Charles Cotton. CIPD Performance and Reward Adviser
The UK Treasury recently launched a legal challenge with the European Court of Justice against plans by the EU to introduce a law to cap bankers' bonuses at no more than fixed salary, or twice that level with shareholder approval. The cap will apply in all 28 countries within the EU and to EU banks operating overseas.
The EU believes that its law will reduce risk taking by clamping down on the ‘bonus-driven culture’ that encouraged inappropriate behaviours and led to the global financial crisis as well as dealing with tax payer anger at the size of subsequent bail outs of the finance sector.
However, the UK government claims that the EU cap had been rushed through without any impact assessment. An unintended consequence of this legislation would be an increase in bankers' fixed pay that would then be more difficult to reduce or claw back if the pay did not reflect subsequent performance and so employees may feel able to take more risks. As a result, instead of making financial institutions more stable this law would actually make them riskier. In addition, the government is also challenging the legislation on the grounds that the EU has gone beyond its remit in seeking to clamp down on bonuses.
This throws up the question of whether it is appropriate that governments should dictate reward practices to employers? When it comes to providing a floor, or a safety net, below which employees are not allowed to fall most UK reward professionals that I have spoken to believe that one should exist. If we want to promote an innovation-based, high-value economy then low wages and employment rights mitigate against this aspiration. While, there are arguments around how high you set these minimums and whether there should be some variation by region or sector, no one is arguing for their removal.
However, when it comes to determining rewards for high paid employees, should the government also have a role? I believe that it does in ensuring that in publically owned companies investors are able to review executive reward practices to ensure that they reinforce a performance and a culture that are sustainable over time. I also believe that politicians have a role in actively questioning and challenging the appropriateness of executive reward practices. However, I do not believe that they should dictate how reward at the top is managed. This should be left up to individual organisations and their owners.
Some will argue that the so called City ‘bonus-culture’ encouraged inappropriate behaviours and led to the financial calamity that engulfed the world. Therefore, the EU should intervene to ensure reward practices do not destabilize economies. However, did large incentives create and drive an inappropriate culture or are they a symptom of an inappropriate culture? If they are a symptom than the EU is looking at the wrong thing and is misdirecting attention away from the real problem, which is whether the assumptions, beliefs and values that guide and shape employee perceptions, judgements and behaviours are appropriate.
Talking to one senior reward consultant he expressed the opinion that incentive plans, whatever their design and earnings potential, are an expression of a pre-existing culture. They can act as an important vehicle of communication about what matters to the organisation, they can turn up the volume and augment the sense of priority but they are followers, not the initiators, of culture. They do not create it and they do not drive it. That’s not to say that bonuses do not matter, they are important as a way of carrying and reinforcing the message of what things are important to the organisation and how they will reward and recognise staff who achieve those things. I suppose you could say that variable pay is the pressure leaders put on the accelerator that drives the organisation, the bigger the incentive the faster the activity and, potentially, the quicker the car crash.
So, even if bonuses had been fixed before the financial crisis it is likely that some in the sector would have looked for other alternatives. As one commentator told me: “If these financial services firms had not rewarded their people with short-term bonus they would have rewarded them with capital appreciation and probably designed a CDO that was aligned to that imperative. People are endlessly creative and will generally act in self-interest – it just expresses itself in different forms”.
Instead of trying to fix performance and culture through diktat, the EU would be better of asking how appropriate skills, values and behaviours are being recruited, developed and managed as well as being rewarded and recognized. As a CIPD report on leadership concludes: “New notions of leadership stress that leadership is not simply the domain of a few, but is prevalent throughout the organisation in the untapped talent of all its employees. The role of the organisation and its formally appointed leaders is to create a culture in which such latent potential is nourished, recognised and released in daily interactions and ways of ‘being’, and of doing things together.” How does the way we reward employees, currently based on principal agency theory and tournament theory, recognise these new notions?
Of course, some of you will have thought that if the EU is muddleheaded in believing that a bonus cap will reduce risk then the UK government must similarly be muddleheaded in believing a bonus cap will increase risk. However, there is the fear that what starts off as a intervention limited to banking ends up spreading across the whole of finance and then into other sectors. There are also concerns around the impact the law could have on the attraction and retention of talent. For instance, EU banks operating overseas could find themselves at a disadvantage in attracting talent as a rival non-EU bank will not have to comply with these pay regulations. So, for these reasons, I think the government is right to challenge the EU, even if some of the reasons for doing so are incorrect.
There is also a concern that widening pay dispersal between those at the top and the bottom, which has been growing due to a number of factors over the past few decades, will be a trigger for social unrest. While I would welcome executives to exercise a little more self restraint and show a greater empathy for those who earn less, I’m not convinced that those towards the bottom of the earnings pile are going to better off if those at the top see their pay regulated. Surely, government action should be focusing at looking at how pay for those at the bottom can be brought up? This requires action to ensure that school children and students receive the education, information, advice and guidance that will help them secure a high-skilled job and an economic policy to ensure that these skilled jobs attract a decent wage that is sustainable over time. Unfortunately, this option is more difficult and takes longer, and possibly explains why governments are tempted to go for quick-fix regulation on pay.
I could go on, but the point of my blog is to stimulate discussion so please share your thoughts on this topic with me.
Thank you for your comments. There may be a short delay in this going live on the blog page as we moderate the comments added to our blogs.
Government’s role in reward should be very limited. History has shown that any attempt to regulate earnings has failed, often with disastrous and unforeseen consequences. As is pointed out in the post, the way for Government usefully to become involved in the labour market is to ensure that workers and would be workers have the appropriate skills, qualifications and approach to enter those segments of the labour market which are high paid. The recent report showing how far the UK has fallen against other countries in terms of the skills and qualifications of its school leavers and workforce should not only serve as a wakeup call but be viewed as a clear indicator of the failure of Government education, business and employment policies over many years.
The Government would be much better to focus its attention on encouraging wealth creation, innovation and entrepreneurship. Likewise, and I know some will disagree, remove the stinking swamp of excessive red tape and regulation that stifles flexible labour markets. Sadly, politicians have a habit of picking on areas that are easy targets, such as executive pay, rather than the much more difficult task of encouraging a social and education infrastructure that encourages, rewards and values the skills and qualifications necessary for well-paid work in the modern post industrial age.
The right people to decide remuneration are the owners of the business. It may be that the Government has a role in ensuring that executive pay is transparent to the owners by way of appropriate levels of disclosure and discussion. However, the attempts by the current Government to simplify pay disclosure are doomed to failure. Executive pay is complex and getting more so. As the US examples have shown more disclosure is not better disclosure.
Leave reward to the owners and the professionals; do the work that the electorate expect by creating a society where wealth creation is encouraged and rewarded. Create an educational infrastructure that produces individuals with appropriate skills and qualifications.
11 Oct, 2013 14:49
Interestingly, the OECD finds that middle-aged English workers are better at maths than the younger and older generations. The Economist thinks that this may because middle aged workers have a more precarious status in the labour market and so need to refresh their skills and picking up new ones. This contrasts to the job for life culture, that is more prevalent in Japan, France and Spain.
11 Oct, 2013 15:22
Employers always say they look after their staff, yet a morning on the ACAS or TUC helplines is a stark reminder that many do not. Employer bodies opposed the creation of the welfare state, the NMW and now the living wage and the gender pay gap is simply not being adddressed and not a priority for most employers and Hour functions . The threat of legislation, as on women on boards, establishing minimum standards like the NMW, and policing these (frightening numbers fail to pay apprentices their national minimum rate) is an essential role for government. Government can also play a vital role in spreading best practice, as in Engaging for Success, and ensuring openness and transparency to highlight bad practice- there should be a requirement to publish gender pay gap stats, pay ratios and numbers below the living wage, as well as the executive pay reporting requirements
12 Oct, 2013 12:05
Thanks for a thought-provoking blog. Three quick thoughts by way of a response.
First, tackling the bonus-culture in financial services is long overdue. Prominent critical analyses of the crisis pointed out long ago the disconnect between individual behaviours in deal-making and the medium-term interests of the firm, never mind the economy more broadly. Bonuses rewarded contributions to the bottom line without any consideration of the cumulative risk incurred. Institutions have done little to address that voluntarily and there is legitimate public interest in ensuring that this is done.
Second, inequality within the UK economy is now a marked weakness. The problem is not just the risk of social unrest (remarkably, in the UK this is rare and episodic and easily contained politically). The weaknesses are structural and sustained. Huge swathes of human capital are being wasted for the need of voluntary investment; personal and household debt remains a problem and may become a bigger one again in the context of falling real wages; and consumption is skewed massively by earnings bracket and by region (think of distortions in the housing market). The experience of the last Labour governments is that addressing this seriously requires a focus over the entire pay range - a concern with low pay alone will not reduce inequality across the scale. Some public policy engagement with high pay is now overdue.
And finally, we have to think carefully about the role of law in these issues. Any expectation that undesirable practices can be eradicated simply by 'dictat' is of course naive. Much depends on the enforcement regime which in this country is generally weak and getting weaker for the moment. The important dynamic is the underlying one of establishing what we might call a 'Compass of Practice' - a model of the preferred model of business organisation. The acceptance of the NMW described in your piece is an important illustration of this. There were real concerns and vehement opposition when this was first mooted and there are continuing problems with compliance even now. Critically though, as a basic principle of policy it is broadly accepted now. We urgently need a similar reorientation on the issue of high-pay.
13 Oct, 2013 12:46
Governments influence reward through taxation and I agree that direct involvement is likely to have unintended consequences.
But there's a fundamental problem with the EU directive - the assumption that bankers bonuses caused the banking crisis in the EU. There were a host of other reasons: Northern Rock (over lending and reliance on the interbank market); Bradford and Bingley (suckered by self-certified mortgages); HBOS (gung-ho corporate lending); RBS and Lloyds (risky acquisitions). Did bonuses drive this behaviour? There's little evidence that they did - banking is an unstable equilibrium and banks are perfectly capable of getting into difficulties without bonuses. The proof of that? NatWest in 1974 and Midland in the 1980's. The one UK bank that was more bonus driven than any other in 2007 was Barclays - and they got away without a direct bailout!
Cranking up fixed pay and limiting variable pay does nothing to rebalance income inequalities - but it will mean that banks will be forced to pay more than they otherwise would when profits dip. The impact of this will be to limit their lending (already being criticised by politicians) and so economies won't be bolstered as they would otherwise have been.
The US, you'll note is not limiting bonuses. Yet it was certain large US banks that created the leveraged speculative instruments that caused the banking crisis - and here the evidence is stronger that bonuses encouraged this. But that's a different type of investment banking to that practiced more commonly elsewhere. The EU has the wrong target.
13 Oct, 2013 20:20
We should oppose the EU’s intended law to cap bankers’ bonuses but not for the reasons the British government is giving. The EU’s plan if it goes ahead will put into law the wrong and counterproductive idea that the financial crisis was caused by greed.
‘Greed’, or to be less pejorative, self-interest, is always present in market societies and in fact is needed for market societies to work at all, so it can’t explain financial busts, which have deeper, more systemic causes. To create a society where we can all have durably rising living standards, we need to boost growth in the real economy - which would also make us less dependent on financial shenanigans - and that means we need more of the spirit and values that this law would attack. We need more ambition and drive for better performance.
As others have commented, the government should instead focus on providing us with a framework for wealth creation, innovation, good education, and the ability to obtain appropriate skills. But it takes a lot of vision and forward thinking to achieve this – and that been lacking in most recent governments. The easier option is to blame bankers’ bonuses, and to wrong-headedly attribute them as the cause of the western financial crisis.
15 Oct, 2013 21:17
This EU regulation is in fact the pointer to why the financial meltdown happened in the first instance - the inability of regulators to keep up due to their lack of understanding of business and ALL it's drivers. The question is what is high pay and when is pay too high? What should the CEO of a Bank that records £1Bn pounds profit be paid? 1%? 0.5%? 0.01%? By running the Bank that well and recording high profits, the economy benefits through high taxes, jobs created and even CSR interventions, yet the drivers should not receive due compensation? It all does sound strange to me.
Two issues seem clear - non performing or loss making companies should not pay bonuses, period. Legislation in that direction is more than welcome. The other issue is the definition of profit which leads to legitimate bonuses being paid. Financial reporting and presentation of figures has evolved to such an extent that a company can appear seemingly healthy today and implode the next. In my view, that's where legislation should go and recent strides made by the IAS standards seem to be headed in that direction. If accurate reporting is assured, regulatory oversight is strengthened and claw backs implemented as the norm then there should be no problem with paying the right compensation to motivate ground breaking business performance which serves more to impact society. The FSA has done good work in this area by defining employee classes that should have claw backs defined, ensuring a strengthening of the Risk function with independence required and then ensuring more oversight and review on practices. This is the way to go.
Problems should be tackled at the source and not the outcome - one does not control weeds in one's garden by cutting off at the top, rather one takes out the entire root. Shareholders, investing public and analysts will still value Banks based on performance. Exceptional talent drives high performance and comes at a premium as it's not in abundant supply hence total compensation will remain the same and merely restructured. This EU regulation merely moves the cost from the variable pay line which at least gave shareholders some measure of control (another area that should be strengthened as being done in the US) to the fixed pay line leaving the Shareholders at the mercy of their employees. As rightly said in the blog, perhaps some more thought should have gone into this.
Finally, every reward program has its aim - drive revenue, increase market share, reduce cost, long term shareholder value, etc. The EU is ostensibly trying to manage risk taking by banks but by capping bonuses it has encouraged a situation in which Banks that did not pay up to the cap will now be required to do so by their top performing employees, talk about unintended consequences! As stated above, there are more effective ways of managing risk taking in Banks, regulators really need to step up to the plate.
16 Oct, 2013 08:35
16 Oct, 2013 08:41
Me again, just to say this link may be of interest to all commenting here - http://bit.ly/16QhBiH
(And can we please develop a critical debate about the connections between executive remuneration and performance that gives due weight the really important issues at stake. The problems have been glaring enough, not least in the kind of leadership and performance that have been measured and those which have not. As the FOS says here, banks 'misaligned their incentive structures, rewarded people for the wrong things and had a culture from the top of profit over customer service.')
17 Oct, 2013 12:54
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