Banking Bonus & Incentive Pay Dilemmas

Bonuses for Banking Executives for 2008 Performance? You’re Kidding, Right? — No.

The near-collapse of the financial services industry has left our economy reeling and made many taxpayers angry. So why should financial professionals keep receiving bonuses? After all, many other workers have never received year-end bonuses — and the ones that have don’t expect to see much of a bonus this year — and perhaps for a long time to come.

Our guest post today answers this question. It is by Jon Jacobs, a staff writer at eFinancial Careers. In it, Jon explains why, in his opinion, the bonuses are necessary not only to keep the best people in the industry, but also to help allow the industry to wean itself off of the public dole.

His Wall Street insider’s perspective is worthy of careful consideration. It runs counter to contemporary black-and-white views of everyone in the financial sector as undeserving, if not downright evil.

I say whenever you start hearing absolutist statements, you’re hearing an oversimplified, partisan view — no matter how many people say it and how often they repeat it — and it’s time to look for “the rest of the story.” There’s another side to all those statements tantamount to “everyone on Wall Street should get lumps of coal for Christmas bonuses this year.” Here it is.

Bonuses Under the Microscope

Financial institutions toted up 2008’s annual bonuses against a backdrop of unprecedented government financial participation and intense political scrutiny.

Both pay in 2008 and the paradigm for future years were reshaped under this spotlight.

Year-end compensation decisions, which traditionally aimed to balance employee retention needs with budgetary constraints, must now also weigh the interests of a daunting array of stakeholders. These newly empowered stakeholders include Congress, the U.S. Treasury, the news media, and the taxpaying public.

Educating the New Stakeholders – “Bonuses” Aren’t Actually Bonuses

Institutions that resist demands for a company-wide and industry-wide bonus moratorium face a public relations challenge. The first thing banks need to do to face that challenge is educate the public about the critical distinction between C-suite executives and hard-working pros in the trenches, and between banking and most other industries whose employees work primarily for fixed salaries rather than highly variable salary-plus-bonus packages.

To do this, banks should emphasize that the word “bonus,” is a misnomer. Year-end incentives constitute the meat of most banking professionals’ compensation packages. Few on Wall Street work primarily for the salary (what’s called “base” – a word that perfectly describes how people in the business view it).

Firms also can emphasize that most finance professionals neither make seven- or eight-figure incomes, nor were involved in creating or selling “toxic” products such as asset-backed CDOs.

Nationwide, about 850,000 individuals are employed in securities dealing, trading, or investment management. Many work in administrative and support roles, and earn incomes that –- although above what other industries typically pay for similar work –- show a human side of banking the industry’s critics are working hard to obscure.

By presenting concrete, detailed, real-life portraits and testimony from such individuals, the industry can counterbalance the cartoon-like caricature of all Wall Streeters as Porsche-driving, Rolex-wearing, island-hopping tycoons.

Uneven Bonuses Can Lead to a Destabilizing Round of “Musical Employers”

The political spotlight on compensation poses both near-term and longer-term risks to financial institutions. An obvious near-term risk is that an institution reining in year-end incentives more severely than its peers might lose talent to competitors early in 2009.

Rivals both traditional (other bank holding companies) and non-traditional (boutique and mid-market investment banks and alternative investment firms) are waiting in the wings, eyeing opportunities to poach star contributors.

Any perceived inequities that arise between similarly positioned firms are a potential trigger for defections. Even hobbled banks and hedge funds will seize opportunities to scoop up top talent that’s disaffected with their current employer. Encouraging employees to play “musical chairs” between employers won’t help in the push to return to financial stability.

Banks as Public Agencies? Is That What We Want?

Besides risking defections in the near term, an institution perceived as letting public officials dictate its compensation procedures runs a risk of gradually metamorphosing into something like a government agency itself.

In public agencies, salaries often are set by published charts rather than managers’ discretion, and bonuses don’t exist. To the extent a bank drifts in that direction, risk-takers and innovators will look elsewhere for work, and its ranks will slowly fill with individuals comfortable with high levels of transparency and public oversight of their own compensation packages –- in other words, the kind of individuals who seek public service-type careers.

After five years, it might no longer be practical to return a partially nationalized bank to the rough-and-tumble private sector.

Before we let this happen by default, the financial industry needs to at least encourage a public discussion and debate on the idea.

Playing Chicken with Salaries

In the face of the political onslaught, the top executives at Goldman Sachs, Morgan Stanley, Merrill Lynch, UBS, Deutsche Bank, and other big-name institutions ultimately decided not to ask for bonuses for themselves or their key lieutenants for 2008.

However, the industry’s critics –- who include such powerful figures as Rep. Barney Frank, the chairman of the House Financial Services Committee — urged a clampdown on year-end cash payouts for all levels of employees. This hothouse political environment led many firms to delay their bonus decisions and turned the outcome into a game of chicken.

Still, although bonuses were drastically scaled back from 2007’s record levels, many financial market professionals will see something in their bonus envelopes.

Long-Term Compensation Reforms in the Works

Aside from the 2008 bonus payouts, broad reforms in compensation models are in store for 2009 and beyond. The direction of change is suggested by new pay paradigms announced separately by both Morgan Stanley and UBS, which each aim to discourage excessive risk-taking and better align employee incentives with shareholder interests.

An important break came on Nov. 17, 2008, when UBS unveiled a new incentive structure for future years. The system will apply to its group executive board, the executives one step below, and all other employees who exercise “key functions,” such as “using risk capital and assuming significant financial risks.”

The new UBS paradigm utilizes a “bonus/malus” system in which each year’s bonus is deferred for a few years and can be clawed back in case of future losses.

However, the Swiss bank said that for most of its employees, “the current system of variable compensation will basically not change.”

Morgan Stanley announced a similar system early in December 2008. It went into effect for 2008 bonuses, and covers a far wider group of employees than the UBS bonus changes.

Over the next 12 months, we expect more institutions to overhaul compensation as Morgan Stanley and UBS have done. Antecedents of those plans can be seen in proposals of the Institute For International Finance (IIF), a global umbrella group that unites bank leaders from the private sector, central bankers and regulators. To discourage market participants from taking excessive risks, an IIF “Best Practices” report published in July 2008 recommends:

  • Base bonuses not on a trader’s raw profit, but on profit adjusted for risk and capital costs.
  • Pay the lion’s share of bonuses in the form of “deferred or equity-related components.”
  • Time payouts to correspond with the period in which a firm’s capital is at risk.
  • Make incentives for risk-takers as comparable as possible across different business groups within a firm.

Jon Jacobs is a staff writer at eFinancialCareers, a network of career sites for professionals working in the investment banking, asset management and securities industries covering 18 global markets. The ideas in this post draw upon commentaries published on eFinancialCareers News during October and November, 2008.

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