In this current crisis, pain is widespread and where there is pain, there is a search for villains. As a result, there is likely to be broad and deep investigation into Wall Street's compensation plans. The outcome of this work could be the most significant shift in the compensation philosophy and plans since firms went public. It is clear that regulatory bodies are taking a hard look at this topic. This attention is not entirely unjustified; there is a clear mismatch between performance and pay.
Most financial institutions are sophisticated enough to avoid direct-drive compensation plans (e.g., commissions) where current cash is paid to employees on the basis of the income they personally generate. However, bank's incentive compensation plans were originally constructed at a time when it was possible and desirable to remunerate a business for its current year production. These plans were highly correlated to what was then largely a cash business environment.
Today, great percentages of firm's origination and trading profits are from securitized and derivative businesses that have risk, inventory, contracts and revenue spanning multiple years, not annually. It is this disconnect between the actual realization of earnings and the pre-payment of compensation that has caused the greatest concern. In the end, there is no question that when a person, business unit and/or firm show greater profits (or profit contribution) there is greater pay. Being very bright and very driven, bankers and traders will follow the money. While compensation was not THE cause of the current credit crises it certainly can be viewed as a significant contributor.
So that begs the question, what should be done about it? First and foremost, action must be taken quickly to get ahead of the regulators. The first step is to fully and publicly audit incentive plans to identify and remove, to the extent possible, those features that incent short-term behavior. Second, proactively communicate, both internally and externally, about why the existing incentive plans are business driven and prudent. Finally, and most importantly, use the partnership model as a touchstone in redesigning plans. This means:
* Expect and ensure that executives have significant personal capital at risk.
* Change the balance of current cash and long-term reinvestment in the firm to better match firms' lines of businesses that create its revenue and profit (i.e., increase the amount of pay delivered as stock and match the duration of vesting to company/unit performance over the full cycle).
* Delay payment for, or provide real deferrals and claw backs, on compensation if real profits never materialize.
* For senior executives, create mechanisms that demand true understanding and ownership of risk as if it was their own. Break down the layers and the distance between those designing and those taking risk. Don't allow these decisions to be delegated.
* Create an environment where there is the ability to benefit over the long run for investments made today. This will be very challenging, because it requires a long-term perspective (i.e., a "sticky contract") and is in stark contrast to the current climate, where employees view themselves as free agents available to the highest bidder. For example a risk adjusted carried interest plan that provides for a "share" in the profits when they are actually realized.
* Measure performance at the firm level and do not allow businesses to get a first call on "their" profits.
But let's be clear: "fixing" the compensation problem will not prevent this from happening again. A number of changes need to be made in concert. The solution lies with a combination of comprehensive changes including:
On pay, match the timing of payouts with the actual realization of profits; live an "ownership" culture; and measure performance at a cross-department level.
On risk management, don't separate risk assessment from decision making; include an accurate "price" of risk in all profitability calculations; and get better insights from rating agencies.
On people management, resist the temptation to employ "hired guns"; build talent from within with a heavy emphasis on collaboration; and build a "long-term" culture. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.americanbanker.com/usb.html/ http://www.sourcemedia.com/