Macaskill on markets: Goldman Sachs – making competitors fail again
Goldman's new incentive scheme for its top management has some curious quirks.
|Illustration: Kevin February|
“It is not enough to succeed. Others must fail,” the writer Gore Vidal once observed. Goldman Sachs made this central to CEO Lloyd Blankfein’s motivation with a change in its compensation policy in March. Most of his pay will be linked to a combination of absolute return on equity for the bank and relative ROE compared with a group of eight peer banks from the US and Europe.
A link to return on equity goals had existed previously as one payment metric for Blankfein and other top managers, but not with an explicit tie to competitor performance.
Goldman said that the change was partly in reaction to shareholder feedback that its compensation policies for senior executive were too complex, but the new system has quirks of its own.
Performance stock units awarded to Blankfein and recently installed CFO Marty Chavez will be tied to Goldman’s ROE compared with peers when the absolute three-year average return is within a 4% to 14% range. At ROE levels below 4%, the units will not be awarded, while at levels above 14% a maximum payout of 150% of the initial amount of the award will be made regardless of the relative performance to the peer group.
Goldman’s returns on equity have been in the 4% to 14% range in recent years, so there is a strong incentive for Blankfein to ensure that he remains eligible for a 150% payout by generating ROE that is in the 75th percentile relative to the designated peer group. Simply ranking in the 50th percentile will deliver a 100% payout, falling to 25% if Goldman is in the 25th percentile of the group.
Given that the group of eight peers includes some struggling competitors, this is arguably a very low bar. Deutsche Bank lost €1.4 billion last year for a return on equity of -2.3%, for example. That was an improvement on the year before, when it lost €6.8 billion for ROE of -9.8%, but Deutsche Bank CEO John Cryan is hardly breathing down Blankfein’s neck in the ROE contest.
When Deutsche Bank announced the terms of its latest capital increase, a €8 billion rights issue, it warned that its new target of a 10% return on tangible equity in a “normalized operating environment” would not be achieved in the near term. It also cautioned that ROE for its core investment bank will have a negative drag of around 2% a year from the planned disposal of €20 billion of risk-weighted assets; so it is safe to assume that Blankfein will not have to worry about ranking below Deutsche Bank any time soon.
Goldman effectively acknowledged that Blankfein’s outperformance goals are undemanding in its announcement of the new compensation structure. In a spirit of full and frank disclosure, and possibly to distract from a disappointing 2016 when revenue fell from the year before, Goldman noted that its 2016 return on equity, at 9.4%, was higher than both the US peer average of 7.9% and the European peer average of 0.4%.
Goldman also observed that its average annual ROE for the last five years of 9.9% is higher than the US peer average of 6.3% and the European average of 1.1%.
Goldman is not the first firm to introduce ROE relative to peers as a compensation metric for its top managers. JPMorgan made a similar move last year for CEO Jamie Dimon and its operating committee members.
The shift by a firm that remains an industry trend setter will nevertheless place more of a focus both on ROE and on the potential to manipulate calculations of returns if the practice of making pay awards based on relative ROE spreads down the executive ranks at big banks.
Group-wide return on equity numbers are difficult to distort. Banks have nevertheless done their bit to muddy the waters with a trend towards emphasis in earnings results of return on tangible equity (ROTE) numbers in recent years. This is generally a relatively harmless way to flatter reported returns by deducting intangible elements such as goodwill from the equity base used to derive ROE, although it can sometimes create large gaps in reported returns.
UBS acknowledged in its recent annual report that its group absolute return on equity for 2016 was 5.9% while stressing that its “adjusted” ROTE was 9%, before also using an unadjusted ROTE of 6.9% in a chart of its “key figures” of the year, for example. Investors should feel free to pick a number, any number, it seems.
There is even more scope for misleading practices when it comes to ROE calculations for business lines within a bank. Here again UBS is a poster child for creative ROE calculation. In the wake of a 2011 reorganization that initiated a withdrawal from some trading businesses, UBS shifted large amounts of capital and non-core assets into its corporate centre. By the end of 2015, roughly half of the bank’s capital was allocated to the corporate centre, allowing UBS to lay claim to a return on equity for its investment bank of 25.9% for the year, in part because it was calculated on a relatively thin base of dedicated capital.
The bank’s senior managers, including CEO Sergio Ermotti and investment bank head Andrea Orcel, touted the elevated ROE as vindication of their business strategy. Bank stock analysts were mostly happy to endorse this approach, in part because UBS was pursuing policies for investment banking that many of them had recommended. Eventually a few analysts started to take issue with the allocation games, however, and UBS announced changes to its capital treatment on its most recent earnings call.
With a planned increase in allocation of risk-weighted assets and related capital to individual business lines at UBS, the ROE reported for its investment bank is likely to be lower in the future.
Creative tweaking of ROE numbers for business lines within banks might seem like harmless marketing exercises or simply a reflection of natural internal competition. After all, battles over resource allocation or attribution of costs are a staple of the corporate infighting that consumes much of the energy of senior executives in any large company.
A focus on compensating bankers based on relative ROE will inevitably create new incentives to manage to this number, however. It will also increase motivation to undercut the performance of competitors, as if any was needed, and remove the burden of feigning indifference or even sympathy when a rival firm is underperforming.
Senior bankers often pretend to be unconcerned by the relative performance of their competitors, or express regret that a former peer has fallen on hard times. This affectation is deeply unconvincing and can undermine their credibility.
Hopefully, a move towards greater use of compensation that is tied to relative ROE performance will allow bankers to shed this mask and embrace the honesty of Gore Vidal, who once also confessed: “Every time a friend succeeds, I die a little.”