Banker compensation may get more complicated and have fewer zeroes if the International Monetary Fund has a say.
The IMF’s most recent Global Financial Stability Report evaluates executive pay, corporate governance and risk-taking in some of the largest banks around the world and recommends policy measures to ensure only prudent risk-taking is rewarded.
While a number of quantitative and qualitative factors contributed to the global financial crisis, the report argues that structure of executive compensation encouraged bankers to take shortsighted risks with lasting negative impacts:
The causes of such risk taking were many and complex, but there is general agreement in the financial industry, the public sector, and academia that incentive structures at some financial institutions played an important role.
Other contributors to reckless risk-taking were weak regulatory frameworks and boards of directors that were not independent of banking operations.
To quell risky behavior, the IMF suggested a number of policy reforms for banks to implement—particularly changes to variable compensation:
More pay that is related to longer-term job performance is associated with less risk, Moreover, banks that have large institutional ownership tend to take less risk. As expected, periods of severe financial stress alter some of these effects because incentives change when a bank gets closer to default.
The IMF’s view that bankers need to take a long-term view on their operations is expressed in a provision that bonuses be paid in the form of long-term bank bonds—akin to a child receiving a savings bonds from their grandparents as a birthday gift—the promise of future money is great but it lacks the “wow!” factor of the season’s hottest toy.
The most controversial measure is a suggested clawback provision on bonuses, which means managers would have to forfeit past bonuses if their decisions were later found to have long-term negative effects. The hope is that executives would be encouraged to take some of the investment risks that are necessary for the bank’s sustainability but that their risk-taking is tied to long-term performance instead of quarterly earnings.
Particularly of concern to the IMF is executives who may use an impressive short-term record as a stepping stone to a new career while the bank is left with a ticking time bomb on its balance sheet.
Changes to board structure were also suggested by the IMF, namely ensuring that bank boards maintain some independence from management— a point that was raised recently regarding JPMorgan Chase CEO Jamie Dimon sitting at both the helm of the company as well as the board of directors:
Reform measures should endure that executive compensation of bankers is sufficiently risk sensitive through mandatory deferrals of compensation and a link to default risk and should require bank boards to be independent of management. Boards should establish board risk committees to improve board oversight and internal risk controls. In addition, policymakers should investigate the merits and pitfalls of having debt holders represented on bank boards.
The IMF acknowledged that its recommendations could have unintended consequences.
Changes to governance and compensation could force the banking activities the IMF wishes to monitor to move to the shadow banking sector—or non-bank lenders—to avoid regulation. Similarly, too many restrictions on fixed and variable compensation could create a problem in which executives see no real upside for their decisions.
While the IMF’s report and suggestions are little more than speculation now, increased regulation and more talk about pay is likely ahead.