Bankers’ Bonuses - solving the risk conundrum

The reputation of the banking industry has been battered harder, and for longer than any other industry in the last 5 years. For many, the root cause has been the bonus culture which produced perverse incentives and very high levels of pay.

The advent of the bonus culture can be traced back to the "Big Bang” in 1986, which reformed the way the stock exchange worked and which allowed the banks to buy the member firms.

Originally bonuses looked like a sensible way of handling the very volatile revenues in stock brokers. They allowed the employees of stock brokers to participate in the years when revenue was high, but kept salaries and fixed overheads down for the lean years. Individual success could be rewarded by a discretionary bonus paid by the partners, but everyone got something in the good years, but equally, very little in the bad years.

Post "Big Bang” the world changed, not simply the nature of the parent bank’s business, but the risks it faced. Gone were the small unlimited partnerships where the partners had joint and several liability for all the firm’s debts. Under the old rules, the risk taking allowed or even countenanced by partnerships with limited financial resources was always going to be very modest. But these partnerships were now swallowed up by merchant banks and in due course they in turn were swallowed by the bigger clearing banks and big international banks. Competition became intense; hardly anybody made any money out of equity broking, so they diversified into new areas, which developed in the wake of the City reforms in the “Big Bang”. Big banks began to throw capital and funding at their investment banking subsidiaries in an effort to squeeze out the competition. And the pell-mell expansion in the decade after the “Big Bang” needed a massive expansion of personnel, which drove up salaries and bonuses.

The scene was now set for the bonus culture to take off. New rich parents allowed individuals to settle into a style of behaviour which maximised their personal income. Increasingly employees began to appreciate that for the risks which they took on, it was a case of heads I win a big bonus, tails the bank picks up the loss. But this style of behaviour involved the parent bank’s reputation in an unexpected way. Not only did the parent supply capital to its investment banking subsidiaries, but they provided cheap funding to oil the wheels. This cheap funding came from the parent bank which on-lent funds raised in the wholesale money markets, at fine rates where the parent bank had a well-established market reputation.

Investment banking subsidiaries could make good use of abundant cheap money whilst things went well, but in 2008 question marks began to emerge about the quality and value of the assets held in the investment banking subsidiaries. This led to a massive haemorrhage of liquidity from wholesale money markets, which not only threatened the supply of cheap funding to their investment banking subsidiaries, but the funding of the parent itself. Without help from the government, disaster beckoned.

Now the banks are under pressure to undo the bonus culture, but to date there is little evidence that bonuses have really been cut back. Are the banks in denial? Don’t they understand how much they are loathed for bringing the country to its knees?

But it would be a brave bank which radically reduced its bonus structure today. The haemorrhage of staff to banks which were not doing the same thing would be evident within a year. The investment banking business may not be making as much as it was pre-2008, but it would still be a big chunk of profits to leave at risk. If all banks were to take action together, and at the same time, it might be possible to cure the bonus cultural problem. Is it conceivable that all the world’s investment banks would agree to take action at the same time? Probably not; but there are signs of a belated recognition of the damage of recent years. Things are changing in ways that should help reduce bank risks if not public outrage.

Following Goldman Sach's example would require top management to hold up to 75% of bonuses as share awards until they leave the company, with many senior staff similarly obliged to hold 25% of any bonus award as shares.

HSBC has followed Goldman’s example, requiring bonus shares to be held to retirement with a clawback arrangement. UBS not only has a bonus/malus system but pays most senior bonuses in bonds and shares and requires Executive Board members to hold at least 350,000 shares and the CEO to hold 500,000. At about twenty francs apiece this means holding from 7 to 10 million francs in UBS shares. And it has just emerged that Credit Suisse now pays part of bonuses in "bail-in-able” bonds that have to be held for 3 years and can be converted to equity or wiped out in the case of trouble.

Progress towards reforming the bonus system is late and slow, but there are signs that the banks are responding. Putting years between the award and the realisation of the bonus helps weaken the perverse incentives arising from a ‘heads I win tails you lose’ approach to risk taking. Bad consequences have time to arrive. It could to lead to regulators seeing such banks as less risky.

Paying bonuses in shares puts bank leaders in the same currency as shareholders, who have still not recovered from the terrible beating of recent years.  Paying bonuses in bonds that 'bail in' is even better.  So may be be the leviathans are starting to get it, and more importantly are doing something about it.  In a way that probably reduces risk.

 

John Tyce

Reputability LLP

London

www.reputability.co.uk

 

Behave yourself; Someone is always watching!

The media spotlight focussed on President 'Malchance' (or Hollande as we Brits know him) illustrates perfectly how individuals and their organisations become overwhelmed by unwelcome attention as soon as a story captures the public's interest.

What started as a report of a personal peccadillo soon gained traction as the beleagured President made a desperate attempt at his news conference to focus interest on his economic policies. This worked with the generally compliant French broadsheets for about a day. Since then, journalists have had a field day, using the ongoing saga as a basis for 'breaking news', 'in-depth features and opinion articles ranging from an examination of the cultural differences between the French and British media to more lurid pieces on the libidos of powerful men. Photographers and cartoonists have joined in with relish!

This damaging episode illustrates a truth, more relevant now than ever before, which is that nothing, but nothing, is private. We may have laws that purport to protect privacy, but anyone can publish information. This information may or may not be accurate, but if redress is to be had, it often comes after the event, giving mischief-makers another opportunity to rake over the embers of the original story.

This reality of modern life is as true for business as it is for individuals. If the media get scent of a story, then their investigative processes are just the same. In our era of complete accessability there is now no part of business life that can genuinely be considered confidential. We may think of something as private or secret, but as News International's former executives, the Care Quality Commission, BBC Trustees, the NHS, the Coop Bank, MPs and even the USA's National Security Agency know, unpalatable stories will eventually emerge.

So, if you are doing something of which the public might not approve you must assume they will eventually find out -and probably in the most inconvenient and embarrassing circumstances. There has never been a better time to renew that commitment to ethics in business - and in life!


Jane Howard
Reputability LLP
London

www.reputability.co.uk

People Risks - Achilles' Heel strikes again!

Behavioural and organisational risks have caused yet another corporate crisis despite a risk management system described as top quality.  Why does this keep happening?  And what are the lessons for boards?

Last week RSA, the UK’s second largest general insurer, announced the results of reviews by KPMG, PwC and its own Internal Audit function into the £200m black hole in its Irish business.  Revelations of the debacle had led to the resignation of Group Chief Executive Simon Lee in December and a share price drop of over 25%.  The reviews describe how senior managers in Ireland had ‘inappropriately collaborated’ in the accounting of premiums and reporting of large claims so the accounts did not reflect the true financial position of the business. The managers involved have since been dismissed.

Fortunately for RSA, the reviews confirm that the problem is confined to Ireland and that other parts of the Group are unaffected. They go on to say the Group system of governance includes a control framework built on the ‘good market practice of three lines of defence’. They emphasise that it is appropriate in terms of structure and design for an international insurance group of RSA’s size and complexity, and elements of its design compare favourably across the market.

So why did a conventional risk framework, in this case apparently as good as it gets, fail to pick up such a key risk to an insurer? After all, improper manipulation of premiums and claims reserves is hardly a new phenomenon.  Those who know the history of the insurance industry will remember many other examples including Michael Bright’s Independent Insurance and HIH; some memories will go back as far as Emil Savundra’s Fire Auto & Marine in the 1960s.  Analagous ‘financial irregularities’ regularly occur in other sectors. 

An important pointer can be found in 'Roads to Ruin' the seminal Cass Business School report for Airmic and in Reputability’s follow-up report 'Deconstructing Failure'.  The root causes of almost all the catastrophes studied emerged from human behaviour and the way in which humans are organised within a firm – behavioural risks and organisational risks or ‘people risks’ for short.  These include people risks right up to people at board level. 

Unfortunately it has recently become clear that conventional risk frameworks, including the ubiquitious 'three lines of defence' approach, provide no systematic defence against people risks.  They just don’t to go there.  This is partly because conventional risk management hasn’t evolved far enough.  But it’s also because the area is far too dangerous for anyone below board level to delve into.

As the Parliamentary Commission on Banking Standards put it, the officially approved and widely used ‘Three Lines of Defence’ approach gives firms ‘a wholly misplaced sense of security’.

The Financial Reporting Council is one of many regulators that has tuned into the importance of behavioural and organisational risks.  Their latest proposals require companies explicitly to disclose and describe significant risks with their origins in behavioural and organisational issues; and they list dozens of practical questions for boards to ask themselves about behavioural and organisational risks.  The aims are to help boards oversee the practicalities of managing such risks below them and to recognise that such risks surround and permeate boards themselves.

RSA's crisis provides a timely warning to all boards.  Few if any risk management systems have behavioural and organisational risks systematically in their sights let alone under control. These potentially devastating risks are unrecognised and thus unmanaged.

Boards need to gain a deeper understanding of the underlying issues before they can lead their risk teams in the right direction to bring these dangerous risks under control.  Board leadership is essential.  Specialist education for boards is the first step.  

Anthony Fitzsimmons

Reputability LLP

London 

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Speaking truth to power

Some parts of Government are in 'desperate failure' and across the whole of Whitehall there is 'an inability to learn the lessons of failure and speak openly and truthfully to each other'. That is what Bernard Jenkin, Chair of the Public Administration Select Committee in the UK’s House of Commons, believes according to a report by the journal Civil Service World (CSW).

For an example of what he means, we need look no further than the Department of Work and Pensions’ (DWP’s) flagship Universal Credit Scheme. Only last week, Secretary of State Ian Duncan-Smith was forced to defend implementation delays and admit that upwards of £40m has been lost on an abandoned IT system which was simply not fit for purpose.

The story didn’t begin there.  In September the National Audit Office (NAO) highlighted delivery problems on Universal Credit citing a 'fortress mentality' and 'a culture of good news reporting that limited open discussion of risks and stifled challenge'.

Dame Anne Begg, Chair of the Commons Work and Pensions Committee, has criticised the DWP for 'an inability of ministers to admit there was anything going wrong in the Department'. Asked by CSW whether it is possible for DWP civil servants 'to speak truth to power' she said 'I think it's difficult, and the attitude is set from the top'.

If true, such attitudes have very worrying implications for sound decision making and good governance. Adding to the concerns is a recent survey from CSW and the marketing firm Claremont which found that 'just 9% of civil servants surveyed believe that ministers and senior managers openly encourage challenge, debate and reporting of operational problems'.

A recent study from Reputability, 'Deconstructing Failure: Insights for Boards' determined that amongst the key root causes of corporate crises were risk blindness exhibited by those at the top and defective information flows throughout the organisation.

If difficult news is seen as unwelcome by managers, it is easy to understand how individuals might withhold particular unwelcome data or disguise unpalatable truths so as not to be seen to be rocking the boat. Unfortunately, the consequences of misreporting or being economical with the truth can have devastating results for the organisation and its corporate reputation.

Examples from the business world abound, but the debacle surrounding the delays to the EADS Airbus A380 and the Toyota 'accelerator surge' recall in the USA are particularly telling examples of delayed or inadequate reporting of problems which had severe adverse consequences. In both instances the financial cost of insiders holding back critical information from leaders ran to billions, bringing with them immense loss of reputational capital.

Regular readers will also recall what we have written about the effects of killing the bearers of unwelcome news and the importance of a culture of openness.

Fortunately there are signs that not all in Government are blind to these dangers. Speaking recently at the annual Civil Service Awards ceremony the Prime Minister encouraged his audience 'to talk truth to power and tell it like it is'. He added, 'That is really important. Don't stop doing it.'

Let's hope that his colleagues were listening.



Rob Haslam
Reputability LLP
London
www.reputability.co.uk

Note to Board: Reputation is down to you

Thinking back over discussions with FTSE Chairmen about optimum board structures for effective governance, I was struck by how often the subject of “corporate reputation” recurs. 

This is not surprising.  Studies show that the bigger the organisation, the more value is contributed by reputation.  In the FTSE100, corporate reputations are contributing on average, 32 per cent of companies’ market cap. By comparison, reputations add an average 14 per cent of value to FTSE250 companies.  

Whatever the precise figure, few doubt that reputation is a significant business asset even though it doesn't appear in the balance sheet.  It is interesting therefore, to ask why more businesses do not organise themselves at board level specifically to protect and enhance their reputation.  A few have a “reputation” committee alongside those of “audit”, “remuneration” and perhaps “risk” but most do not.  Those that do often seem to see managing reputational risk as a PR issue.

Perhaps boards believe that they have an innate ability to manage this most valuable asset.  Maybe they think that reputation management is covered by existing processes.   They shouldn’t.  The 2011 report from a high level workshop, 'Policy and Governance for Risks to Reputation',  led by Airmic and Reputability concluded that boards should take ‘deliberate responsibility’ for risks to reputational capital, highlighting that standard risk management wouldn’t systematically find the risks that cause reputational damage.

Recent research shows that nearly half - 48 per cent - of in-house communications directors do not think that their boards take responsibility for the organisations’ reputation.  If the ethics and tone, the aspirations and the heritage of an organisation are not set and proactively managed by the board, who has the authority to lead on them?

It’s not only communication professionals who see this lack of credible leadership.  Results from the Edelman Trust Barometer show that public trust in what CEOs say has never been lower.  When asked: “If you heard information about a company from one of these people, how credible would that information be?” the number citing a CEO as reliable rose to 40% in 2013, having only been higher once in the last 5 years.  It is no consolation that government officials and regulators were even less trusted.

In our transparent, internet-accelerated world, reputation and risks to it need to be taken out of the traditional silos of risk, Human Resources, Public Relations and Investor Relations.  It is time for boards to take responsibility for reputation, that most valuable yet vulnerable of assets.  It's too precious to be delegated.

Jane Howard

Reputability LLP

London

www.reputability.co.uk

Cover-up at Colchester

Targets create incentives to behave in ways that will achieve a particular result.  Sometimes the incentives are hidden - such as when staff fear to report bad news.

The latest example, explained in more detail in the Guardian, is that National Health Service managers at Colchester hospital  now "fear that at least 6,000 patients may have had their records falsified to meet treatment targets".

We humans are versatile. Face with a target, we can see many paths to the appearance of success. We can embrace the principles behind the target-setter’s good intention; or we can cover up poor performance or cheat. Culture also plays an important role in how we behave. 

It’s not as simple as a matter of how targets are designed and enforced. Human characteristics include behaviours such as creativity, guile and dishonesty. That is why targets, and the incentives they create, should also be seen - and managed - as risks. This creates a vital independent feedback loop that can deal with the risk of self-delusion by leaders and managers.

Risks from unintended or poorly designed incentives regularly bring big organisations to their knees. If you need evidence, read the case studies in ‘Roads to Ruin’, the Cass Business school report for Airmic. Subsequent research, ‘Deconstructing failure – Insights for boards’ found that 40% of the 40 major crises dissected had incentives emanating from board level  as one of their root causes.

It may be that the targets saved lives overall.  But if it did so at the cost of developing a culture of lying and covering-up at the hospital, that is dangerous.  The studies in 'Roads to Ruin' show how easily a small lie turns into a huge one, with disastrous consequences.  Patient safety depends on an open learning culture.  That only works if the truth is welcomed however unpleaseant.

Mike Bell
Reputability LLP
London
www.reputability.co.uk

Values in the City

Bankers were painted in varying shades of amorality and incompetence after the banking crisis.  The City Values Forum has spent two years trying to re-set and restore standards of integrity among London bankers.

The Forum's conference, on 15 October, publicised their progress. They have plenty to say on what integrity might look like.  With help from the City HR Association, they have produced a 'Gold Standard' for 'Performance linked to values'.

But they have ducked two important issues, raised by Anthony Hilton. The first has to do with implementation.  How do you ensure that the desired values are lived consistently from top to bottom of the organisation?

Andrew Hill in the FT has highlighted the importance of behavioural change programmes, but a vital part of the answer is leadership: as John Griffith-Jones of the FCA commented, "If [tone] comes from  halfway down… it just doesn’t have the same impact”.  It is even worse if the leaders set the tone but don't live by it - what Philippa Foster Back pithily calls the "say-do" gap.  Who has the means or authority to bring top leaders back into line - assuming that their double standards are recognised for what they are?

The second problem has to do with bonuses, a complex and poorly understood subject.  It is easy to announce that incentives will reflect not only success but also how success was achieved. But there is an important information asymmetry.  It is hard for leaders reliably to know how success was actually achieved - whereas it is easy for peers to know the truth.  Thus a high achiever, known by his peers to be cutting corners, may be rewarded by leaders who think he is 'doing the right thing'.  The effect will be as corrosive as leaders' double standards.

This highlights a broader problem of implementation missed by the Forum.  All organisations run on people power, and it is the behaviour of people, collectively and individually, that typically makes and breaks organisations.  However, few if any organisations systematically capture, let alone manage, people risks whether from the leadership or elsewhere.  This is a clearly identified hole in risk management systems.  As Anthony Hilton put it, "The ... issue for boards having set a culture is how to know with confidence that its values really are being lived throughout the organisation. What does success look like and how do they measure it?"

The City Values Forum's latest proposals are blind to this fundamental problem of implementation even though it was drawn to their attention two years ago.  That is a missed opportunity.

Anthony Fitzsimmons
Reputability
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”