New approach to bank bonuses in the UK

We might all agree that the lesson learned from the financial crisis is that greed is not always as good as we might have wished but there have only been a few real legislative changes made in order to really confront some of the central issues.

The Financial Services Authority (FSA) is the governing body who is tasked with regulating the financia services in the UK and they have taken an important first step. Until the 31st of January 2010 financial institutions could pay bonuses only based on share price, earning per share or other stock related performance. This meant that the only incentive for bank and financial instruction executives to do better was to nurture this one stakeholder namely the shareholder and in many instances this meant themselves to a large extend.  

In the code that the FSA have issued it has been put this way “Long-term incentive plans should be treated as pools of variable Remuneration. Many common measures of performance for long-term incentive plans, such as earnings per share (EPS), are not adjusted for longer-term risk factors. Total shareholder return (TSR), another common measure, includes … dividend distributions, which can also be based on unadjusted earnings data. If incentive plans mature within a two- to four-year period and are based on EPS or TSR, strategies can be devised to boost EPS or TSR during the life of the plan, to the detriment of the true longer-term health of a firm.”

And it continues

“Firms that have long-term incentive plans should structure them with vesting subject to appropriate performance conditions, and at least half of the award vesting after not less than five years and the remainder after not less than three years.”

I see this as a important first step for the financial institutions to confront the root cause issues that they for so long have been unwilling to tackle. While the 13 principles of the code in many ways resemble what we have seen in other governance codes such as descriptions of Risk and Governance control functions it goes new ways in forcing executive to think about what is going to happen to the company in five or ten years from now.

As we saw during the crisis it was not a one person greed that led to the down turn and destruction of capital it was structures build up ten or fifteen years ago that formed the cornerstones of a disaster waiting to happen. And while much of the blame can be put on the governments of the world in not understanding the ramifications of their own laws there is no doubt that a lot can be done in the area of governance and better business control systems.

There are especially two things that spring to mind when I see the code. First is the Exceptional government intervention which applies to companies that have been getting government assistance and have to apply to a special set of norms. The principles effectively put a cap on the amount that can be given in reunification to be limited to a percentage of the net revenues and the elimination of variable bonuses.

 The second is principle number eleven that states that “A firm must ensure that variable remuneration is not paid through vehicles or methods that facilitate the avoidance of the Remuneration Code.”. This means that companies no longer can hide money in the books in order to pay extra funds to executives and high ranking managers. While there might be a public outcry about bonuses there it has been less obvious that money have been channeled through alternative streams in order for companies to avoid public scrutiny. One could say that companies that just paid bonuses, however high, were in fact more honest as they actually showed on their books what they were doing.

Below you find the FSA 13 principles as they are outlined.

Code Principle Handbook references (SYSC)

1: Risk management and risk tolerance

2: Supporting business strategy, objectives, values and long-term interests of the firm

3: Avoiding conflicts of interest

4: Governance

5: Control functions

6: Remuneration and capital

7: Exceptional government intervention

8: Profit-based measurement and risk adjustment

9: Pension policy

10: Personal investment strategies

11: Avoidance of the Remuneration

12: Remuneration structures

13: Effect of breach of the Remuneration Principles (voiding and recovery)

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