Bonus-bashing

11 Nov 2009

Shane Fitzgerald

As legislators across the EU and the world struggle to formulate and implement effective policy responses to the financial crisis, one issue has surfaced as a top priority for voters and their representatives. Certain bankers’ pay and bonuses have long been held up as egregious examples of capitalist excess. But rather than merely rail ineffectually against greedy financiers, critics can now point to the very real role that inappropriate remuneration policies have played in a global financial meltdown. Chronic short-termism, especially in the linking of bonuses to yearly and quarterly profits, had a detrimental impact on companies’ risk profiles, and the worry is that this could happen again if business is allowed to resume as usual. Compounding this is taxpayers’ fury at being forced to bail out the banks, resulting in the widespread conviction that this time, something really must be done to bring the ‘Masters of the Universe’ back down to Earth.

Banks’ compensation practices are ultimately a matter for corporate governance, and in money terms are probably the least important of the areas being targeted for reform. Nonetheless, the combination of popular moral sentiment and severely degraded risk profiles means that the issue is now being taken seriously by regulators and supervisors in determining capital and liquidity requirements. However, while dealing sternly with institutions receiving public support is possible, reining in remuneration in the broader financial sector is proving extremely difficult.

In the US, Treasury is cutting executive compensation at companies which received government funds, while the Federal Reserve wants to monitor pay policy at thousands of banks to ensure that they don’t encourage reckless risk-taking. Yet the ‘Big Three’ investment banks (Goldman Sachs, Morgan Stanley and JP Morgan Chase) are set to pay record bonuses totalling nearly $30 billion in 2009. Having paid back government bail-out money and exited the Troubled Assets Relief Program, there is little that Barack Obama’s pay czar, Kenneth R. Feinberg, can do to stop them.  

The European Commission adopted two recommendations in this area in April of this year: one on the remuneration of directors of listed companies and the other specifically dealing with incentive systems in the financial services sector. Meanwhile, at the Pittsburgh Summit in September 2009, the G20 group of countries agreed to implementation standards, developed by the Financial Stability Board (FSB) on ‘reforming compensation practices to support financial stability’.

Subject to approval by the European Parliament and Council, elements of these recommendations and standards will be given legal force by a recent Commission proposal to amend the Capital Requirements Directives (CRD) of 2006. In addition to imposing restrictions on remuneration policies at banks and credit institutions, the proposal has the following objectives:

·      Address capital requirements for the trading book – It is proposed to change the way that banks assess risks connected with their trading books so as to better reflect potential losses.

·       Increase capital requirements for re-securitisations – This is intended to make sure that banks take proper account of the risks of investing in these complex financial products.

·      Increase disclosure demands for securitisation exposures – This should enhance market confidence and so encourage banks to start lending to each other again.

Despite the wider significance of these measures for both the financial sector and the real economy, it was the proposed amendments in the area of pay and bonuses which came in for the most scrutiny and debate at recent discussions of the Oireachtas Committee on EU Scrutiny.

The proposals were debated in the context of the situation in Ireland, whereby banks covered by the September 2008 guarantee scheme must now abide by the conclusions of the government-appointed Covered Institution Remuneration Oversight Committee (CIROC), which were subsequently amended by the Minister of Finance in order to cap executive salaries at €500,000 per annum. The new EU rules will affect all staff whose activities have a material impact on the risk profile of the financial institution in question. This means that not only executives and senior management but also those involved in sales and trading may be subject to their requirements, which link compensation practices to performance proven over time. The new regime will be overseen by the Committee for European Banking Supervision and later – if the EU’s proposals in the area of supervisory reform come to pass – by its replacement agency, the European Banking Authority.  

These new rules should enhance financial stability by linking remuneration policies to effective risk management. It remains to be seen if they will also help to neutralise the inflammatory issue of bankers’ pay and bonuses in the Irish and European discourse on financial sector reform.

As an independent forum, the Institute does not express any opinions of its own. The views expressed in the article are the sole responsibility of the author.