Contemporary Issues in Accounting and Finance

Bankers' remuneration is perceived amongst the core recession triggers, which lured top bankers to engage into socially wasteful investments. The aim of this report is to discuss how remuneration packages may affect bankers' behavior in the short and long term. Furthermore it will provide a critical evaluation of the main recommendations of the Walker's Review. Lastly, a comparison of the remuneration packages of directors in Barclays and RBS will deliberate whether they are justifiable with performance.

Remuneration is defined as the payment that generally comprises the base salary topped with any bonuses or other economic benefits which an employee or executive receives during employment in exchange for professional services (Investopedia, 2011). It can be divided into fixed pay (not depending on any criteria) or variable (whereby additional payments or benefits are function of performance or various contractual agreements such as sales, profits, return on assets). The above are correlated with the output of the accounting system but may also reward in line with market price of the firm's shares. Both these components may include monetary payments or benefits (such as cash, shares, options, pension contributions) or non-monetary benefits such as health insurance, discounts, fringe benefits or special allowances for car, mobile phone (CEBS, 2010).

Regulatory bodies, (i.e. G20, Committee of European Banking Supervisors), seem to concur that the inappropriate remuneration structures of some financial institutions have been a contributory factor towards the failure of individual financial institutions and systemic problems in the European Union Member States and worldwide. Remuneration policies that offered incentives and encouraged risk-taking above a certain tolerable degree at institution level undermined sound and effective risk management and exacerbated such behaviour. It was admitted that excessive remuneration in the banking industry fuelled a risk appetite disproportionate with the loss-absorption capacity of the sector (CEBS, 2010).

The remuneration of bankers situates at the very centre of moral outrage succeeding the financial crisis. While regulators are mostly concerned with the remuneration structure which incentivised undue risk-taking, society sternly blames the pay-offs to senior executives of failed banks and large bonuses which 'rewarded' bankers whose activities were entangled with the crisis triggering mechanism. The protest is greatly about the perversity of apparently mischievous prizes for blatantly imposing such costs on other stakeholders. The mainstream analysis of moral hazard (information asymmetry) assumes behaviour to be rational with respect to self-interest, in other words opportunistic in the sense that it takes advantage of chances to achieve personal benefit regardless whether that may happen at the others' expense (Dow, 2010).

Society perceives bonuses as the main drivers of "greed and irresponsibly short-sighted behavior" (pp. 1). From an economic point of view, the central critiques about bonuses are concerned with risk-taking and short-term orientation. Nonetheless, it is noteworthy that the design of the overall compensation package appears to have generated bankers' myopia rather than the bonus system per se. In fact, most banks now concur that, preceding the crisis, their systems were excessively short-sighted, and are currently striving to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods (Gehrig & Menkhoff, 2009).

Bonuses have stirred widespread aversion feelings because of their asymmetric payoff structure which invites risk-taking by bankers. As such, should the risky investment have succeeded, the manager would have been granted a hefty compensation; whereas even in the unfavourable scenario, he still satisfied with a comfortable fixed salary incurring no further repercussions. Put differently, the bonus-based compensation package failed to penalise accordingly the various outcomes of jeopardising investments and consequently encouraged them (Gehrig & Menkhoff, 2009).

The remuneration policy should be in line with the business strategy, objectives, values and long-term interests of the credit institution. Otherwise, if the variable part of the remuneration consists predominantly of remuneration instruments that are paid out immediately, without any deferral or ex post risk adjustment mechanisms, based on a formula that links variable remuneration to current year revenues rather than risk-adjusted profit, there are strong incentives for managers to shy away from conservative valuation policies, to ignore concentration risks, to rig the internal transfer pricing system in their favour and to ignore risk factors, such as liquidity risk and concentration risk, that could place the institution under stress at some point in the future (CEBS, 2010).

The Principal-Agent theory implies that executive compensation should be correlated with the total return to shareholders, commonly by granting ownership of the firm through stock or options. However, despite this framework's compelling logic, existing empirical support contradicts the effectiveness of the agency theory when applied to executive compensation (Kakabadse et al, 2004). They are also meant to serve as an effective retention tool for talent in the long term, meaning they should motivate loyalty in successful bankers. However, stock options reward success, but normally do not penalize failure (Branca and Imelmann, 2009).

Frabotta (2000a) argued that short-term strategies may in fact achieve differing outcomes to those actually sought, as they may not be congruent with the long-term profitability of an organization (Taylor and Davies, 2004, pp. 468). As such, bankers might seek to maximize short-run profits by employing creative accounting. This comprises methods such as discretionary costs management (i.e. reduction in allowance for doubtful clients with a view to increase net accounts receivable), sales and expenses adjustment, or non-operational profits e.g. asset disposals. Furthermore, medium-term behaviour might encompass income smoothing to reduce earnings volatility and ensure less variable flow of benefits for the more loss-averse directors.

According to Prasad (2008), evidence shows that executives contractually entitled to receive exhilarating pensions, tend to pursue corporate strategies which aim to reduce the overall risk of the firm. As such, these executives embark on fewer risky investment projects, reduce dividends, avoid excess debt or expand the average maturity of corporate debt. Likewise a CEO is more likely to retire voluntarily his pension has vested and is immediately payable.

Besancenot & Vranceanu (2007) based their study of compensations plans on game theory. The purpose was to analyse whether such structures incentivized managers to engage in fraudulent activities. Their model rendered that under perverse incentive plans managers eluded regulations and committed fraud.

Walker's Review

Sir David Walker's Review of corporate governance in UK banks and other financial industry entities was requested by the UK government in order to evaluate what prompted the financial crisis and how its recurrence could be prevented in the future. The final report suggests a series of reforms to improve the quality of boards, strengthen the role of shareholders, and increase transparency of pay and bonus structures. At the core of the recommendations lies the clear link which the author identifies between board behaviour deficiencies and poor business performance (Gill, 2009). The Review hints at the idea that some banking groups managed to survive the crisis and in relative terms have prospered, whereas others failed to do so and pleaded mercy from governmental bailouts. This situation indicates the gap in the quality of corporate governance between the two categories (Slaughter and May, 2009).

One of the most important and controversial themes in Walker's (2009) Review is the remuneration policy of financial institutions. The recommendations in this respect emphasize that the board level oversight of remuneration policies demands substantial enhancement, in particular where variable pay and associated disclosures are concerned. Besides, the board remuneration committees should receive extended responsibility to cover the entire entity's remuneration framework especially executives whose remunerations exceed the median level throughout the board - 'high end category'. The term depicts employees who can have a 'material influence on the direction and risk profile of the entity' (pp. 93). Through deliberate insistence on long-term focus, they should stand as a major countervailing force against any short-term pressure from shareholders or the executive.

Furthermore, with a view to better align interests, performance conditions and deferment of variable payments for executives should be materially more demanding than anterior industry norms. In other words, it is advised that at least half of expected variable remuneration should be on a long-term incentive basis, and the actual granting depending on performance conditions, to be deferred for up to five years. As to the short-term bonus, which rewards the executive for performance in the current year, the proposal is that payments under any award should be phased over a three-year period, with at most one-third in the first year.

Despite being convincing at first sight, the Report's main recommendations concerning financiers remuneration mask a more fundamental issue of principle: that the current 'bonus problem' is a creation of accounting fictions of reliance on accrual accounting recognition of profit instead of economic profit. Focusing on earned or realised profit as the basis for bonus entitlement would eliminate many of the highlighted problems. The result of such a change in perspective would be similar to the intent of the Report; however it would possess the advantage of returning the debate to a focus on principles (Paradigm Risk, 2009).

What is more, other critics such as Barker (2009) assess the recommendations regarding remuneration to be rather prescriptive or too specialised for implementation in the non-financial sector. The Walker Review does not seek to define the quantum of remuneration that should be awarded to board members or other "high-end" employees. However, it delivers several proposals which target the improvement of the remuneration structure in terms of links with risk taking and performance. An interesting proposal advocated in the Review is that the Chairman of the remuneration committee should stand for re-election if the issued report receives fewer than 75% of votes cast at the AGM. This would serve to increase the accountability of the remuneration committee vis-à-vis shareholders.

Remuneration packages and Performance

Remuneration packages of banks directors are made up of the basic salary and benefits which are topped by several cascading layers of rewards such as pension provisions and various bonuses. Barclays claimed that it had shown restraint on pay as it revealed that its chief executive, Bob Diamond, was paid a bonus of £6.5m for 2010. He also earned a £250,000 salary and was awarded a £2.25m long-term payment based on future performance. As chief executive he will be paid a £1.35m basic salary, a 20% raise compared to his predecessor (Treanor, 2011). But the debates are ongoing as Barclays plans to pay its top bankers bonuses in the form of "cocos" - contingent convertible bonds. These are meant to represent a progressive form of rewards compared to the traditional distribution of upfront cash bonuses. In Barclays' case, the recipient would not receive the amount in question if the bank's core capital ratio (10.8% most recently) fell below 7% at any time during the three years after an award. Thus, the intention is to foster an incentive for traders not to assume any risky endeavours since they must wait three years to turn their bonus into cash. However, stakeholders are irritated with the 7% coupon, or rate of interest, substantially higher than any three-year savings rate available to customers, which Barclays has attached to the cocos to alleviate the waiting period (Pratley, 2011).

The question on the adequacy of such staggering sums is to be dealt with in conjunction with the bank's performance. Last year, Barclays recorded a Group profit before tax of £6,065m, up 32% compared to 2009: £4,585m. Diamond confessed pride with such an achievement, especially with the profit growth and enhanced capital and liquidity positions. He also praised the integrated business model which seemingly provides superior benefits to customers, clients and broader stakeholders because of its diversity by business, geography and funding source (Barclays, 2011). According to the Group's Finance Director, commenting previous year's performance, the Core Tier 1 ratio increased to 10.8 %, return on equity was 7.2%, and return on risk weighted assets increased 26 basis points year on year to 1.12%. Earnings per share grew 26% to 30.4p. The total dividend for the year of 5.5 pence was more than 5 times covered (Lucas, 2011). All things considered, this accrual accounting perspective does indeed convey outstanding results for the past financial year which might arguably justify hefty rewards for the key bankers.

On the other hand, one might not allow similar indulgence to Fred Goodwin from RBS. He was granted £9m in salary, £14m bonuses, and £276,000 extras (relocation expenses, school fees) - totaling over £23m for the past 9 years of employment for the state-aided financial giant. Skeptics would catalogue these amounts as enormous rewards for failure. What is more, this former CEO gathered a sufficiently high pension pot to allow him the comfort of withdrawing £703,000 a year pension. Specialist lawyers infer that his contract was wisely and tightly drafted in his favour and very well negotiated. Moreover, the expenses incurred by the company to keep its executives pleased also included lavish benefits such as a permanent luxurious Savoy hotel suite; fleets of cars available at all times, special food, uncalled for refurbishment of floors, use of own corporate jets on regular bases (Dispatches, 2009).

However, all these come in striking contrast with the modest performance of the bank under Goodwin's steering. In 2008, RBS posted the biggest loss in corporate history and required a bail-out of £45.5bn (Andrews, 2010). Upon the freezing of the financial markets during that year, the government was forced to acquire £5bn of preference shares in RBS and another £15bn of ordinary shares provided the bank would not find willing private investors (BBC, 2008). Nonetheless, despite requiring such rescuing of last resort, Sir Goodwin escaped punishment by the Financial Services Authority. Although the investigation carried out by this entity revealed "a series of bad decisions", it concluded they were not "the result of a lack of integrity by any individual" nor were "any instances of fraud or dishonest activity" identified (Andrews, 2010, pp. 1). Even under these terms the matter of excessive and undeserved payment remains unquestioned and was even recently confirmed by the bank's Chairman, Sir Hampton who assessed that the bank was "paying a lot of people who aren't worth it" and implied regulation would be the only key to this hot issue (Rowley, 2010).

Contrary to public indignation with such policies, results of a study (Fahlenbrach and Stulz, 2011) show no evidence to prove that banks having a better alignment of the CEO's and shareholders' interests had higher stock returns during the crisis. Some findings even revealed that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity. Consequently, many other factors were at play and potentially, in certain cases, an accumulation of uncontrollable events leaned the balance against them. Although the Walker Review might be a step forward in regulating the financial industry, one should bear in mind that a narrowing down the investigation lenses on the executives remuneration might be superficial and inconclusive.

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