As you may have noticed, pay is back on the corporate governance agenda in a big way. As the regulatory response to the credit crisis on both sides of the Atlantic begins to take shape, it is looking increasingly likely that remuneration will be a key area of consideration for both investors and other interested parties. The current crisis is leading to a fairly fundamental reappraisal of financial markets and how key organisations within them operate, and remuneration surely cannot avoid an overhaul.
The regulators are already starting to talk tough. In the UK, Financial Services Authority (FSA) chief executive Hector Sants recently restated his concern at the way banks had structured their remuneration during the good years. In a recent interview with the BBC’s business editor Robert Peston, the FSA boss said financial rewards had been structured in a way that encouraged the taking of significant risks with banks’ capital. He also said that the regulator would look at ways of punishing institutions that continue to incentivise staff to take such risks.
Meanwhile in the US the Counterparty Risk Management Policy Group (CRMPG), which has just published the so-called Corrigan III report, also identified incentive structures as one of the five main causes of the current financial crisis. As such remuneration is given the same kind of billing as mispricing of risk, liquidity and financial complexity as a contributory factor. This demonstrates just how central pay has been as a governance issue.
The report states: “[I]t is likely that flaws in the design and workings of the systems of incentives within the financial sector have inadvertently produced patterns of behaviour and allocations of resources that are not always consistent with the basic goal of financial stability.”
While largely steering clear of the executive compensation debate, the CRMPG does have some comments to make about the structure of rewards. It recommends that in general senior-level remuneration should be based primarily on the performance of the firm as a whole, be heavily stock-based and vest over the long term.
The kind of response needed will require some serious thought. Some, such as former Institute of Directors head of policy Ruth Lea, have argued that remuneration is purely a governance issue to be thrashed out between company boards and shareholders. A similar argument has been put by some in the investment community, and even Treasury minister Kitty Ussher has repeated the mantra.
However, recent experience should make us wary of the text-book argument that rational, self-interested investors are best placed to ensure remuneration arrangements are appropriate. As discussed in previous columns, a combination of the principal/agent problem (fund managers don’t invest their own money), behavioural biases and the sheer number of companies to be monitored, currently renders shareholder engagement less effective than it ought to be, and makes it unlikely that such activity alone will be sufficient. After all, the types of practice that have arisen in respect of bank pay have done so on the watch of supposedly more empowered and engaged ‘owners’.
We certainly need shareholders to reconsider their analysis of remuneration. The current crisis clearly demonstrates that schemes that reward short-term performance may not only be ineffective, they could be hazardous to investors’ wealth. Therefore it must be time for investors to start developing a genuinely long-term approach to such issues and begin to consider the risk that certain types of remuneration run.
But it is also important to keep the option of further regulatory or legislative intervention open. Some may fear that this will result in a heavy-handed response, however, this need not be the case. If investors set out clearly what the current problems are, and the type of reform required, they themselves can set the agenda. If anything, in the UK there has been a marked absence of an investor voice in response to the credit crisis. Therefore, if shareholders want to ensure that any remuneration reforms are effective, then they may find they need to play a part in public policy, in addition to their role in the markets.
Tom Powdrill is head of communications at PIRC.
