Corporate Risk Issue 2 Reshaping the risk-reward balance in compensation How companies outside the financial sector are responding to the new regulatory environment Following the 2007-09 financial crisis, various supranational and local regulators introduced new legislation governing compensation. Though this regulation is initially targeted at financial services institutions, several non-fs firms are using the current shift in competitive landscape as an opportunity to strengthen their compensation practices. This paper highlights what is at stake and the new approaches firms are taking towards compensation.
New compensation guidelines At the start of the financial crisis, several industry and regulatory bodies voiced their concerns about the possible links between the compensation schemes employed in investment banks and their potential impact in encouraging excessive risk-taking. Since then, new regulatory guidelines for the financial services sector have been outlined by the G-20 (see Exhibit: Outline of New Compensation Regulation ). These guidelines are designed to address such concerns and focus on aligning the incentives created by traders compensation schemes with longer term value creation. Oliver Wyman has played a central role in shaping the debate between industry and the regulators during this process. This has provided us with a deep understanding of the key compensation-related issues in the industry and the potential solutions, both within the current regulation and its likely future evolution. Changes to front-office compensation Several non-fs firms, particularly the corporates housing significant commodities trading activity, in areas such as energy, primary industries and agribusiness, are considering changes to their front office compensation in light of the evolving market practices and changing regulatory rules. For many, the potential impact of the new regulatory framework has not been the prime motivator for change. Independent of the regulation, the boards of companies with large trading functions have been focusing on compensation practices in order to improve the alignment of traders incentives. In general, such corporates are aiming to achieve three main objectives: The first objective is to address shareholder concerns. Though shareholder pressure has been largely concentrated in the financial services sector, corporates with significantly large trading arms are realizing that they may also see increased shareholder focus on trader compensation going forward. The second objective is to better align incentives in the trading function with shareholder value creation using compensation as the medium. The third objective is to ensure that the changes being introduced are in line with any likely future changes in compensation regulation that might impact them more directly. The complexity of compensation issues means that there is a diversity of approaches in achieving these objectives. The remainder of this paper looks at the present compensation landscape and the pros and cons of the various approaches. Approaches that increase risk ownership and accountability More often than not, conventional bonus calculations have been based solely on revenues and profits, particularly in proprietary trading linked to capital-intensive Copyright 2010 Oliver Wyman 2
Exhibit: Outline of New Compensation Regulation The G-20 regulators have issued a set of supranational compensation principles and implementation standards through the auspices of the Financial Stability Board (FSB). These principles and standards have been drafted into local regulation, and included in the Pillar 2 requirements by the Basel Committee. The standards included in this regulatory framework aim to create compensation processes that incentivize appropriate risk taking across all producers in the organization, including both executives and the risk-takers. The key elements of compensation processes covered by this regulation are outlined in the exhibit. As can be seen from the exhibit, while certain regulators have adopted the FSB principles more-orless directly, internationally there is considerable variation in terms of how these principles are being interpreted in local regulation. Structural gap 1. Weak Compensation Governance Board oversight Links between risk oversight and compensation governance Public disclosure 2. Level of executive and risk taker compensation Compensation levels (quantum, caps) Alignment between middle/back office comp and value added Linkage to firm-wide results 3. Limited use of risk adjustments in determining compensation Risk adjustments in bonus pool sizing and allocation Long term risk accountability in performance measurement 4. Weakness of pay structures (leading to the free option issue) Potential short-termism of payout currencies 1 Alignment of deferred component with risk holding period Ability for clawbacks/malus on deferrals (beyond misbehaviour) Use of unfunded deferred compensation Global implementation standards (Sept. 2009) Financial Stability Board/G20 principles/ Basel 2 1 Institute of International Finance European Commission/ Committee of European Banking Supervisors UK: Final rules (Aug. 2009) Financial Services Authority Paris Financial Community Working Group Guiding principle issued Concrete recommendation Explicitly not treated 1. Basel 2 amendments to guidelines approved July 13, 2009; FSB principles embedded in Pillar II guidelines and execution responsibility assigned to the Supervisory Board 2. Short-termism of metrics used in incentive programs, weaknesses of equity/options time window for executives 3. Covers executive compensation USA: Final rules (Oct. 2009) US (Dodd Amendment to TARP 3 ; Special Master s rules)
businesses. The lack of risk adjustment has been widely seen as a structural gap in the industry s compensation practices. In response, leading non-fs firms are considering two complementary approaches to align traders incentives with longer term value creation. The first of these approaches includes the introduction of risk adjustments in bonus pool calculations. The second involves the refinement of payout structures, i.e. the use of deferrals and payout conditions to hold traders responsible for the risks originated over the risk holding period. The aim of both approaches is to develop mechanisms of both risk adjustment and strengthening that directly connect traders compensation to the risk profile of their trading activity and to bring this in line with the overall risk appetite of the organization. a) Risk adjustments: This approach involves the use of cost of risk/capital adjustments in the bonus pool calculation and allocation processes. Such adjustments aim to hold traders directly responsible for the level and the cost of risk that they take, link this back to the firm s overall risk appetite framework, and provide the management with effective levers to manage risk taking at the producer level. Though risk adjustments are undoubtedly useful, they are no panacea. As yet, there is no single, reliable and accurate method for measuring the risks inherent in a position. This is particularly true in illiquid markets, where there are no commonly accepted metrics. The limitations of current risk approaches pose a key challenge to accurate risk measurement and the use of associated risk adjustments. Hence the need for stronger payout structures to complement the risk adjustments arises. b) Strengthening the payout structures: Firms are increasingly moving towards the introduction of the pay at risk concept in their payout structures. This typically involves deferring a part of a trader s bonus over the risk holding period, and subjecting it to certain payout conditions, e.g. clawbacks, bonus/malus or performance hurdles. The profile and span of deferrals and payout conditions is designed to reflect the nature of the markets the firm operates in, and the seniority of the employees to be covered. The use of such structures allows a firm to mitigate the limitations of risk modelling and the associated risk adjustments, but also to address the free option issue related to trader compensation. In the past, traders have benefited from a significant upside in years of strong market performance, while facing no corresponding downside in years of poor performance. Observers refer to this as the trader s free option. This lack of a downside can encourage excessive risk taking. Increasingly, the use of deferrals and payout conditions is being seen as the preferred approach for addressing this issue. Another related aspect of payout structures receiving attention in the industry is that of the mix of instruments used to pay out the non-cash component of compensation. From an incentives perspective, stocks/options based pay is often discounted by traders, who see these instruments as too distant for an individual trader to influence. This is particularly relevant for non-fs corporates, where trading typically represents a small part of the overall business. Copyright 2010 Oliver Wyman 4
To address these limitations, some firms are considering virtual stock instruments, which track the performance of the trading unit more directly compared to stocks/ options. Since the traders have a closer control on the value of phantom stock, both upwards and downwards, these instruments can provide an effective mechanism to control the excessive risk taking incentives among traders. Approaches to enhance compensation governance None of the compensation approaches discussed above will work effectively without strong governance and oversight. Regulators and industry commentators alike have noted that boards need to play a much more active role in compensation governance. Accordingly, important changes are taking place in the industry: a) Board level: The new regulatory framework suggests that Boards should include representatives with experience at the interface of compensation and risk, something which was not common practice before the crisis. A number of firms that are in the process of making changes to compensation practices, including the introduction of risk adjustments and payout structures, are also considering the addition of independent risk and compensation experts to their remuneration committees to enhance Board level governance. b) Business level: At the business level, the Chief Risk Officer and the Risk function are being given a wider role in the key compensation processes, for instance, in the allocation of risk capital and the monitoring of its usage, defining the way risk capital is used in risk adjustments, and actively monitoring the impact of compensation on the firm s risk profile. The challenges in implementing these changes are largely operational. The revised roles and responsibilities need to be clearly articulated across functions such as HR, Finance, and Risk, while the use of the revised risk reporting infrastructure needs to be embedded in the functional processes. * * * Compensation linked to corporate objectives Oliver Wyman has been closely involved in the debate about the management and governance of compensation since the start of the credit crisis, during which time there has been an unprecedented shift in sentiment. National governments have intervened directly to ensure compensation policy doesn t inadvertently encourage excessive risk taking. Shareholders are more focused than ever on trading risks. Corporates are increasingly seeing compensation as a key priority going forward. They are reshaping the way it is handled, using the various approaches discussed in this paper to enhance the effectiveness of their business. Compensation approaches as a result have changed for the good they are more sophisticated, nuanced, and better integrated into the overall corporate objectives than ever before. Copyright 2010 Oliver Wyman 5
Oliver Wyman is an international management consulting firm that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation, and leadership development. For more information please contact the marketing department by email at corporaterisk@oliverwyman.com or by phone at one of the following locations: North America EMEA Asia Pacific +1 212 541 8100 +44 20 7333 8333 +65 6510 9700 Copyright 2010 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. This report may not be sold without the written consent of Oliver Wyman.