A storm is brewing for financial institution CEOs and board compensation committees.

On the public front, high and persistent unemployment and underemployment continue to batter American workers. Many expect unemployment to come close to 10% in the fourth quarter and perhaps exceed that early next year.

On the regulatory front, in Washington and points east including London, Paris and Bern, agencies and politicians are debating restrictions on pay. These will probably stop short of caps. And they will probably align closely with the principles announced by the Financial Stability Board in April, at least for the time being.

But the issue of regulating pay remains extremely volatile and uncertain. For example, although the House Financial Services Committee has voted out legislation, it has not yet passed the House, and the Senate has yet to act. Regulatory certainty may not emerge until late this fall, if then.

On the earnings front, financial institutions face continued uncertainty about the strength of the economy's recovery, the extent to which consumer spending will revive and the performance of commercial real estate portfolios.

In short, financial institutions will be completing 2009 compensation packages and formulating 2010 pay plans while unemployment peaks and the political, regulatory and economic environments are uncertain. At the same time, financial institutions will be mindful that they have many deserving employees who are weary after manning the financial rigging though the crisis. Financial institutions will need to compensate these employees fairly. If not, top talent will move elsewhere — and that would spell trouble for the industry.

Financial institutions are taking different tacks. Some, resentful of creeping regulatory involvement in their businesses, are doing as little as possible. Others are looking to pay back public funds in the hope this will let them avoid additional requirements and public criticism. Still others are adopting compensation principles and hoping potential public anger at high compensation will be mollified by assurances the compensation, though high, was at least principled.

In fact, financial institutions may have little they can do to avert regulatory, legislative and media criticism. With unemployment nearing 10%, financial services executives are not likely to be popular this bonus season, even if they check all of the right regulatory boxes, such as multiyear performance evaluation, balanced equity and cash compensation, clawback provisions and long vesting periods.

But some financial institutions will do better than others.

These will be the ones that adopt principles tying compensation to the long-term well-being of the institution and its stakeholders. This is easy to say but hard to do. Some examples exist of good practice. But even the best examples tend to leave employees and shareholders wondering what they mean in practice. Principles should not merely echo the Financial Stability Board's rubric but state plainly how the institution will pay its people. Such succinct principles could include commitments to:

  • Condition pay on control. Do not reward employees who have repeated audit issues, exceed trading or credit limits or who fail to meet compliance objectives. Do reward executives who model good risk-management behavior — such behavior cascades throughout an organization and reinforces the "tone from the top."
  • Base pay on value. Do not reward employees who exploit one-off opportunities at the expense of risk and reputation. Do reward employees who contribute to a sustainable business model that adds value by meeting real customer needs.
  • Take the long view. Do not pay for promised profits, unless you can claw back awards if the promises do not pan out. Do vest equity awards over longer periods.
  • Consider all risks. Do not take a siloed view of an employee's contributions. Consider everything, including credit, market, liquidity and operational risks, that arises as a consequence of the executive's activity. Consider notional exposure as well as net exposures. Consider daily spikes in risk as well as longer-term, smoother averages. Consider risks to the bank from stand-alone perspectives net of any diversification benefits based on noncorrelation assumptions that may prove unreliable.
  • Reinforce a culture of risk management. Do not let risk management be seen only as a negative, as a brake on performance and potential reward. Do make control a positive. For example, reward executives whose business units self-identify significant issues before audits do.

In addition to practical principles, institutions that fare better will have invested in culture, communities and training. Cynics may spurn these as, paradoxically, both too "intangible" and too "touchy-feely." But experienced executives know the following efforts can make a difference:

  • Measure culture and work to improve it. Some financial institutions ask the vendors that do their employee opinion surveys to include more questions on culture and the culture of risk management so that they can better measure these over time for comparison with peers. Some develop plans to improve their culture. Some use compensation principles to reinforce aspects of their culture, such as teamwork, innovation or customer service. Some hold business unit executives accountable for their units' culture.
  • Renew a commitment to community. Financial institutions are often the best corporate citizens in their communities. Some are seeking to do more, particularly with their communities under stress.
  • Train compensation committees on risk management. Institutions are recognizing that compensation committees cannot make good decisions on rewards without understanding the risks that were run to earn them.

None of these steps are "escape routes." But institutions that take them should be better prepared for the coming heavy weather — and better positioned, when the storm subsides, to continue contributing to economic recovery.

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