FINANCIAL SERVICES
Hermes calls on banks to end annual bonuses
Hermes Equity Ownership Services has called on banks to end annual bonuses and significantly reduce basic pay.
Hermes urges banks to “reform their remuneration practices further to lengthen performance periods, not just deferral”. Instead of the annual period commonly used for bonuses it wants to see bonuses based on three-to-five year performance:
Bonus deferral, malus structures and clawing back of bonuses move towards a more effective two-way response to risk so that individuals face the downside of risk as well as benefiting from the upside. However, these need to be accompanied with longer performance periods; at present the risk is that with annual performance still driving the bulk of incentive pay, it is still the annual horizon on which the individual focuses rather than the period over which many risks may be seen to have an impact. Deferred portions of bonuses under such a structure tend to be given less weight as they are less certain than the cash in hand - the result being, potentially, a still greater focus on what can be earned in the short term. Longer performance periods would enforce a longer time horizon and bring a greater consciousness of the possibility of risks coming to pass within the horizon of payouts. Such longer time horizons may also align banker interests more fully with those of their clients; deferral and claw back would still be required but at least a longer-term vision would be built into the very structure of the incentive.
In addition, banks need to apply an appropriate - that is, normalised - cost of capital when assessing the performance of their staff. This is the only way in which the state and central bank subsidy that all banks are enjoying in these extreme times will end up where it is intended - rebuilding capital and available to fund the real economy - rather than around half of it ending up in banker pay. It is simply not acceptable for the extraordinary government and central bank measures to stabilise economies end up in large part giving stable incomes to individuals, But these steps are not enough. Quantum also needs to be addressed.
Hermes calls for lower overall pay levels so that the staff remuneration accounts for no more than 25% of revenue, rather than the 50% figure that banks typically spend:
The simple fact is that compensation ratios are simply unacceptably high. The returns left for investors remain too low in part because returns to staff remain too high. Compensation ratios - the portion of overall revenues which is swallowed up in staff pay - are often around 50%. This may have been appropriate when banks were partnerships and the staff pay in part reflected a return on the capital invested by the partners; it is hard to see how it is appropriate in publicly owned banks where the shareholder bears the ultimate risk. It is totally unsustainable in a world where bank returns are being squeezed to the extent that is currently happening.
Paying out half and more of all revenues simply does not leave enough left over to recompense the shareholders for their investment. It is a significant driver of bank returns being in many cases significantly below the cost of capital, and so it is a significant driver of the buyers’ strike on bank capital. We suggest that 25% might be a more appropriate ceiling for compensation ratios, though the most efficient banks will achieve far less, and the appropriate level will depend in significant part on the bank’s business model. What is clear is that this number must be reduced rapidly from current levels. This seems to us the only way in which there will be sufficient money left over to compensate investors for their investments and it seems therefore the only way that the buyers’ strike will fully be ended.
A final word from Hermes:
Regulators have chased banks into making significant reforms to pay structures. However, from an investor’s perspective, it is not at all clear that the changes that have been made have been helpful. The visceral opposition to bonuses, driven by the perception that these incentivise risk-taking, and the rapid time-scales for delivery, simply led to a ratcheting of basic pay so that bonuses are a smaller percentage of overall reward. Quantum of pay did not decrease but the flexibility of bank cost structures deteriorated dramatically, and in the current context of required restructuring this means that the cost of cutting headcounts has gone up very dramatically. Performance measurement has become wiser but it has not yet fully incorporated an accurate assessment of the cost of capital attached to each line of business and usually does not wholly reflect necessary risk adjustments to the calculated returns. The leverage in banker pay has decreased but given that the rewards remain just as significant and while performance is not measured as appropriately as it might be, it is not at all clear that the shift of money from bonuses to fixed pay will have had any impact on the risk-taking appetite of individuals.
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Tom Gosling, head of PwC’s reward practice, said: "The Hermes announcement demonstrates the vigour with which shareholder bodies are engaging with banks on both the level and structure of pay. This emphasises how important it is for firms to have a clear articulation of why they pay what they do, and how this is consistent with acceptable returns to shareholders.”
He added: "Bank pay can only be cut so far by reducing bonus pools. Almost every major bank would have had a pay ratio above 25% of revenues last year even if they'd paid no bonus at all. In the absence of economic recovery, getting pay ratios down to the levels suggested would require further job cuts, many of which would fall on low earning staff.
Commenting on the proposal to get rid of annual bonuses, Gosling said: "We are likely to see some radical reform of executive pay in banks, particularly in Europe where significant regulation to limit incentives is likely. Abandoning bonuses will be right for some, but not all.”
He added: “Our research shows that the problem with moving to longer performance periods on incentives is that they get ever more heavily discounted in executives' minds, to the point at which it's questionable whether they have much impact on behaviour. In many cases having shorter performance periods but with extended shareholding requirements can be a better way to achieve alignment with shareholders. In all of this we need to remember that focussing on what people are getting paid for, and how much, is more important in influencing behaviour and culture than continued changes to the structure of pay.”
Want to know more?
Title: Epidemiology – next steps for banking regulation, Hermes Equity Ownership Services, November 2012.
Availability: The eight-page report is available to download in PDF format at: www.hermes.co.uk/eos/Literature/PolicyDocuments/tabid/240/language/en-GB/Default.aspx.
Hermes Equity Ownership Services (HEOS) enables “institutional shareholders around the world to meet their fiduciary responsibilities and become active owners of public companies”. HEOS is based on the premise that “companies with informed and involved shareholders are more likely to achieve superior long-term performance than those without. For more details visit www.hermes.co.uk/eos.