Reward Issues in Financial Services
Jonathan Chapman explains how banking remuneration is changing
The context for reform
“Excessive risk taking in the financial services industry… has contributed to the failure of financial undertakings”………”Whilst not the main cause of the financial crises that unfolded……there is widespread consensus that inappropriate remuneration practices…also induced excessive risk taking” European Commission 2009.
In the UK, the Financial Services Authority (FSA), the independent body that regulates the financial services industry, has introduced a new regulatory rule to apply to larger banks and building societies, namely that "a firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management". This rule is supported by a range of evidential provisions which were set out in a code of remuneration practice.
At the same time we have seen unprecedented interest in the pay of bankers from politicians, media, the public and investors. In this context, reform seems inevitable.
What is happening?
Financial services firms are all proactively examining their reward structures in a way not seen before. This is readily apparent from research currently underway at Cranfield School of Management. However, what is not yet clear to me is the extent to which this activity and the increased external scrutiny of these firms will lead to lasting change in reward structures in the sector; or whether the effect is transitory and practices in the long run will remain relatively unchanged. The initial findings of the research point to how strong are institutional pressures to maintain the status quo and these will be hard to break.
I see three main areas where the banks are focusing their attention:
Governance – The extent to which financial services remuneration committees will be able to focus their work solely on the reward of the executives appears to have changed. They are now increasingly looking down the organisation, especially to the roles and individuals who can take large amounts of risk on behalf of the organisation. This deeper examination is not just about setting the firm’s overall reward philosophy, although this is important, but examining in detail how lower level reward structures are aligned with the firm’s risk appetite. In addition, firms are putting in place more formal structured governance of lower level reward, with committees reporting back to the firm’s overall remuneration committee.
Performance measurement - There is increasingly a shift from measuring performance for bonus purposes based on revenue to profit. In addition, more sophisticated ways of adjusting profits made for the risk taken are being examined so that this can be considered in remuneration decisions throughout the firm. Profit measurement itself is likely to be much more prudent, especially around product valuations and adjustments of prices to take into account concerns over product liquidity. Increased provisions are being taken or conservative marking to market policies are being used in the calculation of profits used in bonus pools. Finally, whilst large numbers of firms use balanced scorecard type measurement systems, the significance of behavioural measures in these systems will rise in importance, especially individual’s compliance with risk management procedures. The common historical practice of solely focussing on financial performance of sales and trading staff for bonus purposes is being adjusted to take more account of poor compliance records or risk limit breaches, even where star profit generating employees are concerned.
Changes in pay structures - A number of banks have already adjusted their reward mix (the relative proportions of fixed and variable reward making up total remuneration), paying higher base salaries and lower bonuses. Deferral of bonuses may, if regulatory and political pressure wins through, become a feature of reward packages. Even clawbacks of previously earned bonuses are being discussed, although there are a number of legal and practical issues involved.
What does this mean for other sectors?
The signs are that any changes occurring will impact on other sectors:
A significant time of reflection and debate is underway in this area. Time will tell whether lasting change will really occur.
- The Financial Reporting Council is reviewing the combined code, which covers remuneration issues, in light of the financial crises. The aim is to see whether there are any universal lessons to be learnt. This may lead to wider recommendations on remuneration governance applicable to all firms covered by the code.
- Many members of both full boards and remuneration committees sit both on financial services and non financial services committees. By their influence, they will potentially spread practice wider.
- Reward management is a very institutional profession. Practices are spread across the industry through benchmarking, conferences and consultants’ advice, which may mean practices gaining wide acceptance outside of financial services.
Jonathan Chapman is a FME Teaching Fellow at Cranfield School of Management. He has over 15 years’ experience in the financial services industry, having worked for the FSA as a banking and securities regulator, risk manager and more recently as a member of the FSA’s senior management team as Head of Organisational Development, Reward and Industry Training, and Director of Financial Capability.
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