Compensation and Risk-Taking

Spurred on by an angry public, regulators will be requiring banks to demonstrate that their compensation policies do not result in “excessive risk-taking.” Any bankers hoping this issue will fade away are going to be disappointed. Risk-based compensation is on its way and banks should start now to get ready for it.

The good news is that factoring risk into incentives can not only satisfy regulators' expectations ' it can lead to better business decisions that increase the valuation of the firm. And it is not only banks that need to pay attention to this issue ' risk-based compensation could evolve into a best practice for companies in many industries.

Compensation Guidelines

Most global financial regulators have endorsed guidelines on compensation that are similar to the principles published in April 2009 by the Financial Stability Board, a working group of financial regulators drawn from the G-20 countries. On Oct. 23, 2009, the Federal Reserve announced its version of the guidelines with Chairman Bernanke underlining the seriousness of the Fed's intentions: “Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability. The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system.”

With the Fed announcement, it is clear that banks need to accept the coming realities of risk-based compensation, like it or not. Among those realities are: 1) the board must be more active and independent in designing, operating and overseeing the compensation systems of the firm; 2) financial and risk control staffs must have sufficient independence and authority to ensure the integrity of performance measurement systems that affect compensation; 3) compensation systems must not incent “excessive risk-taking”; and 4) the firm must convince regulators that they are making satisfactory progress toward goals 1, 2 and 3 or unpleasant consequences will follow ' such as higher capital requirements or other regulatory sanctions.

The Greatest Challenge

The greatest complexity and challenge lies with goal number 3 ' demonstrating that compensation systems do not incent “excessive risk-taking.” Right now, risk assessments and compensation decisions are unconnected at most firms. The amount of each year's incentive payment is usually linked to conventional measures such as sales volume, revenues or short-term earnings ' just the sort of linkages that regulators believe led to the excessive risk-taking that intensified the financial crisis. Explicitly relating compensation to risk-taking behavior is a huge challenge that few banks are ready to meet. Sadly, many banks still do not have good view of how much total risk they are taking as firm, let alone a way to assess the effects of compensation policies on those risks. This is new territory and banks that get out front on this important and contentious issue will have a chance to shape the emerging standards in a constructive way. Banks that drag their feet may alienate their regulators or end up being saddled with standards that fit their competitors' business strategies better than their own.

General Prinicples

The regulators have put forth general principles that banks should follow to avoid creating incentives for excessive risks, but they leave many questions unanswered.

Size of Bonus Pools

The size of bonus pools should be linked to the performance of the individual, business unit and/or the firm. In other words, poor performance should result in much lower or no bonuses. Banks can no longer pay out fat bonuses in lean years in the name of preventing key talent from fleeing to competitors.

Incentive Payments

Incentive payments must roughly match the time horizon over which the results of risk-taking are realized. In other words, the longer the risks stretch out over time, the longer the wait for bonus payments. The days when people could collect a big check upfront and wash their hands of the transaction are over.

Long-run Performance

The form of compensation should align incentives with the firm's long-run performance for shareholders. In other words, the mix of incentive awards should shift away from immediate cash toward restricted stock that vests over a period of years. Employees who have the ability to significantly affect the firm's performance should have a big personal stake in how well the firm's shareholders do over time. (Ironically, many senior officers of failed or bailed-out firms did have such a stake ' but to no avail ' suggesting that shareholder-friendly incentives do not always overcome ignorance of risks, unfounded euphoria or the expectation of selling out to the greater fool before the bubble bursts).

Adjusting for Risk

By far the most important general principle is that compensation must be adjusted for “all types of risk.” Two people who book the same profit in a period but who took different amounts of risk should be paid differently ' the one taking higher risk should be paid less. By “all types of risk” the regulators really do mean all, including hard to measure risks like liquidity and reputation. And these risks must be reflected in a cost of capital deducted from earnings. This reasoning cannot just be applied piecemeal to different parts of the firm, but it must be applied to the firm as a whole for it is the total risk of the firm that the regulators are ultimately concerned about. The regulators, thankfully, do not spell out a specific formula for doing this, but it must be done with a combination of quantification and judgment that is persuasive to the regulators. (Anyone doubting the enormity and difficulty of what lies ahead should reread this paragraph.)

Defending Against Risk-Taking Charges

Given these regulatory principles, it should be clear that to defend against a charge of incenting excessive risk-taking, financial firms will have to demonstrate that: 1) they know how much risk their firm is taking and who is taking it; 2) they have adopted a prudent upper limit on how much risk they are willing to take; 3) they can assess how different compensation policies will affect risk-taking behavior and the total risk of the firm; and 4) they have chosen compensation policies that will keep the firm's total risk within the agreed upper limit.

There no persuasive way for a financial firm to do all this without a credible enterprise risk management framework that assesses and governs risks across the whole firm, since these are just the sort of questions that an enterprise risk framework is designed to answer. Consistently defined and measured risk assessments from across the firm, for each compensation pool, must feed into carefully balanced compensation strategies that combine risk sensitivity with the need to attract, motivate and retain key employees. This is going to be a difficult challenge for most banks, especially those who have been laggards in building and applying their enterprise risk management capabilities. The regulators realize that this is not an overnight project, but as they see what the most diligent and capable banks can do, the standards for everyone else will become increasingly demanding over time.

Setting Up Risk-Based Compensation

The first step in getting ready for risk-based compensation is for a bank to do an objective readiness review that: 1) assesses the likely regulatory standards for risk-based compensation; 2) reviews the firm's current practices and capabilities in risk governance, enterprise risk management and stress testing, compensation policies, and relevant financial and risk controls; 3) identifies gaps between the status quo and likely requirements for linking risks to compensation; and 4) develops a staged, prioritized implementation plan to reduce those gaps within a timeline acceptable to the regulators.

It is at this point that a seemingly dreary and costly compliance exercise can be turned into a golden opportunity to radically improve the way the firm does business. The real reason for strong risk governance, strong enterprise risk management and a strong risk culture based on risk-sensitive incentives is not to placate regulators but to identify new ways to invest the firm's scarce capital in businesses and products that offer better risk/return tradeoffs and thus higher valuations in the equity market. Profitable opportunities can be identified and exploited whose risks can be managed within prudent boundaries. Products and client relationships can be rationally screened and priced to cover their risks. The potential benefits for shareholders of smarter risk-taking are huge.

The readiness review and subsequent actions should be guided not only by the need to comply with regulatory requirements but also by the opportunity to boost the valuation of the firm by improving its risk/return decision-making in all its businesses. The mission is to maximize shareholder value while complying with regulatory requirements. And, depending on how they are interpreted and applied, many of the regulatory guidelines on compensation may be roughly aligned with shareholder interests. Both regulators and shareholders want banks to avoid reckless, inappropriate or uninformed risk-taking.

Dan Borge is a director in LECG's New York office, where he offers advice on enterprise risk management and corporate strategy. Previously, Borge was the principal designer of the first enterprise risk management system, Bankers Trust's risk adjusted return on capital (RAROC). He may be reached at [email protected].

Spurred on by an angry public, regulators will be requiring banks to demonstrate that their compensation policies do not result in “excessive risk-taking.” Any bankers hoping this issue will fade away are going to be disappointed. Risk-based compensation is on its way and banks should start now to get ready for it.

The good news is that factoring risk into incentives can not only satisfy regulators' expectations ' it can lead to better business decisions that increase the valuation of the firm. And it is not only banks that need to pay attention to this issue ' risk-based compensation could evolve into a best practice for companies in many industries.

Compensation Guidelines

Most global financial regulators have endorsed guidelines on compensation that are similar to the principles published in April 2009 by the Financial Stability Board, a working group of financial regulators drawn from the G-20 countries. On Oct. 23, 2009, the Federal Reserve announced its version of the guidelines with Chairman Bernanke underlining the seriousness of the Fed's intentions: “Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability. The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system.”

With the Fed announcement, it is clear that banks need to accept the coming realities of risk-based compensation, like it or not. Among those realities are: 1) the board must be more active and independent in designing, operating and overseeing the compensation systems of the firm; 2) financial and risk control staffs must have sufficient independence and authority to ensure the integrity of performance measurement systems that affect compensation; 3) compensation systems must not incent “excessive risk-taking”; and 4) the firm must convince regulators that they are making satisfactory progress toward goals 1, 2 and 3 or unpleasant consequences will follow ' such as higher capital requirements or other regulatory sanctions.

The Greatest Challenge

The greatest complexity and challenge lies with goal number 3 ' demonstrating that compensation systems do not incent “excessive risk-taking.” Right now, risk assessments and compensation decisions are unconnected at most firms. The amount of each year's incentive payment is usually linked to conventional measures such as sales volume, revenues or short-term earnings ' just the sort of linkages that regulators believe led to the excessive risk-taking that intensified the financial crisis. Explicitly relating compensation to risk-taking behavior is a huge challenge that few banks are ready to meet. Sadly, many banks still do not have good view of how much total risk they are taking as firm, let alone a way to assess the effects of compensation policies on those risks. This is new territory and banks that get out front on this important and contentious issue will have a chance to shape the emerging standards in a constructive way. Banks that drag their feet may alienate their regulators or end up being saddled with standards that fit their competitors' business strategies better than their own.

General Prinicples

The regulators have put forth general principles that banks should follow to avoid creating incentives for excessive risks, but they leave many questions unanswered.

Size of Bonus Pools

The size of bonus pools should be linked to the performance of the individual, business unit and/or the firm. In other words, poor performance should result in much lower or no bonuses. Banks can no longer pay out fat bonuses in lean years in the name of preventing key talent from fleeing to competitors.

Incentive Payments

Incentive payments must roughly match the time horizon over which the results of risk-taking are realized. In other words, the longer the risks stretch out over time, the longer the wait for bonus payments. The days when people could collect a big check upfront and wash their hands of the transaction are over.

Long-run Performance

The form of compensation should align incentives with the firm's long-run performance for shareholders. In other words, the mix of incentive awards should shift away from immediate cash toward restricted stock that vests over a period of years. Employees who have the ability to significantly affect the firm's performance should have a big personal stake in how well the firm's shareholders do over time. (Ironically, many senior officers of failed or bailed-out firms did have such a stake ' but to no avail ' suggesting that shareholder-friendly incentives do not always overcome ignorance of risks, unfounded euphoria or the expectation of selling out to the greater fool before the bubble bursts).

Adjusting for Risk

By far the most important general principle is that compensation must be adjusted for “all types of risk.” Two people who book the same profit in a period but who took different amounts of risk should be paid differently ' the one taking higher risk should be paid less. By “all types of risk” the regulators really do mean all, including hard to measure risks like liquidity and reputation. And these risks must be reflected in a cost of capital deducted from earnings. This reasoning cannot just be applied piecemeal to different parts of the firm, but it must be applied to the firm as a whole for it is the total risk of the firm that the regulators are ultimately concerned about. The regulators, thankfully, do not spell out a specific formula for doing this, but it must be done with a combination of quantification and judgment that is persuasive to the regulators. (Anyone doubting the enormity and difficulty of what lies ahead should reread this paragraph.)

Defending Against Risk-Taking Charges

Given these regulatory principles, it should be clear that to defend against a charge of incenting excessive risk-taking, financial firms will have to demonstrate that: 1) they know how much risk their firm is taking and who is taking it; 2) they have adopted a prudent upper limit on how much risk they are willing to take; 3) they can assess how different compensation policies will affect risk-taking behavior and the total risk of the firm; and 4) they have chosen compensation policies that will keep the firm's total risk within the agreed upper limit.

There no persuasive way for a financial firm to do all this without a credible enterprise risk management framework that assesses and governs risks across the whole firm, since these are just the sort of questions that an enterprise risk framework is designed to answer. Consistently defined and measured risk assessments from across the firm, for each compensation pool, must feed into carefully balanced compensation strategies that combine risk sensitivity with the need to attract, motivate and retain key employees. This is going to be a difficult challenge for most banks, especially those who have been laggards in building and applying their enterprise risk management capabilities. The regulators realize that this is not an overnight project, but as they see what the most diligent and capable banks can do, the standards for everyone else will become increasingly demanding over time.

Setting Up Risk-Based Compensation

The first step in getting ready for risk-based compensation is for a bank to do an objective readiness review that: 1) assesses the likely regulatory standards for risk-based compensation; 2) reviews the firm's current practices and capabilities in risk governance, enterprise risk management and stress testing, compensation policies, and relevant financial and risk controls; 3) identifies gaps between the status quo and likely requirements for linking risks to compensation; and 4) develops a staged, prioritized implementation plan to reduce those gaps within a timeline acceptable to the regulators.

It is at this point that a seemingly dreary and costly compliance exercise can be turned into a golden opportunity to radically improve the way the firm does business. The real reason for strong risk governance, strong enterprise risk management and a strong risk culture based on risk-sensitive incentives is not to placate regulators but to identify new ways to invest the firm's scarce capital in businesses and products that offer better risk/return tradeoffs and thus higher valuations in the equity market. Profitable opportunities can be identified and exploited whose risks can be managed within prudent boundaries. Products and client relationships can be rationally screened and priced to cover their risks. The potential benefits for shareholders of smarter risk-taking are huge.

The readiness review and subsequent actions should be guided not only by the need to comply with regulatory requirements but also by the opportunity to boost the valuation of the firm by improving its risk/return decision-making in all its businesses. The mission is to maximize shareholder value while complying with regulatory requirements. And, depending on how they are interpreted and applied, many of the regulatory guidelines on compensation may be roughly aligned with shareholder interests. Both regulators and shareholders want banks to avoid reckless, inappropriate or uninformed risk-taking.

Dan Borge is a director in LECG's New York office, where he offers advice on enterprise risk management and corporate strategy. Previously, Borge was the principal designer of the first enterprise risk management system, Bankers Trust's risk adjusted return on capital (RAROC). He may be reached at [email protected].