Most big banks not even paying lip service to risk-based pay

bank_pay.gi.top.jpg By Eleanor Bloxham, contributor


FORTUNE -- Last October the Federal Reserve issued proposed guidance to banks on the structure of bank pay. The reason for the guidance was the need for banks to change pay so it would no longer encourage the excessive risk taking that led to the financial crisis.

In proposing the guidance, the Fed asked banks to immediately address the issues in current bank pay: "The Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements and related risk management, control, and corporate governance processes and immediately address deficiencies in these arrangements or processes that are inconsistent with safety and soundness," the guidance read.

Now the question is being raised: what part of "immediately" do the bankers not understand?

A New York Times article on the initial findings of a Federal Reserve review of bank pay practices explains that "many of the bonus and incentive programs that economists say contributed to the worst financial crisis since the Great Depression remain in place." Further, "bank executives and directors ... are often in the dark on the pay arrangements of employees whose bets could have a potentially devastating impact on the company."

Major messages of the guidance issued in October were that performance metrics are important to the incentive structure and that both risks and returns should be considered in doling out pay:

"The performance measures used in an incentive compensation arrangement have an important effect on the incentives provided employees... An incentive compensation arrangement is balanced when the amounts paid to an employee appropriately take into account the risks, as well as the financial benefits, from the employee's activities and the impact of those activities on the organization's safety and soundness." Programs "should be implemented so that actual payments vary based on risks or risk outcomes."

Although the Federal Reserve is not expected to issue formal findings of its reviews until next year, our review of this year's proxies for some of the major banks point to issues the Federal Reserve may need to address in their report:

Bank of America (BAC, Fortune 500): While the proxy states that "financial results should be adjusted, where appropriate, to reflect risk and the effective use of capital to encourage sustainable, risk-appropriate and profitable performance over the long-term", risk adjusted financial results don't appear to be part of the actual plans for executives, as a primary feature, just yet: "The Committee places the greatest emphasis on company-wide financial performance, with a particular focus on earnings, earnings per share, total stockholder return and revenue as collectively the best indicators of our financial performance."

Citigroup (C, Fortune 500): At Citigroup, while some risk related metrics were used in determining top officer pay, they were jumbled together with other measures on the compensation scorecard. The issue with that approach is that employees can't be certain how to take action to generate the best risk adjusted returns. As they note in the proxy, "Citi has strengthened its risk management framework, but the [personnel and compensation] committee is not complacent and recognizes that Citi must constantly improve these practices".

Goldman Sachs (GS, Fortune 500): The way the C-suite is paid sets the tone at the top for how the company is run so it's critical to address their pay. Although there is recognition that "contracts or evaluations should not be based on the percentage of revenues generated by a specific individual", the metrics considered by the Compensation Committee for the top officers include revenues, expenses, earnings, earnings per share and return on equity, none of which take risk into account.

JP Morgan (JPM, Fortune 500): The JP Morgan proxy states that "Incentives are based on risk-adjusted P&L and are calibrated to the underlying risk of the business activity". That sounds right, but when listing the performance criteria for senior level employees, the financial measures cited are "operating earnings; revenue growth; expense management; return on capital; capital and liquidity management; quality of earnings". Including measures such as revenue growth and expense managements can provide mixed signals for individuals in terms of risk and return. Should we goose risky revenue growth? Or eliminate expenses that could help us reduce risk?

Morgan Stanley (MS, Fortune 500): Although a working group at Morgan Stanley reviewed "applicable performance metrics", according to their proxy, performance metrics were not listed as "among the factors considered in making [the] determination" that the compensation programs do not encourage unnecessary or excessive risk. And, in fact, "the Company's core financial metrics - return on equity and total shareholder return" are used in incentive compensation decision making, according to their proxy. Neither of those measures tie pay to the risk that is being taken on. In fact, as the crisis showed, stock prices rose in the period where risks were building but had not yet been exposed. Return on equity, as a measure, can have the opposite effect from limiting risk taking. That's because one way to increase return on equity is for the bank to hold less equity, thus increasing its leverage and potential risk. "Growth in revenues", another metric cited in the proxy, is one which clearly does not consider the risks of that business and the impact on the organization's safety and soundness.

While banks have taken some steps, they still have some distance to travel to meet the intent of using metrics which help shape appropriate motivations and behaviors and adjust bank pay based on risk. One suggestion, not provided in the guidance that might assist in executive and director motivation to consider this task more strongly? Tying a healthy portion of pay to getting this right and ensuring that all signals clearly point to effective risk management.

--Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm. To top of page