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Compensation: Best practice on pay is ignored

Banks say guidelines unworkable; Guaranteed bonuses still rife

Investment banks are practically required to pay out the very kind of guaranteed bonuses the Financial Stability Board (FSB) condemns if they wish to attract new staff, according to an Institute of International Finance reportreleased last month.

The survey, conducted by Oliver Wyman and rather optimistically entitled Compensation reform in wholesale banking 2011: Assessing three years of progress, shows that while multi-year guaranteed bonuses are in decline, in 2010 single-year guarantees to new hires made up 8.5% of the bonus pool – a 3% increase from 2009.

Bruno de Saint Florent, partner at Oliver Wyman, says: "2009 was a good year for wholesale banks, so there was a lot of hiring in the first half of 2010. All of the institutions that were hiring were offering single-year guarantees. If banks want to develop in a particular area they need to offer these guarantees." He says this was not just a case of a few aggressive new entrants distorting the market for new hires: "I don’t think you could find a major bank that wasn’t guaranteeing in some way."


A guaranteed bonus for the first year is expected by new hires, and banks that do not offer it run the risk of putting themselves at a competitive disadvantage.

This is at odds with FSB guidelines, which indicate that guaranteed bonuses are to be discouraged as they oppose the FSB’s aim of linking bankers’ compensation to their risk-adjusted performance. The FSB’s best-practice guidelines provide that "guaranteed bonuses are not consistent with sound risk management or the pay-for-performance principle," allowing an exception only for "exceptional minimum bonuses" in the context of new hires.

So were these one-year guarantees, many now expiring, truly exceptional? "You cannot expect bankers to move jobs without a guarantee of a bonus, as their productivity tends to be lower in the first year after they switch," says de Saint Florent.

The IIF report cautions against according too much importance to the spike in single-year guarantees in 2010. The implication is that it might not be a continuing trend, with more banks now cutting staff. "Bank hiring patterns naturally fluctuate over time and many survey respondents explained that these one-year guarantees were exceptional decisions in direct response to senior staff hiring pressures during 2010," says the report.

Charles Dallara, managing director of the IIF, claims: "Survey results indicate that the trajectory of change is positive across the compensation agenda and that the wholesale banking industry is now focusing on practical and detailed implementation of the FSB’s Principles."

Development of bonus guarantees  
As a percentage of the total bonus pool
Source: Institute of International Finance & Oliver Wyman 2011 Compensation Survey  

However, bank shareholders still need to be wary. In addition to increases in fixed single-year bonuses, the report also indicates that 60% of banks have raised their fixed salaries and a further 27% plan to do so in the next year. These salary increases come amid an alarming decline in investment banking earnings and returns. Less variable compensation can quickly consume a high amount of banks’ earnings in tough markets. UBS’s struggling investment bank spent 90% of its third-quarter revenue on compensation while turning a SFr650 million ($754 million) loss.

Oliver Wyman argues that shareholders will have been consulted on the salary increases. "The apportionment between fixed and variable pay has been discussed heavily – including with representatives of shareholders," says de Saint Florent. "This may look weird from the outside, but it simply reflects the reality of the competition that the banks face – particularly from institutions such as hedge funds that face less regulation."

During the banking sector’s nadir in 2008 almost all banks continued to pay out bonuses. This suggests that bonuses might have been variable only in name, so any inflexibility that comes with higher salaries might be less of a departure than it appears. Whether this counts as progress in compensation reform depends on whether one looks at it as an employee of an investment bank, a shareholder, or a regulator.

De Saint Florent says: "2008 was obviously a very bad year for the industry, and yet only 7% of the banks we surveyed paid no bonuses that year. This suggests that at least part of the bonus pool was only variable in name, and was basically being paid out as a fixed amount."

The report suggests, though, that banks are increasingly using clawback clauses, with many having clauses in place to reduce or reclaim deferred remuneration in instances of bankers booking year-one profits that bring subsequent losses in their wake.

"There are many, many examples of bonus-malus clauses being exercised – and these will be even more clear to see in the future," says de Saint Florent.

Third-greatest challenge

However, the IIF report does express concern about the take-up rate of such clauses, and identifies their introduction as one of the more difficult elements of FSB recommendations. "Performance-linked deferrals are cumbersome to introduce and their introduction has been rated as the third-greatest implementation challenge to compensation reform for the second consecutive year," states the report.

The two things even more difficult than dealing with deferred compensation are the "alignment of deferrals with risk time horizon" and – most challenging of all – the "measurement and incorporation of risk in the compensation process". It seems 70% of banks surveyed are still struggling to work out how risky behaviour should affect how much they pay their employees.

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