Financial services firms are moving forward with far-reaching changes in their approaches to employee compensation, said the Institute of International Finance (IIF). Firms are proceeding with reforms that are both in line with the principles published by the IIF in July 2008 and by the Financial Stability Forum that said its principles "aim to ensure effective governance of compensation, alignment of compensation with prudent risk taking, and effective supervisory oversight and stakeholder engagement in compensation."
Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance, Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, said, "The message today is that progress is being made in reforming compensation in firms across our industry. The leading edge of these efforts reflects the first of the IIF's principles, which stresses that compensation incentives should be based on actual performance and should be aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital."
Last summer the IIF published a comprehensive report highlighting needed industry reforms in a range of areas including compensation (Final Report of the IIF Committee on Market Best Practices ). Today, the IIF released a report on compensation practices carried out by the consultancy firm Oliver Wyman comprised of a survey of financial services firms, which includes corporate and institutional banking sectors, and interviews with senior industry executives at a range of firms. The report found wide agreement that compensation incentives should not induce risk-taking in excess of the firm's own risk appetite, and significant support for the view that compensation should include a component reflecting the firm's overall results in line with sound risk management and business goals.
Dr. Ackermann added, "The industry broadly recognizes that compensation structures in the past had shortcomings. It is necessary for firms to put in place practices that are more appropriately aligned to the current and prospective needs of our industry and to the exigencies of market stability. The IIF's principles are unique in their global emphasis and scope and have been endorsed by senior executives from major firms from a large number of countries. They established benchmarks for the industry and we are pleased to note the recent announcements of principles for compensation by key regulatory and supervisory bodies that are broadly consistent with those of the IIF."
Mr. Rick Waugh, President of Scotia Bank and the Co-Chairman of a special IIF Steering Committee on the Implementation of Market Best Practices, said, "At a number of firms there has been a culture that has fostered employee bonus expectations that are not consistent with long-term performance, with current conditions in the market or with sound risk management practices. We are now seeing a whole range of fundamental changes in industry practices that are principles based and that is very encouraging."
The IIF is the leading global association of financial services firms with 380 members world-wide. Mr. Klaus-Peter Mueller, Chairman of the Supervisory Board. Commerzbank AG, and Co-Chairman of the Steering Committee noted, "The majority of firms surveyed are moving towards full alignment with the seven principles set out by the IIF Committee on Market Best Practices in its 2008 Report and they are doing so on an urgent basis. The consensus around the direction of change in industry compensation practices is unprecedented and provides a solid basis for the initiatives underway in the financial services industry."
The IIF said that a lot of work still remains to be done to fully reform compensation structures, but it noted that today's report showed that a number of firms have already developed systematic approaches towards reflecting risk in performance measurement, handling deferred compensation mechanisms and establishing sound governance standards for the overall compensation process. The survey, which involved firms in North America, in Europe, and Asia conducted during a three-month period just ended, found that 98% of respondents agree that compensation structures may have been one of several factors underlying the current market crisis. With regard to competitive considerations, the IIF pointed out that as the process of reform moves forward through the industry so this can contribute to a diminution of the "first-mover disadvantage", i.e., the risk that the first firms to introduce new compensation schemes will lose talent.
IIF Managing Director Charles Dallara noted, "Discussions with many executives suggest that the current crisis presents a unique opportunity to address some difficult reforms in the compensation area and the report sets out most useful guidelines to this effect. Alignment with the IIF's principles does pose technical and organizational challenges. It is also evident that no "one-size-fits-all" approach can be applied to employee compensation, given the major differences among firms and their diverse goals and markets. We believe, however, that an increasing number of firms are now tackling these challenges - in terms of governance standards and performance measurement metrics - as they pursue the agenda for change towards full alignment with IIF principles."
The IIF stated that in developing compensation approaches that better align payouts to risk taking, firms should:
- Incorporate adjustments for risk in performance measurement.
- Measure performance over a multi-year period where appropriate.
- Defer compensation delivery in businesses that have a multi-year risk time horizon.
- Pay compensation in units with value that is linked to the individual's future performance (i.e. company stock may not always be the best currency) thus focusing deferrals on alignment with performance development over time rather than on retention.
Mr. George Abed, Senior Advisor to the IIF Managing Director who oversaw the study, highlighted the pathbreaking character of the work done by Oliver Wyman, adding that, "while the agenda for change is put before the financial services industry as a whole, it is at the level of the individual firm that needed reforms are implemented while taking into account each firm's own circumstances."
Mr. Abed added, "The compensation setting process involves trade-offs and the balancing of occasionally conflicting demands. This makes it especially important that efforts to promote change include priority attention to issues of governance and oversight to help ensure appropriate checks and balances, most notably in the process of bonus generation and allocation within the firm."
Compensation: Principles of Conduct
Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations. Financial Services Industry Response to the Market Turmoil of 2007-2008. Published on July 17, 2008.
- Compensation incentives should be based on performance and should be aligned with shareholder interests and long-term, firm-wide profitability, taking into account overall risk and the cost of capital.
- Compensation incentives should not induce risk-taking in excess of the firm's risk appetite.
- Payout of compensation incentives should be based on risk-adjusted and cost of capital-adjusted profit and phased, where possible, to coincide with the risk time horizon of such profit.
- Incentive compensation should have a component reflecting the impact of business units' returns on the overall value of related business groups and the organization as a whole.
- Incentive compensation should have a component reflecting the firm's overall results and achievement of risk-management and other general goals.
- Severance pay should take into account realized performance for shareholders over time.
- The approach, principles, and objectives of compensation incentives should be transparent to stakeholders.