In the light of the global financial crisis, discuss how the remuneration of chief executives
of banks should be determined.
The assignment must not exceed 1,000 words (excluding any tables, charts or diagrams, and
the list of references/bibliography). It should be prepared in Times New Roman 12 point
font with 1½ line spacing. A word count must be shown.
The determination of executive remuneration and the problem of setting pay at appropriate
levels have always been a controversial issue in corporate governance due to the ever
enlarging ‘divorce of ownership from control’ (Berle and Means, 1932) resulting from
internationalisation of investment and globalisation of capital markets. In the wake of global
financial crisis, the inappropriate executive arrangements in banking industry have been
blamed as one of the contributory factors by encouraging short-termism and excessive risktaking at the expense of shareholders and stakeholders in general (Bebchuk and Fried, 2010).
For that reason, it is crucial to analyse how the remuneration of chief executives should be
determined so that it can incentivise management to act in alignment with shareholders’
interests without excessive risk-taking, and maintain financial stability in the future.
This essay will mainly focus on the discussion of executives’ remuneration in the UK banking
industry by firstly looking at the components of current remuneration package, followed by
an analysis of the defects in the current pay arrangements and the corresponding
suggestions. It goes on to illustrate the proposals and reforms raised up after the financial
crisis. The significance of other influential factors in the determination of executive
remuneration will be examined at the end of this essay.
The total compensation of a chief executive consists of a base salary, short-term incentive
plans (e.g. bonuses), long-term incentive plans (e.g. stock and options), and other benefit
packages (e.g. pensions and health care). (Demsez, 1999) According to Figure 1, there is a
general increasing trend in average remuneration of FTSE 100 CEOs since 1998 (except in
2006 and 2009). In addition, we can see the three largest portions of CEO’s pay comprise of
base salaries, bonuses and LTIPs. As the base salary is usually determined through
benchmarking via peer surveys, we are going to mainly focus on the other two components.
It has been identified by FSA (2009) that an excessive emphasis on short-term profit figures
had stimulated executive pay to be focused on the bonus element which is based on firms’
recent total shareholder return (TSR) and other accounting figures in the absence of
incorporating risk into consideration. The Committee of European Banking Supervisors (CEBS,
2010) claims that risk parameters should be incorporated into the performance criteria in
order to produce risk-adjusted performance figure. The more detailed risk adjustment
process of using quantitative, qualitative measures and judgemental measures has been
proposed by CEBS (2010). Walker (2009) suggests a variety of recommendations in reaction
to the on-going crisis, including aligning performance measurement with long-term
successes and deferring short-term incentive pays (deferred bonuses) should be realised
over three years. Walker goes on to propose (2009) that claw back should be used to allow
compensation is in line with changes in performance measurements.
There is conflicting evidence suggesting the link between executive pay and
company performance has been doubted by the most comprehensive survey
conducted by Tosi, werner, Katz and Gomez-Mejia (2000) have suggested that only
4 percent of the change in CEO pay will be reflected in the company performance.
The remarkably low sensitivity could lead to moral hazard problem, which might
encourage excessive risk-taking.
However, Guo, Jalal and Khaksari (2011) have examined the determinants of executive pay
arrangement and agrees with John and John (1993) that increased leverage should be
aligned with decreased PPS ( pay-for-performance sensitivity) in order to balance the greater
risk borne by the manager. Therefore, it is suggested that larger banks which often
accompanied with greater risks will tend to compensate their executives with greater
percentages of incentive pay. This opinion is in accordance with FSA’s proposals (2009) and
the UK corporate Governance code (FRC, 2010) that the remuneration arrangements should
be determined at a level that is attractive enough to incentivise executives to perform their
commitments.
The increase in LTIPs in executive pay structure over the years has not only been found in
Figure 1 but has also been emphasized in the academic literature. For example, Both
Fahlenbrach and Stulz (2011) and Guo, Jalal and Khaksari (2011) agree that a greater
percentage of long-term incentive pay could avoid short-termism investments, and thus
decrease the probability of being in financial distress. As a result, a greater proportion of
LTIPs in the setting of executive remuneration should be promoted to link CEO’s pay
with long-term performance results of the firm.
Despite a reconstruction in the determination of the remuneration package is eagerly
needed, a number of other aspects should also be thoroughly considered when setting the
remuneration for chief executives.
Firstly, the issue of independence in determining executive compensation has been
addressed long ago by suggesting remuneration committee to include independent
members into Greenbury report (1995). With regards to independence, Pebchuk and Fried
(2006) has also support this view by insisting CEOs should not involve in the process of
setting their own pay. Furthermore, BIS (2012) has suggested a greater level of shareholder
involvement by giving shareholders’ a binding vote on corporate governance issues including
executive remuneration, therefore their interests will be protected to its full extent.
Another aspect of significance is the urgent need for changing the profit-driven culture and
rebuilding public confidence in the banking industry, following the Libor and other bank
scandals (e.g. mis-selling insurance, anti-money laundering breaches and etc.). With the
growing concerns of corporate social responsibility and general stakeholders’ well-being, the
elements of professional integrity, voluntary compliance and sustainable development
should be embodied in the setting of executive remuneration.
Going forward, we can already see a revolution of the attitudes towards executive pay
according to PWC’s survey of over 40 companies (around a third of the FTSE50) in 2013. The
freezing of base salary, bonuses as well as simplifying LTIPs have been identified as the
current trends of remuneration. PWC(2013) also maintains that greater evidence of restraint
on pay rises, improved transparency and increased care in the setting of executive pays will
be likely to happen after the recent disclosure requirements proposed by BIS Department
for Business, Innovation and Skills, 2012). As discussed above, there is no perfect equation to
determine the compensation for chief executives, multi-faceted plan and a variety number
of factors will need to be compiled and refined in order to match with the dynamic financial
environment.