large amounts of money, but also to do it quickly. Once again, former Société Générale
trader Jérôme Kerviel is a remarkable example of what a single person could be able to
do, but also an amazing example of how true is that at superior level nobody was able to
understand and foreseen the hazard of the transactions traders were carrying out on the
banks’ behalf and of how risk was not object of appropriate and constant control within
the bank.
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As suggested by the Independent Commission on Banking established in the UK,
reported profits on the basis of which traders were paid were neither risk- nor time-
adjusted. The latter reference has to be associated with the lack of consistency of the
overall bonus system with the same banks’ long-term interest. Bonuses were paid
immediately, whereas benefits for the banks would have been eventually reaped in the
future. As suggested by Stiglitz (2011), the system was rather designed to “encourage
excessive-risk taking” or even gambling.
Could have HR and reward specialists helped to avoid the impending disaster caused by
excessive risk-taking and bonus payments? Either we consider bonuses as a contributor
factor to the financial disaster or as a “symptom rather than a cause” (Cotton, 2011), we
can agree with Williams (2011) that it is very likely that HR could have actually done
little or nothing to avoid the catastrophe. Before the issue emerged publicly, whatever
HR’s attempt to persuade the banks board to change their bonus payment system would
have certainly been tantamount to pure madness. When in 2008 the Royal Bank of
Scotland (RBS) changed its bonus system, shifting from cash bonuses to fully deferred
bonuses, it underwent a brain drain phenomenon leading attrition to double.
Smedley (2011) suggests that the real problem was that nobody was considering the
risks associated with “high-value reward for short-term risk-taking”, the system failure
was hence essentially linked to the way the overall mechanism worked and with the way
banks were used to get massive profits.
Additionally, according to Wright (2011), the major risk was not that much associated
with paying bonuses for transactions made in the short run, but rather with the
circumstance that bonuses were paid before the final outcome of transactions were even
known. Banks should have better used deferred bonuses approaches, but did not
because they would have otherwise risked immediately losing their best talents. It would
be just like proposing to Arsenal, Real Madrid or Inter Milan soccer players a £200,000
salary a year, professional footballers would definitely leave their teams lured by the
staggering pay offered by Barcelona, Manchester City and Milan or by other football
clubs.
The anonymous former senior HR professional cited above related that, as long as
traders were enabling the bank to collect large sums of money, they could do whatever
they wanted. Nobody, for instance, dared to fire a manager who had received several
final written warnings on his personal record given the fact that this accounted for the 10
per cent of the bank profit.
After the financial crisis burst, the way banks and financial institutions were paying
bonuses to their investment specialists emerged and after everybody was acquainted
with the issue, as expectable, regulators come to play.
In the UK, the Companies Act 2006 already included specific rules concerning the
disclosure of the banks and financial institutions boardrooms members’ compensations,
but traders and senior executives’ pays were not included in the provisions.
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Subsequently, the European Capital Requirement Directive III (CRD III) was
promulgated and the UK Financial Services Authority (FSA) Remuneration Code was
amended introducing some significant restraints.
More in particular, the FSA Remuneration Code introduced regulations prescribing that:
no less than half the amount of the agreed bonuses could be paid in the organization’s
shares or in other equivalent non-cash means; no less than 40 per cent of variable pay
for “code staff” (namely, senior managers, risk takers, staff in charge of control
functions and other staff who receive a remuneration package at senior management
level) had to be paid over a period of at least three years; this percentage (still of
variable pay or incentives) had to be raised to 60 per cent for individuals receiving an
annual pay of more than £500,000. Additionally, according to the amended provisions,
financial firms could no longer offer guaranteed or retention bonuses of more than one
year.
The EU CRD III directive went even further afield ruling that, in their annual report,
organizations needed to:
Provide information about the way remunerations were decided and reward
systems designed;
Explain the link existing between pay and performance;
Explain factors and underlying principles for resorting to variable pay;
Disclose comprehensive details about senior managers and risk-takers
remuneration.
In order to avoid the risks associated with traders’ activity, banks are now reinforcing
their risk control systems and developing KPIs enabling them to assess individual
performance in a systematic way, taking also into account risk exposure.
Just a very few years ago, whether proposed by the HR function, such measures would
have been tantamount to HR bureaucracy and definitely rejected by the banks’ boards
(Williams, 2011).
Albeit it would have been virtually impossible to do it in the past, because of the way the
overall system was working, banks are now turning towards more traditional
performance management processes and developing engagement strategies (Wright,
2011).
The final and decisive coup de grace to the banking reward system, however, has been
actually inflicted by the European Parliament approbation of the EU CRD IV, introducing,
amongst the other measures, a cap on bankers’ bonuses. More specifically, the new
regulation provides for all of the banks operating in the European Union territory to
comply with a 1 to 1 (1:1) ratio of base to variable pay of the reward packages agreed
and paid to their staff. This ratio can actually be increased to 1 to 2 (1:2), but only with
the approval of at least 66 per cent of the shareholders, whether these represent the
quorum of 50 per cent of the total institution’ shares; differently, the 75 per cent of the
votes is required.
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In the light of the new legislation and of its development, reward specialists are now
clearly acquiring a major role within the banking and financial institutions. Their role,
however, is really going to be everything but straightforward, they have in fact to design,
develop and implement practices enabling their organizations to attract and retain
individuals who are used to earn large amounts of money, and even quickly, not
exclusively relying on financial reward. It is quite improbable that bankers will gladly
accept a cafeteria benefit scheme, unless this would offer them the option to choose
between, for instance, a Ferrari, diamonds and some other luxury items. Let alone it is
expectable that these individuals would get excited about the introduction of a voluntary
benefit scheme. It is therefore most likely that cash is still destined to remain the most
appealing component of banks total reward packages. The legal framework development
is thus likely to cause a turn of tide in the financial sector reward practices; in order to
secure to investment experts the reward packages these are used to and readdress and
counterbalance the effects of the new legislation, employers could decide to increase the
fixed component of financial reward (Longo, 2011b).
Increasing basic salaries, however, would clearly impact the firm fixed costs, which will
make it even harder for organizations to eventually face future downturn periods.
Keeping higher the level of fixed pay would in fact mean that in case of economic
recession, in order to reduce costs, banks will have no other option but to make people
redundant (Longo, 2011b). Yet, once the fixed component of pay has been mutually
agreed between the employer and the financial professional, this will need to be paid by
the institution regardless of the individual performance. In the light of the peculiarity of
the profession this does not clearly represent an ideal solution for the financial sector
employers. It would be in actual fact like paying a sales professional a higher percentage
of base pay irrespective of the annual total volume of sales s/he is capable of yielding.
Indeed, in the banking sector it is even worse in that not only at the end of a year an
investment specialist can contribute nothing to the bank, but this can also even cause a
disaster. The case of Mr. Kerviel taught us a lesson also in this sense; putting aside the
causes behind it, is it unquestionable that he originated a huge loss to the bank. What if,
rather than having being paid approximately €100,000 a year, he would have received
€400,000 or €500,000 a year? The bank would have practically suffered even more. It
should be considered that individuals filling these positions can generate losses not
necessarily worth to attract the media interest and that things can go objectively wrong
when performing that type of activity. Whether these losses would be caused by several
individuals at the same time the consequences could affect and cause remarkable
prejudice to the overall financial institution operations, whereas these individuals would
continue to receive staggering salaries.
Balancing overall reward packages towards variable pay does not potentially produce the
same threat; banks could also pay their staff large sums of money, but only when
businesses are performing sorely well. Risks would even be reduced to zero whether
banks would pay bonuses only after having ascertained to actually having cashed in
thanks to their professionals’ activities.
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In terms of reward and of how employers balance the ratio between fixed and variable
pay, we have witnessed to two completely different scenarios. Banking and financial
services employers have traditionally offered bankers reward packages markedly and
predominantly variable-oriented, whereas private and public sectors employers have
offered to their staff reward packages mostly fixed-oriented or, if the worst comes to the
worst, balanced.
Whilst the aftermath of the financial crisis and the following reviewed legislation has
more recently pushed banks to readdress their views about the composition of the
reward packages they offer, or rather, of the ratio of fixed pay vis-à-vis variable pay, the
other industries are doing and planning to do exactly the opposite. In general, private
sector employers, contrary to banks, are the more and more incline to contain basic
salary and to contribute more generous variable components of financial reward to their
staff according to their actual results. Used in such a way, bonuses could actually be
considered fairer than they might seem.
This is, for instance, what emerged from the findings of an investigation carried out by
Farmer (2010). The study, covering the period from 2003 to 2007, when the new
regulation imposing big companies to disclose their top bosses remunerations had been
introduced, includes salaries of 200 UK’s big organizations such as Tesco, British Airlines,
GSK, BT and WH Smith. Findings of this study suggested that only 38 per cent of CEOs
bonuses were received automatically that is without any correlation between the
additional component of pay they received and their or their organization actual
performance. In the remaining 62 per cent of the investigated cases, CEOs received
higher financial reward packages if, and only if, they had done a good job enabling
businesses to increase their profits or their company’s share price. Conversely, that is, in
case of negative performance of their organizations, CEOs undergone a salary reduction
(Tobin, 2010).
Farmer’s investigation shows that when making decisions about a financial reward
package what matters the most is to separately consider its different components, rather
than regard the overall compensation package. The study also revealed that private
sector executives’ salary packages are better designed (and, indeed, a step forward)
compared to traders and banks senior managers’ salaries in that during the period from
2003 to 2007 these salaries have the more and more aimed at rewarding long-term
achievements rather than short-term success.
Over the period investigated, the proportion of variable reward linked to long-term
incentives increased from 22 per cent to 28 per cent. Additionally, CEOs who wanted to
receive the highest level of variable pay had to show their shareholders that they really
deserved it achieving better results than their industry competitors (Tobin, 2010).
The study carried out by Farmer could not be extended to banks for a whole range of
reasons, amongst them the fact that, as claimed by Farmer himself, a thorough and
reliable investigation of banks pay would have required access to senior bankers’ pay in
addition to that of boards members. Farmer also highlighted the circumstance that at the
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time bankers bonuses were “used synonymously" with executive pay. More importantly,
as discussed earlier, many bankers earn remarkably more than executives as a matter of
course.
Farmer admits that the way bonuses are managed in banks is typical of the banking and
financial sector only and that the same approach is not habitually used in any other
industry.
Automatic bonuses
According to a relatively recent survey carried out by Towers Watson (2013), the
number of employers offering to their staff bonus programmes is constantly growing
compared to the figure emerged from similar investigations carried out in the early and
mid-2000s. Findings of the study also revealed that the number of organizations
extending staff eligibility to bonus schemes is constantly increasing. This can, in general,
be perceived as a clear indicator of how employers are determined to link pay to
performance and can thus be appreciated. What, in contrast, appears to be much less
positive, or rather, completely negative is the use private sector employers are making
of bonuses. According to the findings of the Towers Watson investigation in fact
employers would be the more and more executing automatic bonus schemes practices
by means of which individuals receive the pre-agreed component of variable pay
regardless of their, or of their organization, performance.
Albeit private sector employees’ proportion of variable pay to fixed pay is not
comparable to that of bankers, whether confirmed, this trend should not be considered
positively. It is obviously unlikely to generate any international financial crisis, but
drawbacks for organizations can potentially be remarkable. Inasmuch as identifying and
developing brand new, effectual approaches enabling employers to really motivate their
staff becomes the harder and harder, completely losing the support of reward to this
extent can seriously risk completely weakening and jeopardizing the effectiveness of any
reward strategy.
In many cases managers may find it objectively difficult to assess and measure their
direct reports performance, but the diffusion of automatic bonuses is not really the
correct solution; on the contrary, this could contribute to magnify the issue. Whether
measuring performance should reveal to be particularly tough and tricky, especially if the
business has not provided managers the tools and training necessary for these to
properly carry out this task, managers could try to base their assessment on individual
behaviour, gained competencies and capabilities and other similar, albeit judgmental,
elements, rather than automatically pay bonuses.
Automatic bonus practices may help employers to attract individuals from the external
environment, but whether strongly attracted by this bonus payment mechanism it can
hardly be believed that these would be hard workers, hi-flyers or real talents.
Whether automatic bonuses should spread amongst private sector employers, it is very
likely that bonuses will gain back the media interest anytime soon, whereas firms
fostering these practices might be prompted to face reputational risks.
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The
impact
of
the
European
financial
sector
regulation
development
The approbation of the EU CRD IV Directive, which had been expressly developed with
the intent of preventing the risk of other international financial crises, introducing
specific rules about the bonus-to-salary ratio, shows that, at least at the European
political level, a clear relationship between bankers’ bonuses and the past international
financial crisis has been identified.
The effects and implications of the Capital Requirements Directive are actually twofold,
on the one hand it imposes clear constraints to the banks autonomy to determine the
bonus-to-salary ratio of employees receiving an income above a pre-set threshold;
whereas on the other hand it introduces more stringent and severe provisions aiming at
increasing banks’ reserves whilst ensuring their prompt availability, or rather, liquidity.
With particular reference to the bonus-to-salary ratio, the bonus cap has been
introduced as regards the reward packages received by individuals deemed as “material
risk takers.” According to the new regulation an individual who do not receive a reward
package exceeding €750,000 and who do not manage any risks for the institution this
work with can be exempted from the bonus cap limitation. Individuals receiving reward
packages between €750,000 and €1,000,000 can be exempted from the limitation
whether their exclusion is approved by the national regulator, in the UK the Prudential
Regulation Authority. For individuals receiving over €1,000,000 the waiver will need to
be approved by the European Banking Authority (EBA).
The imposition of a bonus-to-salary ratio has actually caused vigorous discussions and
reactions especially in the UK, prompting the Government to lodge a complaint with the
European Court of Justice (ECJ). Further concern is caused by the circumstance that the
FSA as a consequence of the introduction of new laws usually amend regulations, in this
case the Remuneration Code, imposing more stringent and cogent regulations vis-à-vis
its European counterparts.
As Nava (2011) pointed out, in order to avoid the repetition of international financial
crises European countries should all have the same rules and this objective can only be
attained by means of a common regulation. This is clearly supportable, but European
regulations do not indeed apply to the United States, Australia and the Asian countries.
The best European talents, because of the weakening of the variable reward packages,
that is bonuses, European banks and financial institutions can offer them, could opt to
join American and Asian employers lured by the attractive reward packages these are
still able to offer. Indeed, the unprecedented EU Parliament move could hopefully push
the American Congress and the Asian lawmakers and regulators to follow suit but, at the
moment in time, there is no evidence that this is within their plans.
The UK government and financial sector fierce opposition to the new provisions is
obviously justified; its introduction can remarkably weaken the City attractiveness and
appeal at global level. As highlighted by Browne (2013), London is not representative of
the UK’s banks only, but rather of all of the international banks based in Europe, which
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are usually operating from London. According to the EBA, in 2012 the number of “high
earners” in the UK has increased from 2,436 to 2,714, compared to the 212 high earners
recorded in Germany, the 177 in France and the roughly 100 high earners existing in
Italy and Spain (Clinch, 2013). The central role of London within Europe is clearly not
threatened; talents from across Europe have always moved to London and will possibly
continue to do so, provided these would not decide to better move to New York, Tokyo,
Singapore or Hong Kong in order to receive larger financial reward packages.
As we have seen above, the EU CRD IV, in a bid to make more unlikely or less relevant
the eventual public intervention in case of other financial crises, introduced regulations
prescribing banks stricter capital requirements and better liquidity management. The
objective of these rules is clearly that to force banks and financial institutions to keep on
board some parachutes. The fact is that banks practically have to pay for these
parachutes, with the immediate consequence that they will have less money to invest
available to them. In order to continue to be productive and not reduce the productivity
levels to which banks are used, these should attain better ROI rates. All of that, as
appropriately suggested by Wright (2011), could just have the effect to increase the
temptation to favour short-term risk investments.
The question is: can actually regulations help to definitely address the problem?
According to Cotton (2011), regulations can have a limited effect in that they are
normally retrospectively drafted, in the sense that they tend to settle problems when
these have already occurred; as such, regulations are not likely to prevent the impact
that unexpected new circumstances may produce. This entails that whether in the future
a financial crisis should burst because of different-related reasons, the current
regulations could