Bankers' Bonuses - some more considered thoughts

A few months ago I recorded a video for Cranfield, aiming to set out both sides of the ‘Bankers’ Bonus’ debate – why they should get bonuses, and why they shouldn’t.  I tried to be even-handed, but most people reckoned that I was far less convincing when arguing that they deserved them, than I was when I was explaining just why they should not be awarded. 

Having tried on Thursday night to defend Stephen Hester’s bonus at RBS – which resulted in a bit of a minor media storm[1] about my ‘pro-bonus’ views, I thought I’d like to restate the position, using more words that I was able on air.

There are two issues here.  One is the level of bankers’ bonuses in general, and one is the particular bonus for Mr Hester. 

As regards bankers’ bonuses in general, indeed, the whole top echelon of executive pay packages, it is difficult to argue that they are justifiable.  The arguments in their favour are weak, and mostly boil down to ‘custom and practice’.  We pay bankers a lot of money because we have always paid them a lot of money.  But being a banker is not riskier than being a soldier; it is not more stressful than being a nurse; it is not more physically demanding than … well, than most things, really.  Society has arranged itself in such a way that it values some jobs more than others; there is no logic behind it.

There is another argument against these bonuses: they don’t work.  Research indicates that bonuses can be very successful to motivate people to do better in low-level tasks that involve physical work .  They are much less successful in motivating performance in complex cognitive tasks.  Worse, the research suggests that giving a bonus for such tasks actually has detrimental effects on performance: the exact opposite of what we want.

So, logic suggests that we should change things.  But logic has only a small role in this.   Society does not change easily.  Governance experts (myself included) have endlessly discussed what might be needed to restore trust in our boards, and how the pace of executive pay acceleration might be slowed.  If it were easy, an answer would already have been found.  Back in 1995, the Greenbury Study Group thought additional disclosure would be the answer: ‘name and shame’ the highly-paid directors, and they would be humiliated into receiving less.  As we know, that didn’t happen.  The Government’s new proposals, set out by Vince Cable earlier this week, may chip away a bit at the edges of the issue, but on their own are unlikely to achieve the result desired by politicians and by a public which is being hit hard in a recession caused, by and large, by many of these highly-paid individuals.

The debate is not helped by a distortion of the facts.  A 2011 survey by IDS has been widely reported as saying that directors’ pay had risen by 49% in the year.  That is an egregious figure which, not surprisingly caused a great deal of outrage and distress.  However, Manifest, taking a closer look at the numbers has suggested that the calculations behind that 49% are misleading, and a better indication of the rise in executive pay would be around 12%.  That in itself may be too high - it's a lot higher than the rest of us are getting - but it would probably not have attracted the level of opprobrium of widely-publicised numbers.

Similarly, we hear the phrase ‘crony capitalism’ used to describe how directors sit on each others’ boards and vote each other high pay.  Now, I can refer you to several academic theories that show how this might happen: how people at a certain level tend to mix with others at that pay rate, and so this anchors their views of what is reasonable.  But if this is happening – and I suspect to some extent it is – it’s happening at a more subconscious level: there are very few cross-directorships within UK PLC, and people just don’t get to vote on each others’ pay in that way. 

I could say more about the pay debate – and no doubt at some point I will.  But I want now to return to Stephen Hester, whose bonus I was defending in the media.

First some facts.  Mr Hester was not responsible for the mess that RBS got itself into.  Indeed, he was not even a banker at the time it happened – he was the well-respected CEO of a large property company.  But, his track record as a banker in earlier years, coupled with being untainted by the so- called ‘credit crunch’ meant that he was invited to become a non-executive board member of Northern Rock and the RBS, and then, a few months later, invited to take over the top job at RBS.

Not many people would want that job.  Company turnarounds are not easy at the best of times.  The job Mr Hester was brought in to do – de-risk the bank, restore it to eventual profitability, sell off parts of it – is a complex one, made more difficult by the fact that we, the public, own it, and so politicians and the media take a close interest in every move.  As I said, not many people would want the job; and probably only a few of those who wanted it would be capable of doing it.

In recent days it has been argued, quite reasonably, that because we own RBS, Stephen Hester is a public servant and as such should be on a salary much lower than his £1.2 million, and with no bonus.  Public sector employees all over the country have faced huge pain: so should he.  Whilst I appreciate the emotional appeal of this argument, I think it’s a bit disingenuous.  He wasn’t employed as a public sector worker; he was employed as a banker.  He agreed a contact at a certain level of salary, and with the possibility of a bonus.  And whereas we wage-slaves might gasp at the size of the numbers being discussed, in the world of bankers it is, I’m afraid, relatively low.  Set in the context of an industry where the CEO of Barclays got a bonus of over £6m last year (with more rumoured for this year), and where the CEO of Lloyds would have been in line for bonuses of about £2m (ill-health and a leave of absence meant that he waived all right to that bonus), the RBS bonus (which was undoubtedly kept below £1m for political reasons) is not extraordinary.

There has been much call for Mr Hester to waive the bonus or to give it to charity.  Well, he chose to waive his 2009 bonus, which would have been in excess of £1 million.  That was a generous gesture: we may argue that the bonus was too high, but most of us, given the chance, would have taken the money.  As to giving it to charity – what he does with the money is his business, not mine.  For all I know, he could give most of his pay to worthy causes, but that is between him and his conscience; it is not for me to judge.

Two final points on that bonus.  Everyone is speaking of £963,000 bonus as if it will be piled up on his desk in crisp fivers.  That’s not the case.  He has been awarded 1.6 million shares which, at that day’s price, were worth about £963,000.  But those shares are in a ‘bonus bank’.  What that means is that he can’t touch them until 2014.  If between now and then the bank’s performance get worse, the shares will be ‘clawed back’.  In the same way that he was awarded them for what the board saw as ‘good’ performance, he will lose them for bad performance.  Oh, and even if he keeps all 1.6 million of them, he won’t get £963,000 – what he actually gets will depend on the share price in 2014.

Personally, I hope that by 2014 Mr Hester’s bonus is worth several million pounds.  If that’s the case, it means that the share price will have recovered enough to repay the taxpayer what we invested in it.  And that can only be a good thing.

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[1] 11 interviews in 24 hours is probably normal if you are a public figure, but quite a big day if you’re just a finance lecturer.

It’s not market failure; it’s not a market

The debate on executive pay became more intense in the UK last weekend, with politicians of all hues arguing that it is too high and needs to be contained.  In an interview, Prime Minister David Cameron told the BBC that there had been a "market failure", with some bosses getting huge rises despite firms not improving their performance.

I won’t argue with the comment that many executives receive too much pay.  I won’t argue with the statement that the pay is apparently increasing regardless of performance (although I would refer you to Manifest’s blog which gives some numbers on this).  My position in this article is that it’s not a market failure, because there is no real ‘market’ in top executives.

I’ve been saying this for a while. I first pointed it out in my PhD, in which I interviewed members of remuneration committees, executives and advisors.  I went on to write it in academic articles such as The Platonic Remuneration Committee.  But on the basis that few people will have the time or inclination to read any of that, I set out some thoughts below.

1.      The UK Corporate Governance Code does not require that pay be benchmarked against a market.  It says, more subtly, that committees should “judge where to position their company relative to other companies”. The word ‘market’ is not mentioned, and so the debate really centres around defining appropriate comparators.

Each company selects its own comparators (generally, research suggests, from companies where pay is high).  Therefore, each company sees a different ‘market’.  It could be argued that what is being benchmarked is not a market but instead a sampling population: companies define their market as a limited population of elite salaries, sampled 100%.  (Not surprisingly, nobody ever says that – the term ‘market’ carries a lot more legitimacy than ‘sample of elites’!)

2.      Even if companies attempt to define their market, data become anomalous because companies cannot benchmark like against like.  In my ‘Platonic’ paper I give the example of a utility that unintentionally ended up benchmarking against high tech companies through a hidden chain of comparators.

3.      Individual executives are not fungible.  They have different qualifications, talents, backgrounds and reputations. These human capital attributes mean that any ‘market-determined’ price may need to be tailored to individual circumstances.  Companies too vary widely - two organisations are not similar just because they have the same turnover or market capitalisation.  Simple benchmarks ignore pay that has been awarded for individual skills or circumstances. 

4.      Executive pay will increase for three reasons:  pay inflation, new entrants to jobs; and merit awards for individuals progressing in their roles.  Lumping all pay rises together without differentiating their cause gives a distorted view of the ‘market’ rise, which should just be that inflationary element.

In summary, executive pay is not a market in the generally-accepted sense. When economists speak of markets they assume a competitive market in which prices settle at the intersect of supply and demand curves to arrive at a market-clearing price. The goods being traded are identical, or at least closely similar. If a merchant sets his prices at a premium to the market-clearing price he will find that there are few buyers; likewise, setting below-equilibrium prices should increase the demand for his goods.  That isn’t in any way what we have in executive pay.

Putting it another way, the ‘market’ surveys on which we rely do not themselves represent a price at which individuals could, to put it crudely, be acquired. They represent the prices currently being paid to other elite individuals. They are not an ‘offer for sale’ and will never be tested as such. The market data reflect what others are reporting as earnings, not what a market-clearing price would be. For example, if the median rate for CEOs in a certain sector were £300,000 one could probably find a qualified individual who would take the job for, say, his reserve price of £200,000. Paying the median gives that individual a surplus of £100,000. Put in terms of the UK Governance Code, the money is certainly sufficient to “attract and retain”, but it fails on the criterion of “not excessive”. Indeed, taking this analysis a stage further, we can see that individuals who see their worth as being higher than the median get paid as such, but others get paid at the median, rarely below it. Thus, the median is an inadequate proxy for the true market-clearing rate.

Does it matter that we refer to executive pay as a ‘market’?  Yes, I think it does.  We should not say that the market has failed, because it conveys the wrong impression - the market does not exist.  Trying to correct that ‘market’ is perhaps a waste of time, and other approaches may be more useful.  We need a radical approach to executive pay, and re-defining and clarifying our terms might help us to start to achieve this.

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Why Jack Welch was Wrong - Some thoughts on Shareholder Value

This is a copy of my comments on a LinkedIn thread.  I felt so strongly about it I thought I'd do it again...

Jack Welch was wrong. Twice.

He was wrong when he ran GE for quarterly profits, and he was wrong again when he called Shareholder Value ‘the dumbest idea’.  What he should have said was that running a company for quarterly profits is a silly idea; running a company for quarterly stock prices is a silly idea; but, running a company for shareholder value is actually pretty smart.

Go back to what Rappaport said, in the early days of the shareholder value ‘movement’.  In his book, Creating Shareholder Value, Alfred Rappaport defines Shareholder value in terms of Value.  He sets out seven drivers of value:

1. Sales growth (increase it)
2. Operating profit margin (increase it)
3. Cash tax rate (decrease it)
4. Capex % of sales (decrease it)
5. Working capital % of sales (decrease it)
6. Cost of capital (decrease it)
7. Timescale of competitive advantage (increase it).

#7 is fundamental to value – Shareholder Value is not about the next quarter’s stock price, it’s about building an enduring, profitable business.  And running any organisation in line with these value drivers can be beneficial – I’ve used the model to work with not-for-profits as well as commercial companies.  It’s not used as a strategy in itself, but as a way to evaluate potential strategies, and for that it is very powerful.

In my own book, Corporate Financial Strategy, I address head-on the issue of different stakeholders, and point out the problems inherent in running an organisation to prioritise all of their different needs.  I conclude chapter 1 as follows:

● Stakeholder management is an important part of long-term shareholder value

creation.

● Although accounting results are not necessarily an indicator of shareholder

value, companies spend much time and effort on ensuring that the accounting

results look good, sometimes to the detriment of value.

I don’t disagree with the Martin ideas and the Forbes article.  But it’s lazy thinking to misapply a perfectly useful concept and then damn it for  being wrong.