Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Wednesday, April 6, 2016

The Governance of Compensation: Lessons From The 2007/2008 Financial Crisis!

Ramesh S Arunachalam 
Compensation is indeed a very sensitive and critical aspect in the governance of banks and financial intermediaries and in my opinion, it is one factor that perhaps accelerated and/or led to the 2007/2008 financial crisis. The Financial Crisis Inquiry Commission (FCIC) Final Report[i] (Dated January 2011) also concurs and indeed states compensation as one factor, among many, that contributed to the financial crisis of 2007/2008 in the United States and elsewhere! And I quote the relevant sections from the FCIC report below:

“Both before and after going public, investment banks typically paid out half their revenues in compensation. For example, Goldman Sachs spent between 44% and 49% a year between 2005 and 2008, when Morgan Stanley allotted between 46% and 59%. Merrill paid out similar percentages in 2005 and 2006, but gave 141% in 2007—a year it suffered dramatic losses.[ii]

As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received $3.2 million in 1986 as CEO of Salomon Brothers.[iii] Stanley O’Neal’s package was worth more than $91 million in 2006, the last full year he was CEO of Merrill Lynch.[iv] In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received $68.5 million;[v] Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million, respectively.[vi] That year Wall Street paid workers in New York roughly $33 billion in year-end bonuses alone.[vii] Total compensation for the major U.S. banks and securities firms was estimated at $137 billion.[viii](FCIC Report)

In effect, what was happening was that, in all these firms, the focus was on the short-term performance, incentives, and compensation when, in reality the risks (which existed) were mostly, medium and/or long-term. And of course, the regulator and law/policy makers sat and watched as compensation soared way beyond acceptable levels and firms started paying as high as 50% of their revenues in compensation.

Did not the regulators and policy/law makers find it strange that: a) Goldman Sachs spent between 44% and 49% of its revenue a year on compensation (during the years 2005 to 2008); b) Morgan Stanley allotted between 46% and 59%; and c) Merrill paid out similar percentages in 2005 and 2006, and more importantly, gave as high as 141% in 2007 (a year it suffered dramatic losses). What, on earth, were the regulators and policy/law makers doing?

The above are just few instances, and as we have moved through the financial crisis of 2008 (but are still recovering from its aftermath), there are several important lessons here with regard to the governance of compensation in the larger financial sector that we all need to understand and come to terms with. I will try and articulate some of these here for their benefit of various stakeholders.

Lesson #1: Lack of arm's-length decisions and negotiations: The governance of remuneration and incentive systems seems to have (apparently) failed because decisions and negotiations (carried out) were not been at arm's length. Conflicts of interest at various levels have aided such improper decision-making and negotiation and much of this is applicable to remuneration and incentive systems for a range of senior management personnel and not just the CEO or managing director or chairman of the board. While there are several examples from the 2007/2008 financial crisis, the paragraphs cited from The FCIC offer good factual insights.

Lesson #2: Inordinate level of influence of senior management in establishing remuneration schemes: In my opinion, senior management generally appears to have had far too much influence over the level and conditions (including measures) set for performance based remuneration. On the other hand, boards were often unable to or, sometimes, even incapable of exercising objective, independent judgement. Here again, there were serious conflicts of interest, which certainly exacerbated this whole issue - in fact, this has been one of the most important reasons for inaction by the board against inappropriate remuneration proposals of senior management at many of the institutions at the centre of the 2007/2008 financial crisis.

Lesson #3: Medium and long-term risks are not taken into account: In many cases that I have closely observed, the relationship between performance and remuneration has been rather tenuous and, sometimes, even difficult to establish, especially given the nature of the operations. A very critical aspect here is that medium as well as long-term risks were rarely factored into the whole process - something that should have been done naturally. How can the rewards be in the short-term, when the risks are medium-long term?

Lesson #4: Complicated and opaque remuneration schemes: The remuneration schemes have also been fairly complicated and also opaque in terms of shrouding actual conditions in the operation of the scheme and the consequences. What I am saying is that these (operational conditions and terms) are perhaps not clear and obvious to the naked eye of an unassuming observer. These conditions also tended to encourage excessive and mindless (growth and) risk-taking and especially with a short-term orientation.

Lesson #5: Mere disclosure is not transparency: While transparency (in some cases) did exist in terms of disclosure, several institutions couched the main characteristics of their performance related remuneration programs in verbose technical language and thereby made it very difficult for comprehension to the normal reader. In fact, it was very difficult to get comprehensive information on (a) The total cost of the remuneration program to the institution; (b) The specific performance criteria and measures along with their conceptual and operational definitions; and (c) The manner in which remuneration has been adjusted for relevant risks-especially, medium- and long-term risks (which is so relevant today). That from a shareholder’s perspective was NOT ideal by any means!

Without question, institutions will surely need to have remuneration and incentive systems that focus and encourage at least the medium-term, if not long-term performance. This, in turn, means that they must choose to reward their senior management after some actual performance has been realised and that has not usually been the case - there are several examples of high front-loaded bonuses paid to senior management executives and the results are there for everyone to see. In fact, this single minded focus on the short-term incentives and compensation needs to be changed to reflect the medium- and/or long-term performance and operations. That is very critical going forward!

Also, remuneration at many of these institutions does NOT seem to have been established through an explicit governance process where the roles and responsibilities of all stakeholders involved, including committee members, consultants, risk managers and others, were clearly defined and separated (without conflict of interest). The roles given to non-executive independent board members in the process - although they may seem somewhat appropriate -again appear to be laden with serious conflicts of interest. And finally, while remuneration policies are sometimes submitted to the annual meeting and subjected to shareholder approval, much of this seems to be a routine matter, with minimal (informed) discussion because of aspects mentioned earlier.

Therefore, as has been often mentioned, "Compensation is one factor among many that contributed to the financial crisis that began in 2007. Official action to address unsound compensation systems must therefore be embedded in the broader financial regulatory reform program, built around a substantially stronger and more resilient capital and liquidity framework. Action must be speedy, determined and coherent. Urgency is particularly important to prevent a return to the compensation practices that contributed to the crisis.”[ix]

I sincerely hope that the regulators and supervisors (worldwide) focus on this aspect and ensure that the same compensation practices and incentives that (adversely) affected institutions in the United States in 2007/2008, do not impact the larger financial sector in the future again!

[ii] Goldman Sachs, 2006 and 2009 10-K; Morgan Stanley, 2008 10-K; Merrill Lynch, 2005 and 2008 10-K.
[iii] “Gutfreund’s Pay Is Cut,” New York Times, December 23, 1987.
[iv] Merrill Lynch, “2007 Proxy Statement,” p. 38.
[v] Goldman Sachs, “Proxy Statement for 2008 Annual Meeting of Shareholders,” March 7, 2008, p. 16: Blankfein received $600,000 base salary and a 2007 year-end bonus of $67.9 million.
[vi] Lehman Brothers, “Proxy Statement for Year-end 2007,” p. 28; JP Morgan Chase, “2007 Proxy
Statement,” p. 16.
[vii] New York State Office of the State Comptroller, “New York City Securities Industry Bonus Pool,”
February 23, 2010. The bonus pool is for securities industry (NAICS 523) employees who work in New
York City.
[viii] “Banks Set for Record Pay, Top Firms on Pace to Award $145 Billion for 2009, Up 18%, WSJ Study
Finds,” WSJ.com, January 14, 2010.
[ix] Quoted from BIS paper on Compensation and Corporate Governance, 2010.

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