More financial institutions, facing pressure from regulators and investors, are starting to employ compensation practices that reward ethical behavior and appropriate risk-taking, and that’s the good news. The bad news, underscored by two recent studies, is that financial institutions still have a long way to go.
According to a recent study conducted by law firm Labaton Sucharow and the University of Notre Dame, 32 percent of more than 1,200 American and British financial services professionals said their compensation structures or bonus plans pressure employees to compromise ethical standards or violate the law. Twenty-seven percent said they don’t agree that the industry puts the interests of clients first.
In another study conducted by Deloitte, 51 percent of respondents from 71 global financial institutions, representing almost $18 trillion in total assets, said one responsibility of their independent risk management group is to review compensation plans and assess their effect on risk appetite and culture. The report also found it “surprising” that only 63 percent of respondents said their board or board risk committees review incentive compensation plans to consider alignment of risk with rewards.
At least some banks are now trying to change that dynamic, to move away from compensation plans focused on the short term that can lead to the sort of excessive risk-taking seen before the 2008 financial crisis.
“The shift that’s taking place is to take some of that annual incentive and not pay it out immediately in the form of cash, but rather pay it out in stock that people have to hold for a period of time,” says Steven Hall, managing director of the executive compensation consulting firm Steven Hall & Partners. The idea is that the more equity you give employees, the more stake they have in the well-being of the organization and the more incentive to act in the interest of shareholders.
According to the Deloitte report, some of the new compensation practices banks are adopting include: requiring that a portion of the annual incentive is tied to overall corporate results (72 percent); balancing the emphasis on short- and long-term incentives (64 percent); using multiple incentive plan metrics (62 percent); and deferring payouts linked to future performance (61 percent).
Few respondents, however, said their institution uses other compensation practices designed to align employee incentives with the institution’s risk management objectives, such as caps on payouts; establishing for employees identified as material risk takers a maximum ratio between the fixed and the variable component of their total remuneration; and use of individual metrics tied to the implementation of effective risk mitigation strategies.
“A consistent leadership culture is necessary in which corporate values, business strategy, and formal incentives support each other.”
Jürgen Fitschen, Co-Chair, Management Board & Executive Committee, Deutsche Bank
“It is likely that many of these practices will become more widespread over time as regulators focus on compensation as part of their increased attention to risk culture,” the report stated.
Some bank executives are starting to get the picture. “A consistent leadership culture is necessary in which corporate values, business strategy, and formal incentives support each other,” Jürgen Fitschen, co-chief executive of Deutsche Bank, said in a statement on the company website, describing the company’s compensation practices.
Deutsche Bank has significantly revamped its compensation and bonus program over the last several years. “One important measure is the strengthening of our internal controls, which means that the latitude for unacceptable behavior has been significantly reduced,” the bank stated on its website.
Deutsche Bank’s new internal control system “differs fundamentally from the system in force prior to the crisis,” the bank added. “The objective is to transform our risk culture and ensure that concern for the bank’s reputation is always at the heart of our decision making.”
Internal controls are now better aligned for Deutsche Bank’s “strategic and business policy objectives, its values, and client satisfaction and the bank’s reputation. This includes a stronger focus on qualitative aspects so that compensation is not just linked to financial targets but also a reflection of ‘how’ performance is achieved.”
But the bank still has a long way to go to restore its tarnished reputation. Fitschen and co-chief executive Anshu Jain both stepped down in June in response to investor criticism. Their resignations follow the bank’s $2.5 billion settlement with U.S. and U.K. enforcement authorities for its role in manipulating benchmark interest rates. Deutsche Bank took another blow the week of June 8 after law enforcement officials raided the bank’s headquarters amid suspicions of tax fraud relating to client securities transactions.
MANAGEMENT REMUNERATION IN THE BANKING SECTOR
In a joint position paper issued in 2014, Deutsche Bank and four other German banks—Commerzbank, DZ BANK, HSBC Trinkaus & Burkhardt, and HypoVereinsbank—committed themselves to ethical principles in the remuneration of management. Those principles are outlined below.
“The core aim is to make remuneration systems open and transparent and to eliminate false incentives.” The signatories have committed themselves to leadership that is oriented toward success and based on values. According to the banks, that demands the following:
Every payment must be clearly justified and appropriate to the services rendered.
A decisive factor in performance assessments is that managers are required to act according to company-specific values that need to be clearly transparent inside and outside the company.
The satisfaction of employees and customers are relevant factors for calculating variable salary components.
Every company should set maximum limits for the overall remuneration of its management staff for the financial year in question and justify them accordingly.
Appropriate consideration needs to be given to market-driven earnings that cannot be specifically attributed to the performance of the company’s management when decisions are taken on profit-oriented variable payments. This implies that variable salary components must not be exclusively fixed to a rigid set of financial indicators.
Any loss of earnings, short-time working or redundancies among employees that are necessary in times of crisis and the measures that are adopted need to be given appropriate consideration in the variable remuneration of managers.
Management remuneration systems must counteract any incentives that promote excessive risk-taking.
Managers that take risks and that stand to gain an advantage from taking them must also suffer the disadvantages caused as a consequence of taking these risks and be in a position to pay the price.
Decision-makers must deal with the issue of external expectations and be in a position to deliver a credible opinion.
Source: Deutsche Bank.
Another financial institution that recently amended its compensation practices is Denmark-based Danske Bank. Last year the bank revised its remuneration policy “to reduce the maximum amount of share-based severance payments,” the bank stated.
“Further, for material risk takers a deferred bonus is conditional upon the employee not having been responsible for, or having taken part in, conduct resulting in significant losses for the group, its shareholders, and/or the alternative investment funds managed by alternative investment fund managers within the group and that the employee has proven to be fit and proper,” Danske Bank stated.
Some hedge funds are also revisiting their compensation practices. For example, hedge fund Point72 Asset Management (formerly S.A.C. Capital Advisers) has adopted a “philosophy” that it refers to as “Rewarding What Matters.”
“The norm in a hedge fund environment is for portfolio managers to receive a percentage of the profit that they generate. They then share that with the teams of analysts who support them,” says Perry Boyle, head of equities at Point72. “In our view, it’s not enough to just pay for profit generation. We want to make sure that our compensation process is aligned with the mission, values, and goals of the firm.”
Portfolio managers are compensated not just for the percentage of profits that they generate, but also for “factors that lead to them contributing to the firm beyond their own self-interests,” Boyle explains. For example, the firm in the last year has implemented a new “P72 Academy” to hire and train undergraduates. “We need the help of our teams to train those people,” he says. For their efforts, employees, in turn, are rewarded in the compensation process, he says.
“We also need the help of our teams to train each other,” Boyle adds. If they spend time training their peers on skills they’re particularly good at, for example, that also gets rewarded, he says.
Point72’s initiative is hardly unprompted; a new name doesn’t erase a checkered past. In 2013, before S.A.C. Capital took the name Point72, it reached a record $1.8 billion settlement with the U.S. government and pleaded guilty to engaging in a widespread insider-trading scheme.
Financial institutions that offer annual incentives to foster a culture of ethics and compliance can institute similar practices that award employees of ethical behavior, Hall says. One example might be to award employees who engage in initiatives that help people qualify for mortgages who otherwise would have difficulty getting one, or awarding employees who offer educational training sessions for homeowners.
Bank of America’s storied legal history paints a painful picture of what can happen to a financial institution that does not foster a culture of ethics and compliance. Sworn testimony given by several former employees of the bank describe a culture where employees were awarded bonuses for the number of calls they held and the shortness of their duration.
Other employees said they were awarded gift cards to retail stores as rewards for placing accounts into foreclosure. In one particular example, an employee testified that “a collector who placed 10 or more accounts into foreclosure in a given month received a $500 bonus.”
As important as it is to reward employees for engaging in ethical behavior and appropriate risk-taking measures, it’s equally important not to promote those who have, says Eleanor Bloxham, founder of board advisory firm The Value Alliance. You cannot continue to incentivize employees, on one hand, but then promote those who have been involved in, or failed to oversee properly, these kinds of issues, she says.
Moving forward, financial institutions can also expect that enforcement authorities will place more emphasis on pay-for-compliance—in particular, compliance with anti-money laundering practices and the Bank Secrecy Act. “A large part of compensation is still based on either the assets under management or the actual transaction,” says Sven Stumbauer, a director with business advisory firm AlixPartners.
What should happen, Stumbauer says, is that objectives of the sales team and the compliance department need to be better aligned, focusing more on how clients are on-boarded, rather than simply bringing on new clients. Financial institutions need to show to regulators that they’ve established not only a culture of compliance, but also incentives for compliance, he says.
Compensation practices that align with ethics and a culture of compliance need to be embedded at the highest echelons of financial institutions, not just among rank-and-file employees. “Until it happens at the top of the organization, we’re going to continue to see the headlines that we’ve been seeing,” Bloxham says. “It has to be part of the culture throughout.”