G20 calls for curbs on bank bonuses

Global standards aim to align compensation in financial sector with long-term stability
By Sarah Dobson
|Canadian HR Reporter|Last Updated: 10/05/2009

With the G20 pushing for curbs on excessive risk-taking activities in the financial sector, if not a full cap on banker bonuses, Canada could see some changes to its guidelines. Banks may be required to defer some executive bonuses for three years, according to Finance Minister Jim Flaherty.

“One of the major things is to spread out bonuses so that bonuses are not paid for short-term profit, which was one of the issues that led to the crisis in the past year,” he said.

The announcement comes despite the fact Canada already has stronger regulations and has suffered much less than others in the financial markets — banks such as RBC did considerably well this year.

“This produces the embarrassing spectacle of banks handing out huge bonuses while everybody else is suffering,” said Jeffrey Gandz, a professor and managing director of program design at the Richard Ivey School of Business at the University of Western Ontario in London, Ont. “I don’t know how you deal with that — the optics are lousy and boards struggle with those optics.”

Those optics are part of a much larger struggle that’s emerging among G20 members (an economic forum consisting of 19 of the world’s largest economies, plus the European Union), who recently released a declaration on further steps to strengthen the financial system. They recommended several actions to prevent future crises, such as greater disclosure and transparency around remuneration and corporate governance reforms to ensure appropriate board oversight of compensation and risk.

They also called for global standards on pay structures, including deferrals, clawbacks, fixed and variable remuneration and guaranteed bonuses, “to ensure compensation practices are aligned with long-term value creation and financial stability.”

There’s a concentrated effort to push through global regulatory harmonization with respect to the financial markets, said Gandz.

“It’s going to have to be tackled. I don’t think at the rules level but at the principles level because the vast majority of people running the vast majority of companies recognize something needs to be done,” he said. “Probably say on pay will be legislated in a number of countries.”

But figuring out the how and why of executive bonuses is definitely a challenge. For one, nobody can really define what a bonus is, said Gandz.

“It takes so many forms and legislating against one merely creates an opportunity to be inventive in other ways,” he said. “The big problem with bonuses is not the size — it’s what they’re given for. A lot of short-term money was given for companies loading up on risk, where people got money but didn’t share in the risk.”

Also difficult is the fact some large companies, such as AIG, suffered because of one badly run division, said Gandz. Should all those at the top pay the price when they themselves had outstanding results?

“To put all the bonuses in jeopardy because of that probably wouldn’t get the effects you want,” he said.

In the late 1990s, the United States instituted a cap on non-performance-based compensation, so companies then threw everything into leveraged compensation, said Robert Levasseur, a senior executive compensation consultant at Watson Wyatt. That’s one of the reasons, along with greater disclosure, why executive compensation went up so dramatically — market competition.

The first major bank to slash compensation or change the compensation structure would lose its best talent to others.

“There’s a game of chicken going on there,” he said. “It’s an easy statement to make but you have to retain and attract.”

Risk management comes to forefront

Looking at the way the whole collapse unfolded in the U.S., it’s possible compensation had nothing to do with it, said Levasseur. Ratings agencies said the instruments were safe and the risk-management metrics didn’t detect undue risk.

“I don’t think it was a question of people wanting to gain personally from this, it was more a question of the risk systems not picking up on the real risks that were there,” he said.

It would appear the actual measurement of risk in some surprisingly big organizations was not being done or was being ignored, said Ken Hugessen, a partner and founder of Hugessen Consulting in Toronto.

“It’s a little as if we were all out on (Highway) 401 and none of our cars had speedometers,” he said. “You might be driving in your nice car and have no sense there’s a huge risk.”

Even companies that knew how fast they were going had no program in place to manage the speeds. When it came to the governance of executive pay, the concept of risk was at best a minor consideration, he said.

“For the most part, performance hurdles were set with some regard to risk but it was not a central part of the planning or evaluation process and so we expect to see a lot more (of that),” said Hugessen.

The scrutiny of company boards in the oversight of risk is clearly a hot-button item, as is the premise the management of these institutions is in a potential conflict, he said.

“Arguably they could be handsomely rewarded for assuming large amounts of risk,” he said, so there is growing recognition the board, rather than executives themselves, will play a more important role in measuring, budgeting and monitoring risk.

“That creates all kinds of issues because many boards are not prepared to do that,” said Hugessen, adding there will be much more interaction among audit, compensation and risk committees.

Clawbacks are increasingly coming in as a good corporate governance, said Gandz. The trend is to put provisions into executive compensation that state, in the event of fraud or material restatement of earnings, bonuses can be clawed back. However, it is not easy to ask for money back years after a disappointing deal.

“On a going-forward basis, compensation committees and boards are preoccupied with this right now — what is the reasonable balance between paying for results and nevertheless recognizing that, long term, those results may in fact contribute some risk?”

Clawbacks are very sensitive because there’s a cash-and-carry attitude, particularly in the financial trading industries, said Hugessen.

“There are a number of rudimentary clawback rules out there today but when you inspect them up close, you come to realize they wouldn’t really apply in a number of situations, he said.”

Deferrals are a much better, cleaner way of measuring for risk in the future, said Levasseur. However, in Canada, the tax act is very restrictive, so companies can’t defer longer than three years without getting into complicated mechanisms, he said.

While it’s a virtual certainty these G20 recommendations will come into force, how much teeth they will have is a good question, said Hugessen.

However, Canada and the U.S. are not likely to advocate a full cap on executive bonuses, said Levasseur.

“It would have to be legislated and then you’re really toying with the fundamental tenets of capitalism,” he said.

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