation of talent For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance. [ ] At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources. While some part of what they do helps to allocate our investment capital more effectively, much of their activity adds no economic value. [ ] Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful. Benjamin Friedman, economics professor at Harvard University, excerpt from his Financial Times article from August 26, 2009 R. Fahlenbrach and A. Wagner : Incentive design for banks
14 International evidence on benchmark-adjusted wages in the financial industry Source: Wages and Human Capital in Finance: International Evidence, by Boustanifar, Everett Grant, and Reshef (2014) R. Fahlenbrach and A. Wagner : Incentive design for banks
15 Summary and outlook for non-executive wages Finance employees had higher relative wages and were more skilled than non-finance workers during the past two decades Both of these trends correlate strongly with the level of deregulation In some sense, one can interpret this evidence as deregulation helping employees use their skills creatively and this commands higher wages Finance employees have earned excess wages during much of the 1990s and 2000s, i.e. a higher wage than what one would have predicted taking the level of education, employment risk, and hours worked into account Future will bring more regulation of products, higher capital requirements, etc the presented evidence would predict pressure on finance wages
16 Recent settlements and its implications for incentive design and HR management in finance
17 Initially, much of the public outrage about banker s compensation contracts and the resulting incentives stemmed from a relatively small subset of top (investment) bankers and traders It has been amplified by perceived misdirected incentives in other areas of the financial sector and its contribution to the recent crisis Misdirected incentives will remain in the news as banks continue to pay fines and settle law suits for legacy issues R. Fahlenbrach and A. Wagner : Incentive design for banks
18 Fines for corporate misconduct source: Fines have been levied for, e.g., help with money laundering, Libor manipulation, circumventing sanctions and selling subprime mortgages and bonds Next issues are foreign exchange manipulation, more mortgage settlements,?. Top 10 banks had posted 57bn in reserves at the end of 2013, but nobody knows whether this is enough
19
20 Implications for incentive design and HR How do you design and enforce an incentive contract if you worry that a trader may manipulate a reference entity and you only find out after 5 years? Continuing bad reputation of the financial sector may make young talent shy away Legacy legal risks may also make talented people worried about joining a specific bank Lawsuits and settlements may convince the regulator to (try to) put more restrictions on incentives and pay Restrictions on pay may make highly qualified (and highly incentivized) employees leave for less regulated entities
21 In the light of all this: How to structure incentives in banking? Alexander Wagner will provide some thoughts
22 Seven challenges and opportunities in pay design in banks
23 Agenda 1. Alignment vs. controllability 2. Caps vs. linear variable compensation 3. Options vs. shares vs. performance shares 4. Disclosure of goals vs. confidential information 5. Relative vs. absolute performance 6. Special events vs. ordinary business 7. Crowding in vs. crowding out
24 1. Alignment vs. Controllability vs. Team Work Incentive system needs to fit the business model Key insight: «You get what you pay for» Consider a private bank Net new money as a KPI OK, but
25 2. Caps vs. linear variable compensation (Stated) reasons to impose caps, especially in banks It s not only how you pay, but also how much Public outcry over poorly calibrated systems CRD IV Proxy advisors. In 2014 AGM season, top 50 companies, AGAINST recommendations regarding comp reports and comp proposals: Ethos: 55.4%, ISS: 23.1%, SWIPRA: 30.8%, zrating: 38.5% «Avoid excessive risk-taking» Compensation can actually induce liquidity problems
26 2. Caps vs. linear variable compensation Caps are not «fire and forget» tools They need to be managed Let s have a look
27 2. Caps vs. linear variable compensation 800 Compensation (e.g., in thousand CHF) Target performance: Performance measure Linear performance-related plan Capped "bonus" plan (with threshold) Also see: PwC (2013), Murphy and Jensen (2011)
28 3. Options vs. shares vs. performance shares Stock options have a bad reputation But stock is also an option and can imply strong risktaking incentives in highly levered companies (such as banks!) Newest fashion: Performance shares. Calibration is important Performance shares have option-like properties
29 4. Disclosure of (quantitative) goals vs. confidentiality A touchy issue for many banks (and other corporations) Regulation (e.g., SIX, ERCO, etc.) does not require detailed disclosure But several companies do provide fairly detailed disclosure it becomes harder to argue that this information is confidential for competitive reasons Strongly diverging views of institutional investors and companies, see next page for an example from the SWIPRA corporate governance survey 2013 SWIPRA survey results 2014 will be presented on November 18 at the SIX Swiss Exchange
30 Compensation disclosure: Diverging opinions Explicit presentation on whether the individual compensation relevant goals for the board of directors / the executive management members were achieved 5 - very relevant not relevant 21.4% 28.6% 17.9% 16.1% 16.1% 0.0% 20.0% 12.0% 32.0% 36.0% 40.0% 20.0% 0.0% 20.0% 40.0% Institutional Investor Issuer 50% of institutional investors have a strong preference or some preference for issuers disclosing individual goal achievement levels of executive committee members, while no single issuers regarded this as very important, and only 20% regarded it as important. Question: Certain companies publish the following items in detail in their compensation report. How important are, in your opinion, these items for a compensation report? Source: SWIPRA Corporate Governance Survey 2013, 30
31 5. Relative vs. absolute performance Basic intuition of standard economic model: Filter out observable shocks In fact, economics literature takes pay-for-luck as a sign of bad governance But this doesn t necessarily always make sense from an incentive point of view And don t forget retention.
32 6. Special events vs. ordinary business Suppose a bank gets a fine (a purely hypothetical scenario ) Fairness (ex-post)? Incentives (ex-ante)? Sneak preview into the SWIPRA corporate governance survey 2014: 70-80% of institutional investors think adjusted profit measures are unsuitable as determinants of bonuses
33 7. Crowding in vs. crowding out Many reasons why explicit incentives may crowd out intrinsic preferences for pro-social behavior (information, framing, self-determination) Crowding out may require greater, not lesser use of incentives But 1/3 (!) of top published studies actually finds evidence of crowding in! Incentives / regulation per se are not the problem Key insight: The effect of incentives depends on the meaning that incentives convey to the agents Incentives can mean different things in different cultures what about the culture in your bank?
34 Concluding remarks One system does not fit all Not even within an industry Reward = broader than monetary compensation Incentives, Attraction, Retention
35 Discussion
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