GUEST COMMENT: Clawbacks are coming

23 January 2009

2 minute read

The current crisis is forcing the financial services sector to re-examine its bonus structures and how employees are remunerated. Indeed, some banks have already taken steps to change their compensation structures and have placed more emphasis on ensuring that risk and reward timeframes match.

In 2009 and beyond we are likely to see a significant overhaul in the way in which the financial services industry will measure performance and remunerate employees, with a particular focus on implementing clawback structures and using risk-adjusted performance measures.

Remuneration policies have a significant influence on employee behaviour and the risk culture within an organisation. We have already seen banks making changes to executive compensation plans by introducing clawback arrangements and limiting severance packages to avoid present reward for future failure.

These arrangements represent the start of a broader move away from the culture of lump sum cash bonus payments, to one in which a substantial portion of the executive's bonus is deferred or put into an escrow arrangement. In this case, the bonus only becomes payable after an agreed deferral period. Clawback provisions, which have the effect of reducing the deferred portion of the bonus in the event of the future poor performance of a business unit or a risky trade, will have a strong effect on the risk culture within organisations.

Risk-adjusted performance measures, such as economic profit based on economic capital or risk adjusted return on capital, are also useful tools as firms look to enhance their risk culture. These measures essentially take into account the expected profit from an investment and the cost of capital needed to support the investment. Riskier investments will require a lot more equity capital attributed to them and will need to achieve a higher return hurdle to justify a bonus payout for the employees.

Organisations will be able to use risk adjusted performance measures only where they have effective and adaptive risk measurement tools. Once risk measurement systems have been improved and embedded at operational levels within organisations, we expect firms to increasingly use risk based performance measures in the incentive plans of executives and middle management.

The bottom line is that incentive structures do still need to reward and incentivise good performance. However, it is also clear that these structures should not lead to undue risk taking.

AUTHORMike Eckes

Insider Comment

Gh
Gholam
28 January 2009
How can one argue that the traditional bonus system has worked as bonuses delivered in shares have drooped in value by 70%-90%? Yes the value of bonuses delivered in shares in the last few years have dropped but one also needss to acknowledge that shareholder value has been destroyed. A shareholder would argue that from their perspective the incentive system was not rewarding the right behaviour.
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Do
DominiConnor
24 January 2009
Mr Eckes is going to do well out of that scenario, and he's probably right.
But...
As a headhunter I have to tell you that although his thoughts will be shared by the rtop management of most banks, it will be followed very quickly by the thought of "how to we use this to make *our* bonuses bigger ?"
"Risk", as any quant will tell you can be worked out many different ways, giving wildly different numbers. What is the risk of investing in the equity of a bank ? Take the last year you get scary numbers, take the last three years less scary. Will the next three years be more or less scary ? Is the pain for banks more than half way through ?
Any quant who could not make the same risk look both rock solid and suicidally insane, merely by choosing different weighting and the period to use as a base should not even be employed.
If he wants a couple of such people, I am easily found :)
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ja
jake
23 January 2009
gotta love banking...it's like the aristocracy and nobility of ages past when the world was governed with absolute power by kings and queens.
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GS
GS Banker
23 January 2009
Mike, i do not think you have been in banking or really understand the culture. Bankers think only about the bottom line, not about risk adjusting pay etc fine as a discussion point but totally airy fairy.
Once the spot light is off it will be back to the old days of cash is king and this goes all the way to the top in the board rooms. Besides a lot of bonuses when they become significant are paid in shares - many have seen 90% of their share value go up in smoke, that seem to suggest the bonus system has worked and no need for a claw back.
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Ol
OldTimer
23 January 2009
Sensible article...but please dont believe that we dont realise how some banks are pricing the "toxic" elements of securities that will eventually remunerate them. It would apprear that some think that we dont know what they are doing
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