Extraordinary times call for extraordinary actions. Or so it seems, given the findings of a group headed by Finnish central-bank Governor Erkki Liikanen (PDF). The group was established last year by the European Commission with the aim of informing reforms to the banking sector in the wake of the financial crisis.
Most reports have focused on two main points of the group’s findings:
- Banks should be required to separate their deposit-taking banking operations from high-risk trading activities of significant size, creating distinct legal entities. Transfer of risks or funds between the deposit bank and trading entity would be on market-based terms.
- Banks should create a category of debt instrument called a “bail-in” instrument that would be offered to non-financial institutions and used in executive remuneration. In the case of failure, banks would then have the power to cancel these debt instruments or convert them into equity to allow the bank to remain solvent. The idea is that to save the bank, these instruments would fund part of a recapitalisation so that the taxpayer doesn’t foot the bill. Offering the instruments only to non-financial institutions limits the interconnectedness of the banking system, making it possible to use the bail-in instruments for recapitalisation without risking widespread collapse.
However, there have also been some interesting points raised about Board responsibilities and executive remuneration.
The group noted that banks had become more complex and opaque, making them more difficult for Boards and stakeholders to supervise “in particular when it came to understanding, monitoring and controlling the complexity and interconnectedness of banks that expanded increasingly in trading activities”.
This lack of monitoring has led to managers choosing risky strategies that achieved their personal agendas, but didn’t necessarily benefit other shareholders in the bank during the GFC. The third version of the EU’s Capital Requirements Directive sets out that incentives are not to encourage excessive risk taking. It also requires that 50% of variable remuneration be paid in shares or similar instrument, with a portion deferred. The proposed fourth version will tighten remuneration rules, adding a one to one ratio between fixed and variable remuneration and increasing the effectiveness of risk oversight by Boards and the risk management function.
The Liikanen group agreed with the need for a more risk-aware Board and a cap on how large bonuses can be in relation to fixed pay. It also suggested that banks consider setting limits on the total amount of variable income. For example, dictating that the amount paid out in bonuses cannot exceed the value of dividends paid out.
Yet it was still concerned that executives had limited liability and, therefore, limited downside risk. It suggested that bail-in instruments should be used as part of variable pay for top management to align decision-making with longer-term performance in banks — their debt could then be cancelled as part of the safety valve if the bank fails.
Egan Associates considers that providing a portion of executive remuneration in debt instruments would provide a more steady return for executives in difficult times, but would be less attractive during boom times, when such strategies could lead to problems in attracting executives.
We note that in APRA’s Prudential Practice Code for Remuneration, it states that in the event of exceptional government intervention to stabilise or rescue the firm:
- supervisors should have the ability to restructure compensation in a manner aligned with sound risk management and long-term growth; and
- compensation structures of the most highly compensated employees should be subject to independent review and approval.
This seems aligned to setting out compensation for future years rather than looking retrospectively at pay as problems arise.
The Liikanen group also recommended that “fit-and-proper tests” be used to evaluate how suitable Board and management candidates are for their role and that the Board be given enough firepower to punish executives who shirk their risk management and disclosure responsibilities. The measures the report suggested, in addition to clawback, included lifetime employment bans where management’s stewardship reflected extreme risk.
We believe that clawback is a more measured punitive action than a lifetime ban for an executive, as the latter could lead to overly cautious risk-taking behaviour that would act against shareholders’ best interests.