THE CASE FOR DEFERRED CASH COMPENSATION | Good Culture | Bad Culture | Series
Loss aversion is a powerful motivator of behaviour. In most cases, stronger than the chance of a speculative gain.
Deferred Cash Compensation can potentially reduce short-termism, improve internal risk monitoring, reduce compliance costs and internalize the cost of excessive risk and misconduct.
Deferred Cash Compensation contingent upon minimum regulatory capital requirements is strongly symbolic (to potential investors and regulators); and positively correlated with lower credit spreads.
Deferred Cash Compensation is not the same as Deferred Equity – it is more tangible, direct and immediate – and thus is potentially more effective in inducing behavioural and cultural change. Deferred Cash eliminates much of the ‘free-rider effect’ of Deferred Equity Compensation.
All references are provided, however the main conceptual source of this paper is Mehran & Tracy (2016)1.
Behavioural economics suggests most people would rather avert a certain loss than seek marginal speculative gains.
Workplace compensation is based on a model of reciprocal contractual obligation. You work, you get paid. Usually in cash, once a month, in arrears. In banks, there tends to be an implicit expectation of a variable component (bonus) at some point in the future.
This paper explores whether deferring a portion of a person’s cash compensation might change the way they behave. Essentially, could giving an employee ‘something to lose’ make them more risk aware?
For decades organisations have studied customer behaviour in order to increase their engagement with the firm (sales). Using similar principles, a number of innovative companies seeking to create improved cultures are using employee choice, behaviour and motivation to increase engagement.
The Case for Deferred Cash Compensation
Consider the following classic behavioural economic choice:
Would you take this bet? A simple coin toss:
A: Heads you lose £100
B: Tails you win £150
At first glance, many people agree to take the bet. Though after a few seconds thought, most people then decline (Kahneman 2011).
This essay explores the idea of loss aversion, motivation and the alignment of interests.
By paying a person a fixed sum of cash, but holding onto that cash until a future vesting date, is it possible to effectively motivate employees to behave more like creditors?
In the normal course of events, creditors are more likely to take decisions and actions that preserve the value of their claims. So the idea of creating a fixed sum, payable on a fixed date in the future, subject to a number of specific contingencies, may have the effect of motivating individuals take decisions as if they are creditors, or partners in the firm.
A fixed cash sum is tangible and meaningful to an employee.
The concept of deferred cash compensation raises several issues, but principally, can it appeal to a person’s self-interest via an instinct to avert the loss of a near certainty?
Consider too, on a group level, it is unlikely that members of a team would allow an individual to act in a manner that puts their collective future cash payments at risk. The implication for first-line risk management is significant.
In the event of an incident of misconduct for instance, the social cost of covering it up increases substantially. A direct and tangible consequence, for individual managers and their immediate team, has always been a strong motivator of behaviour.
This paper argues that a compensation scheme that appeals to three very distinct traits of bank culture: individualism (self-interest), internal competition, and group identity dynamics (peer-pressure), rather than attempts to bring about culture change through external agency efforts (such as regulators, tone-from-the-top etc.), is likely to be more effective. Ultimately, a more stable financial system is the logical outcome.
But first you have to first give people something to lose.
Bank Culture: It’s All People Can Talk About These Days
Culture in financial services has become a key theme in recent years. Taxpayers and their representatives (the media and politicians) have become fairly hostile towards the sector.
Shareholders have had to pay back some of the profits made during a period of aggressive deregulation. In excess of $300bn in fines, settlements and redress since 2008 (Whooley, Invine, Agarwal, & Ouaknine 2016). .
Unsurprisingly, this has pushed conduct and culture risk management up the agenda, alongside traditional asset-quality and market risk management.
The focus on conduct and culture is no longer a trend. The media awareness, investment by regulators, and resourcing by banks in the conduct space, makes it clear culture is an established area of management. Stability in the financial sector and bank culture are now part of the same narrative.
Culture: ‘the expected attitudes and behaviours’ of this organisation.
(of this group, this school, this church, this profession….this family)
All employees that have been around long enough understand the formal and informal rules of engagement. Stated values and policies aside, everyone know how things get done, how decisions are made, who wields the power and how that status is affirmed.
This applies to all cultures – one’s personal culture; and the culture of the institutions and groups we choose to belong to.
It is the subtle elements of culture that really matter to the social scientist.
How much time is spent on preparing internal management information such as PowerPoint? How sensitive are people to ‘optics’ rather than candid disclosure? How internally competitive is the organisation? Is the firm closed, hostile to new people, ideas or outside agency?
These issues matter because they are the real indicators of how open an organisation is to real cultural change, if it is indeed even possible.
Changing existing organisational habits is extremely difficult. If the impetus for change is statutorily mandated by an external agency such as a regulator, then the system tends to resist change even more strongly.
External demands for in-group individuals to become more accountable will never be as effective as in-group peer pressure. In other words, increase the social cost of non-compliance within the expected attitudes and behaviours of a group for really effective culture change. This is evident in social attitudes to smoking, seat-belts, and work ethic expectations from one organisation to another.
The Aim of Regulation
Robust regulation essentially seeks to enhance:
How are decisions made.
How quality information flows through the system.
How misconduct is punished and good conduct rewarded.
In other words:
Raise Risk Awareness when decisions are made
Enable Pre-emptive Action.
In describing the bank risk paradigm, the basic principles are accepted as:
To make profit, risks need to be taken.
Those that manage that risk most effectively, make the most profit (ROE).
Banks with the highest, long-term ROE are the banks that are able to operate as close to the optimal risk frontier as possible. Too little risk results in a transfer of wealth from shareholders to creditors. Too much, and entity value rapidly diminishes.
From a regulatory perspective, the ideal bank culture:
Internalizes the costs and benefits of risk-taking and conduct across all stakeholders, especially by senior decision makers.
Levels the asymmetric distribution of risk, reward and information between employees, executives, shareholders, creditors, regulators and the taxpaying public.
Fosters real first-line, rather than second, third, or external risk and compliance management.
While several approaches to creating an optimal risk culture have been proposed, efforts to date have largely focused on the application of external pressure – the regulator or the board. The board being far removed from the daily experience of the rank-and-file, is more of an abstract concept which limits the impact of ‘tone-from-top’. Sociology tells us that influence in a person’s environment is strongly linked to proximity.
One challenge with the internal acceptance of conduct risk management across multi-divisional organisations is that explicit misconduct is usually covered by existing law anyway – fraud is a crime, market collusion is anti-competitive and wilfully misleading regulators will at the very least cost people their jobs.
If the objective is to change behaviour; change the culture so that risk is identified and managed at source, introducing more laws isn’t going to achieve this effectively.
Real Culture Risks
The major cultural risks in high-status, hierarchical authority structures like banks are GroupThink, Group Polarization and the impact of dominant personalities in a strict hierarchy.
But group pressure can be a force for both good and bad.
Most bank employees fully understand what concepts such as ‘Optics’ and ‘Career Limiting Move’ mean. Bank culture can be extremely intimidating for people who feel they need to speak up when they believe poor decisions are being made.
Richard Fuld was Chairman & CEO Lehman Brothers from 1994 until 2008 and created what amounted to little more than a cult of personality which earned him the nickname ‘Gorilla’, ‘Worst American CEO of All Time’ and a place on Time Magazine’s ’25 People to Blame for the Financial Crisis’ (Wikipedia 2017)
Culture has little to do with Perspex Values Statements in lobby, mission statements and how many charity events are sponsored. Perhaps a stronger message about a bank’s culture is an unequivocal signal that the costs of excessive risk taking and subsequent instability to the financial system will be shared by those that have a role in creating it.
One way to do this may be to recreate a compensation structure that mirrors the Partnership Structure of investment banks of old.
Deferred Cash Compensation may do this.
More specifically, by providing guaranteed, future cash compensation, contingent on firms remaining adequately capitalised; and employees acting in everyone’s best interests - it may result in a culture in which consequence for poor risk management and misconduct is perceived as real for each individual.
Given the importance of banks to an economy, the risks they take is a matter of public interest. In this sense, banks are semi-public utilities.
The idea of ‘too big to fail’ nationalises the consequences of poor decisions and misconduct, while privatising the benefits of short-term performance.
This it’s a free option to risk takers and decision makers.
In a ‘normal’ economic environment, shareholders and creditors accept the consequences of their decisions. Their investments carry the risk of lower dividends, debt restructuring or full-blown liquidation / default if things go wrong. Capital is allocated according to supply and demand, with the risk of investment factored into the price.
Once capital is provided to a company, the CEO’s mandate is to manage it as efficiently as possible. The financial well-being of an organisation is the primary responsibility of the executive layer of management.
The challenge comes in times of crisis. At precisely the point at which additional external shareholder and creditor funding becomes difficult to raise at a reasonable cost.
In extreme cases, even large banks have no recourse to the capital markets (case in point, Lehman Brothers and Bear Sterns). In addition, the web of interconnectedness in modern banking further exacerbates the situation.
Post-2008 saw the concept of contingent capital becoming more prominent.
The idea of a contingent capital buffer is not new. The simplest form being a cut in dividends in times of financial stress. Think of it as a reinvestment of cash contingent on prevailing circumstances.
Microsoft funded their spectacular business growth in part by paying the first dividend on its ordinary stock only in 2003. In 2004, they paid a huge cash stockpile back to investors in the form of a special dividend. Management basically said, “Here we have too much cash, take it back, perhaps you can find a better return. Sitting on too much cash is an inefficient use of capital”.
In the debt markets, creditors also generally accept a managed default to achieve a similar outcome, and often a company will negotiate a reorganisation (or Chapter 11 filing) in an attempt to preserve the value of creditor claims as far as possible. Most stakeholders would agree a going-concern is a preferable outcome.
A Deferred Cash Compensation Scheme (‘DCCS’) has the potential to create a similar interest from the employees of the firm. Shareholders and creditors accept much of the risks of financial performance, and when they signal they are willing to provide a contingent buffer for use in times of crisis, the long overall stability of the firm is enhanced.
Key Features of a Deferred Cash Compensation Scheme
Each organisation will need to devise its own variation on the DCCS theme, however some of the basic tenets include:
Under a DCCS, a portion of an employee’s variable cash compensation (“bonus”) is held in escrow and vests at a predetermined dates in the future.
For example 40% of a person’s bonus is paid immediately, 20% after Year 1, 20% after Year 2 and the final 20% after Year 3.
This would have to be an after-tax amount (or the employee would face PV cashflow implications).
The full bonus amount is expensed in the Income Statement in the year it is awarded, and in no way is contingent on an employee’s continued employment with the firm in the normal course of business.
This is a crucial element of using a DCCS to motivate behavioural change. As soon as a DCCS is used to retain employees, the potential leverage to induce behavioural change is lost.
All DCCS funds held in escrow belong to respective employees, however these funds act as a contingent capital buffer should the bank need to recapitalise in the event of a banking crisis.
This excludes recapitalisation in the normal course of events such as funding growth or due to poor operational management (as is often the case with legacy costs, IT investments or operational inefficiencies such as high Cost-to-Income ratio situations).
In addition, if an employee or their business unit is found guilty of misconduct that harms the bank; any fines, settlements or redress is first paid out of those respective employee’s deferred cash compensation escrow account.
A quick hypothetical calculation shows that after 4 years under normal circumstances an employee receives the sum of:
40% of their current cash bonus;
20% of (T – 1) Year’s bonus;
20% of (T – 2) Year’s bonus;
20% of (T – 3) Year’s bonus.
This equates to roughly an equivalent amount as current cash bonus compensation structure (of 100%), but with future vesting cash compensation (of 20% for each of the previous 3 years) at risk. The key words being “at risk” – it is this risk of loss, this contingency that induces the desired change in behaviour as individuals act to preserve the value of their claims.
During strong periods, when bonuses are relatively larger, typically when banks historically start taking even larger risks, a well-managed DCCS may encourage greater risk awareness and conservatism. Something management theorists argue is exactly when it is needed in today’s boom-and-bust global economy.
A DCCS is not a staff retention scheme. Regardless of an employee’s continued employment, all compensation is contractually due to them in the ordinary course of business.
The only scenarios in which DCCS vesting rights become contingent are in the event of subsequent discovery of:
As the first round of a recapitalisation of the bank to meet depleted regulatory capital requirements in a time of crisis.
An employee in a DCCS is effectively a creditor of the bank, a holder of a de facto convertible security contingent on their conduct during the time of their employ and any subsequent discovery of misconduct during the vesting period afterwards.
If the objective of a DCCS is to induce cultural change and keep employees fully engaged – then it must not become a proxy Restraint of Trade mechanism.
It should not hinder labour market flexibility in anyway. This is important for a number of reasons explained below.
One example is that in many instances, risk managers only discover something is wrong when employees leave the firm. Restraint of trade agreements encourage people to remain in place.
Equally, their specific vesting terms must remain unaffected by employment status – in other words, if they leave the bank, or are made redundant, the terms, conditions and future payment dates do not change at all.
Any DCCS escrow account balances are already expensed, they are past compensation and must not form part of any redundancy calculation by the employer. Any employer that does this will only create resistance to a DCCS, and will likely be contravening Labour Law.
How a DCCS Might Change a Bank’s Culture:
The Partnership Model
The potential influence a DCCS may have on bank culture is:
Encourage a longer-term perspective in the workplace.
Achieve real time internal risk monitoring – at source rather than by 2nd & 3rd lines.
Align interests of shareholders, employees, creditors and the public (through their representative the regulator).
Mehran & Tracy (2016) suggest that under the old Partnership Model, the principle of joint-and-several liability induced a greater appreciation of the consequences of decisions and actions.
They further propose that a Deferred Cash Compensation Scheme, in which vesting of future cash payments is contingent on maintaining adequate regulatory capital levels, simulates a Partnership commitment to a degree.
Under a Partnership arrangement, all partners were on the hook. In good times and bad.
Obviously, modern corporate governance has moved on, and today’s banks cannot be run as partnerships. But an argument can be made that a modern bank in which a class of professional managers essentially take large risks with public money, with no personal downside, is inherently unstable.
The privatisation of profits and nationalisation of large losses is a free option. Some argue it is the price of a social arrangement that ordinarily greases the wheels of the economy; banks are crucial to society and society must do what they can to keep them going. Sure, but these semi-public utilities are entrusted to managers with fiduciary obligation. Fiduciary only really means something when those with the obligation stand to lose too. A recent trend in investment management has been to deferred cash bonuses by requiring fund managers to invest in the funds they manage alongside their clients.
Any person that believes banks are not semi-public institutions, and therefore not subject to greater public scrutiny will struggle to square the concept of ‘lender-of-last-resort’ which unpins the public’s trust in the entire system.
If one considers that in recent years a number of banks have paid out bonus pools that are multiples the amounts paid in dividends to shareholders. Then it is a valid to argue the distribution of risk and reward has changed asymmetrically.
It is obvious that a transfer of value from shareholders to salaried employees has taken place.
Shareholders in such cases are getting lower risk-adjusted returns on their investment than they were a decade ago – especially shareholders in commercial banks. And not just because of external, environmental factors but because of a shifts in profit allocation.
Good Culture in More Detail
Banks have a very specific cultural features.
These stem from an overhang of the investment bank / commercial bank mega-mergers following deregulation of Glass-Steagall, and the fact that, unlike manufacturing, it is often difficult for bankers to truly measure their individual contribution to revenue (they don’t make things and pricing their services is more arbitrary).
Coupled with this has been the wholesale acceptance of Western business school management theory – the concept of the leader as the ‘individual hero’.
Bankers are described as: highly individualistic; overly self-interested in behaviour; with a tendency to form strong in-group attachment to groups that reinforce this self-concept.
One interesting social aspect of the Libor scandal was the extent that those involved more strongly identified with others doing the same, rather than with the banks they actually working for.
This is what reduces the efforts by external agents (regulators) to increase accountability. And why bankers tend to view any effort at change with hostility – be it compliance, audit or the FCA.
Unfortunately most behavioural efforts in changing culture in financial services tend to focus on how individuals make choices. Maybe getting bankers to act in their own interest – either by rewarding positive outcomes or giving them something to lose – regulation may achieve much more.
No person will assume more accountability for the actions of others. It doesn’t fit the self-interest paradigm. Unless, they have a personal incentive to do so.
By forcing managers to sign up to programmes such as the FCA’s Senior Managers & Certification Regime without specifically compensating them for doing so, is far more likely to induce avoidance behaviours such as covering up and denial of knowledge.
In the absence of a social cost of covering up (call it peer pressure), then little is likely to change. Remember most misconduct is covered by existing law anyway, and yet here we are.
It is possible to make an argument that the SM&CR programme makes the system more unstable than it was before. It is politically expedient to ‘make bankers more accountable’; however if your true objective is to lower systemic risk in the sector through improved information flow and disclosure, then we need to be honest about how people behave as individuals and as part of a group.
Individualism as a Basis for Risk Management
In a world of bail outs, it is in a banker’s best interest to take as much risk as the system allows.
If we want to change this, then give bank decision makers something to lose.
A significant amount of cash payable on a set date in the future, provides a direct, tangible interest in the well-being and internal risk monitoring of the firm.
Behavioural Economics 101: People prefer to avoid losses more than we seek gains.
Under a DCCS, today’s cash bonus is deferred, and future vesting payment of that cash is contingent on management taking decisions that ensure adequate capitalisation in a time of crisis (so good long-term decisions) and the prevention of poor conduct (both personally and by those in your team).
The core behavioural transmission mechanism is appealing to each employee’s self-interest.
Against this, consider how deferred cash compensation may:
Deferred cash is a fixed-claim payable under normal circumstances – in other words, the employee is effectively a creditor. Any debt-holder is naturally concerned with the long-term impact of decisions management takes, which in turn will impact the bank’s credit and investment rating.
Managers are more likely to enact policy that reduces risk rather than increase it:
Greater diversification, less leverage, improved cost-management etc.
Successful DCCS management will require the optimal balance of conservatism with the necessary risk needed to provide a market related rate of return.
This approach differs from existing conduct risk efforts which seek to motivate employees to increase the value of the firm, while serving the broader public interest. It places self-preservation at the centre of the decision process.
The reduction in the free-rider effect inherent in deferred equity schemes further motivates on the individual level. Cash compensation is direct and specific, unlike shares that vest in future. Under a deferred cash scheme, each employee understands the benefit to the system (and themselves) of improved internal monitoring of potentially excessive risk-taking and misconduct.
Improve Internal Risk Monitoring
DCCS has the potential to significantly enhance existing internal risk monitoring and regulatory compliance.
Once individuals have something definite to lose if they fail to act on information, they are far more likely to escalate their concerns.
This obviously has important risk management implications.
Under a deferred equity scheme, employee action is subject to a greater number of contingencies. The vesting period, underlying funding mechanism, or the simple fact that equity returns are a product of sentiment, corporate action by management or the actions of others (such as takeover bids and law suits).
Fixed cash payments are far less uncertain.
As part of the social context in which they work, employees are more likely raise issues as they arise. This is exactly the type of conduct risk management regulators seek to embed. Self-correcting and self-monitoring.
Social immediacy of group dynamics is a powerful catalyst for individual behaviour. When employees are made aware of potential problems, the social cost to covering up information increases in a real and immediate way.
The people that stand to lose are the people you sit next to every day.
Bank employees may be able to omit their knowledge of a potential risk in a monthly report to a regulator, but are far less likely to do so in a team environment with people they spend their time with.
This should lead to an environment in which early detection is more likely because the longer the delay, the greater the destruction in value and the higher the social and financial implications.
The obvious commercial benefit of enhancing real-time first-line risk management via a DCCS structure is a lower cost of regulatory enforcement.
A strong case can be made considering that in 2015 JPMorgan reportedly spent over $9bn and employed 43,000 in Risk & Control.
Align Interests and Give Investors & Regulators Confidence
The alignment of stakeholder interests under a DCCS operates via the existence of a financial buffer, funded by employee’s deferred cash bonuses.
In times of crisis, should a drop in minimum capital levels fall below minimum regulatory requirements (through losses & write-offs), raising capital is likely to be difficult and expensive.
If employees stand ready to provide this contingent capital, investing alongside external shareholders (as partners would under a Partnership Model), this sends a strong symbolic message to the market.
The concept of contingent capital: an exchange of one claim for another by stockholders or employees when the firm is in poor financial condition.
A stock dividend, instead of a cash dividend, or giving stock options as a substitute for wages is another example of contingent capital that have been used in times of crisis.
Simply, the firm utilises the cash resources under a DCCS to supplement unexpected capital and liquidity shortfalls in times of severe stress.
This effectively replicates the risk profile of the partnership model.
Evidence suggests that firms with a higher share of deferred pay as a % of total compensation have lower default risk and subsequently trade at lower credit spreads. This has a direct impact on potential margins (Acharya, Mehran, & Sundaram, 2016).
This amount can and should be substantial, especially as it builds up over time. When times are good, the allocation to the DCCS escrow accounts is expected to be high. During leaner times, the existence of a potential capital buffer will provide a measure of comfort for employees and potential funders.
Conduct Risk – Fines, Settlements and Redress
Banks have paid in excess of $300bn in conduct-related fines, settlements and redress since 2008 (Whooley et al. 2016) This places conduct risk firmly on the agenda along with traditional asset-quality and market risk management.
One proposed use for funds in a DCCS escrow account is utilising them to cover the cost of misconduct by individuals and teams.
The potential loss of a fixed, future reward, will at the very least, motivate employee’s to consider the implications of their decisions on customer outcomes and firm reputation.
Currently, fines for conduct-related issues are paid for by firm’s equity holders. This paper argues this should be shared.
Few managers carry personal responsibility for poor decisions and misconduct; beyond possibly losing their jobs. Public outrage has resulted in senior executive contracts containing malus and clawback provisions, but a DCCS provides a similar consequence throughout the organisation.
The Challenges of Implementing a DCCS
With change, resistance is usually the first part of implementation.
Regulators often underestimate how entrenched self-interest is in bank culture. Any attempt to introduce a DCCS must be made on the basis of evidence and as much as engagement is possible.
Selling the Idea to Employees
Apart from the obvious desire many may have to receiving part of their compensation sooner rather than later, there are obvious tax and legal implications in introducing a deferred cash compensation scheme.
On the assumption, that change in bank culture is a necessity – as regulators, the media and politicians demand – then this must happen in a manner in which people remain motivated.
Homeostasis tends to be strong and little changes in the absence of a reason to.
Compensation is pretty big motivation to change. Remember we aren’t discussing the amount we pay bankers, only how we pay them in order to induce an ‘improved’ societal outcome.
Mehran, Morrison and Shapiro (2012) document a trend in bank executive total compensation (salary, bonus, and stock options) for the universe of banks in S&P’s ExecuComp service.
Grants of stock options increased between 1992 to 2001, a trend that reversed between 2001 and 2007. In contrast, average bonuses increased in real terms between 1992 and 2007. Cash – in the form of fixed- and variable- components has increased on a relative basis.
The way authority in organisations is structured is completely different from 50 years ago. The evolution from the owner-manager barons of the early 21-st Century, to the emergence of the professional-manager class, has correlated with the growth in employee bonus-pool pay-outs that often exceed multiples of the dividends paid to shareholders. This illustrates a major shift in structure and power.
The hyper-focused ‘war for talent’ in the today’s ‘Gig Economy’ is likely to further strengthen this trend.
Simply put, managers receiving a greater percentage of the rewards. Whether this is good or bad for society is a more philosophical discussion beyond the scope of this essay, but what is interesting is that while the share of reward has increased, the distribution of risk has not.
Shareholders, creditors and taxpayers still bear the ultimate cost of poor management or misconduct. Surely it can’t be too much to suggest if shareholders receive no dividends in a time of crisis, management could be expected to contribute?
Another way to look at this issue is to consider a DCCS as a de facto Performance Bond. The employee is effectively posting a financial obligation to ensure future performance to acceptable standards. If performance meets the required standard, the bond is repaid; otherwise part or all is forfeited.
A DCCS under this scenario, acts like any malus provision would – especially in cases of misconduct.
DCCS: More Carrot, Less Stick
A DCCS is not designed to be punitive. Under normal situations, there is no reason that employees are not paid in full.
A DCCS may promote longer employment terms, enabling improved talent retention and internal succession planning. However, and this is crucial, it is not contingent on continued employment. It is NOT an employment retention scheme.
DCCS is analogous to an option premium
In a time of crisis, employees may need to forgo their deferred cash but increase the likelihood that their firm will continue to operate. Thus employees may avert redundancy, reputation risk and protect future earnings capacity.
Deferred cash in this sense preserves the option to remain with their employer. It can also be viewed as a type of insurance premium that is rebated should their employer do well over the vesting period. In fact, evidence suggests that deferral of cash compensation increases the likelihood a stable outcome.
Market Examples and Supporting Evidence
According to 2015 public accounts, Barclays deferred £661m (out of total remuneration costs of £8,3bn; a bonus pool of £1,67bn; and off a Tier-1 Capital Base of £52bn). This subject to contingent risk and conduct adjustments, by way of malus, the broad terms of which include:
Amounts can be reduced to nil
Contingent upon but not limited to:
Deliberately misleading Barclays, the market, and presumably regulators.
Causing harm to Barclays’ reputation through misconduct, incompetence or negligence.
A material restatement of financial statements or the Group or business unit suffering a material downturn in financial performance (assumed during the vesting period).
Material failure & significant deterioration of the financial health of the Group.
Regulation & Culture
The impact of the Gramm-Leach-Bliley Act of 1999 on modern bank culture is was significant.
The Act repealed the Glass-Steagall Act of 1933, removing barriers in the market between commercial banks, investment banks, securities companies and insurance businesses6. Effectively commercial banks were now free to acquire investment banks, brokerages and insurance companies. The operative word being ‘acquire’ as this had specific implications for the culture of the acquiring commercial banks.
A number of commentators, including Nobel-prize winning economist Joseph Stiglitz (2009) and Washington Post economics commentator David Leonardt (2008), assert the subsequent deregulation contributed to a sharp increase in the systemic risk of the financial system – the rise of the so-called ‘too big to fail’ phenomenon and consequent 2007/8 financial crisis.
Mehran & Tracy (2016) interestingly suggest that this deregulation resulted in a ‘culture transfer’ from investment- to commercial banks. Prior to acquisition, the risk and compensation practices of investment banks were distinct from the acquiring commercial banks, but over time these aggressive reward structures influenced the entire entity disproportionately.
The creation of entities that are ‘too big to fail’ implies as a last resort management can expect a bail out.
In a model in which risk takers are not required to provide additional equity capital in the time of a crisis, what incentive exists to induce improved risk awareness in decision making?
Inside Debt is Correlated with Lower Credit Spreads.
Debt-like compensation reduces incentives for excessive risk-taking, free-riding and hiding information (Sundaram & Yermack, 2007)
Classical economics is premised on the assumption that people will act rationally. Behavioural economics tells us that people will avert a loss given a choice.
Since creditors can be expected to act in a manner that preserves the value of their claims, research clearly illustrates that large ‘inside debt’ positions (deferred cash & equity, carried interest, DB pensions etc.) reduces the expected probability of a firm defaulting on its external debt (Sundaram & Yermack, 2007)
This implies inside debtors tend to manage firms more conservatively.
It may seem obvious that those with the most to lose would probably be a little more cautious. Exactly. This isn’t a case of Theory-Induced Blindness.
A further study by Wei & Yermack (2011) highlights data that suggests firms managed by CEOs with larger pensions and deferred pay as a proportion of their total compensation exhibited lower credit spreads.
Malmendier & Tate (2008) assert that overconfident, optimistic and celebrity-lauded CEOs tend to subsequently under-perform expectations. These CEOs tend to be brought in from outside and don’t have the large inside debt positions that internal appointees have.
Considering that executive claims rank lower than that of creditors’, it makes sense that insiders may have greater incentive to act in a manner that preserves the value of their personal claims. An outcome any regulator would obviously be keen to see.
A higher ratio of inside debt (pension and deferred cash) to equity-based compensation, is correlated with lower credit spreads. (This could be a business life-cycle effect – a business in the growth phase is more likely to have less cash resources and attract talent based on the promise of growth compared to a more established one; along with a higher risk of default).
The Challenge: Industry-wide Implementation
The biggest challenge is systemic. One bank operating a DCCS will not significantly reduce overall risk in the sector.
The interconnectedness of global banking also means contagion impacts well-run, well-capitalised banks. This means industry wide adoption is needed. And would have to be driven by regulators.
This is likely to be viewed with hostility by the sector initially, especially in the US.
Losing talent is major concern of large banks, and losing talent because of the introduction of DCCS further highlights the risk for first-mover adopters of wide-scale DCCS plans.
Promoting deferred cash compensation as a risk management tool, will require a great deal of supporting evidence on whether it actually leads to the desired behavioural and cultural outcomes. Another challenge is the lack of research and the fact that compensation data is generally confidential and only available for senior executives.
Other Costs and Potential Benefits
A transfer of wealth from shareholders to creditors in the event of an overly conservative management approach is undesirable.
Banking is the trading of risk after all.
Gains in equity are linked to organisational achievement and market sentiment rather than individual performance. DCCS payments are largely contingent on individuals taking responsibility to behave in a manner that preserves their future payments.
The cost of excessive risk taking has an impact on a broader set of employees, especially those in the immediate ambit of those taking the risks and in those responsible to monitoring and reporting the risk.
First-line, internal monitoring among risk takers is likely to be more sophisticated than second- or third-line defence, and certainly more than outside parties.
This will reduce the cost of enforcement to the firm – further any increase in disclosure of excessive risk taking will increase the cost of covering up for those that are meant to take action. Under a deferred equity compensation scheme the costs of covering up seemingly smaller issues is ‘lost’ in the wide distribution of overall organisational performance; something at odds with an improved risk culture.
In fact, a number of strong supporters of deferred cash compensation, such as shareholder activists, even go as far as to suggest that when the dividend yield drops below a specific hurdle rate, bank employees should also see their future vesting balances reduced commensurately.
Another potential benefit of a DCCS is the impact such a programme will have on the reception of the bank by the wider investment analyst and shareholder activist community. Transparent disclosure of the scheme (without delving into specific individual compensation arrangements) would go some way at creating goodwill with investors. This may be difficult to quantify apart from an analysis of credit spreads, but may enhance bank share prices (goodwill) or supress them (if market believes they induce too much conservatism).
The impact on regulators though is likely to be positive.
Promotion of Labour Market Inefficiency
Another potential harmful impact of a DCCS is the interruption of free movement in labour. However this only serves to further highlight a key principle: That a Deferred Cash Compensation Scheme must not be contingent on whether a person continues to work for the firm or not.
Total compensation is expensed in the year it is incurred, and deferred cash compensation effectively sits in escrow at a market-related rate of return. The only time a current or past employee’s deferred cash compensation value will decrease will be upon a pre-agreed trigger event such as the bank raising capital during a time of crisis. Or in the vent that misconduct comes to light prior to vesting.
Deferred cash compensation schemes must not be used as individual employee retention schemes. Doing so dilutes the effective risk control element central to such plans. If an employee does leave, but knows their cash compensation will remain in escrow and will be paid to them at a date in the future, they are more likely to be even more vocal about any concerns they may have had when the leave as they seek to preserve the value of their claim.
Once the social pressure and immediate politics that may restrict speaking up is removed, any potential problems are more likely to surface during the exit interview process.
The goal of public policy should be to enhance the stability of the system. This paper sets out to explore whether a DCCS is able to achieve this by appealing to decision makers at a distinctly personal level.
By warning banks to comply and compelling them to expense a great deal on compliance and conduct resources, banks are far more likely to resist genuine regulatory efforts. Increasing the cost of doing business is only likely to harden the attitudes of those that bear the cost. In all likelihood the expected outcome is increased political lobbying to reduce regulatory ‘interference’ regardless of how noble the intent. In short, regulation can’t force people to be more accountable, despite what regulators may believe.
In fact, it can make a system more unstable if it encourages 'plausible deniability'; information ‘sugar-coating’ and cover-ups.
The goal of the bank should be to position its business on the frontier of the risk / reward curve. Optimal risk, at the lowest cost. First-line risk management is far more effective in achieving this than second-, third- and regulatory level oversight.
Deferred Cash Compensation internalizes the costs and benefits of risk taking for each individual; decreases the dependency on outside parties for capital in times of crisis; and is positively correlated to lower credit spreads.
Conservative managers may seek to build up capital beyond regulatory minimums in order to protect their vesting rights, which will no doubt increase the overall stability of the system. This may come at a cost to shareholders (of a lower ROE) if not accompanied by lower enforcement and compliance costs.
It is worth consideration.
References & Further Recommended Reading
Mehran, H. & Tracy, J. (2016). Deferred Cash Compensation: Enhancing Stability in the Financial Services Industry. Federal Reserve Bank of New York Economic Policy Review, August 2016.
Kahneman, D. (2011). Thinking, fast and slow. New York: Farrar, Straus and Giroux.
Whooley, N., Invine, J., Agarwal, N. & Ouaknine, Y. (2016). ESG Report: Culture Change in Banking. Societe Generale.
Wikipedia. (2017). Richard S. Fuld Jr. Retrieved from en.wikipedia.org/wiki/Richard_S._Fuld_Jr.
Acharya, V., Mehran, H. & Sundaram, R. K. (2016). Cash Holdings and Bank Compensation. Federal Reserve Bank of New York Economic Policy Review, August 2016.
Gramm-Leach-Bliley Act of 1999. Wikipedia. Retrieved 10 January 2017.
Stiglitz, J. (2009). “Who’s Whining Now? Gramm Slammed By Economists”. ABC News.
Leonardt, D. (2008). Washington’s Invisible Hand. New York Times
Sundaram, R. K. & Yermack, D. L. (2007). Pay Me Later: Inside Debt and its Role in Manegrial Compensation. Journal of Finance 62
Bebchuk, L. A. & Spamann, H. (2010). Regulating Bankers’ Pay. Georgetown Law Journal, 98