Regulation of Executive Compensation in Banking: Key Issues, Trends and Challenges

Abstract Executive compensation in the banking sector has come under intense scrutiny around the world, with several critics arguing that it precipitated the turbulence in the global economy in the last three years or so. As outraged stakeholders and the public mount pressure on politicians and regulators to curb the perceived excesses in executive pay level and arrangements, a heated debate has emerged on the merits and demerits of aggressive pay regulation. The Central Bank of Nigeria, in line with its pursuit of radical risk management and governance reforms in the sector, had initially introduced new prudential guidelines with stringent (public) disclosure requirements. Very shortly afterwards, however, the regulator reversed the new guidelines. This u-turn clearly epitomises the global debates and confusion on whether or not, and how to regulate bankers’ pay. In this paper, we attempt to bring some clarity to the debate, examining some of the thorny issues: what aspects of executive pay to regulate, why (not) regulate, how to regulate, and who should be responsible for regulating pay. In particular, we examine the pros and cons of (stringent) governmental regulation, looking at key issues and trends in the US and the UK. We conclude by positing that more (governmental) regulation of pay (alone) cannot deal with the current problems with executive pay, and that more attention needs to be paid to strengthening and improving executive compensation governance processes.

Keywords: Executive Compensation, Corporate Governance, Pay Regulation, Risk Management, Banking.

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Introduction We have resolved to start regulating remunerations and bonuses of banks’ Managing Directors. In the course of the audit, we found out that many of the banks’ executives are receiving unnecessarily high pay and bonuses, jeopardising the health of the banks...Remunerations, bonuses and other compensation should provide incentives for management and employees at all levels to behave in ways that promote long term health of the institution...The present structure of remuneration/bonuses of banks which is characterised by ‘excessive short-termism’ demonstrates a disconnect between incentives to staff and prudent risk management. Charles Akoroda, Deputy Director of Central Bank of Nigeria, Vanguard (November 1, 2009)

The Central Bank of Nigeria has backpedalled on its directive that banks should disclose executive compensation and bonuses in their annual accounts. The apex bank, last week, issued new prudential guidelines which replaced the one issued in May which mandated banks to disclose in their annual accounts monies paid to executives and staff as compensation, profit sharing and bonuses. Babajide Komolafe, Vanguard (July 15, 2010)

Executive pay for bankers has come under intense scrutiny around the world, with many critics arguing that it precipitated the turbulence in the global economy in the last three years or so. In particular, there has been a widespread consensus that executive pay arrangements encouraged imprudent behaviour and excessive risk-taking that led to the collapse of several banking institutions, and the turmoil in global financial markets (Bebchuk, 2010). The ensuing economic hardship left disgruntled shareholders, fearful bank customers, and the public outraged about executive pay levels and arrangements. The “Occupy Wall Street” protests, which originated in New York and have now gone viral and international, epitomise this outrage, and the mounting pressures on governments and other stakeholders to reform bankers‟ pay. The banking sector in Nigeria, no stranger to financial and corporate governance failures, has experienced significant turbulence as well. The sector has “outperformed” other emerging financial markets, racking up an estimated staggering sum of N9 trillion in toxic assets (Merrill

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Lynch, 2009). In a $ 4 billion bailout package, the Central Bank of Nigeria “rescued” nine banks in 2009, and in 2011 revoked the licenses of three of these banks. At the root of this crisis, regulators maintain, is reward systems that encouraged imprudent and risky behaviour. To address this issue, the CBN introduced new prudential guidelines with stringent disclosure requirements in May 2010. However, as the quote at the head of the paper shows, the regulator reversed its decision shortly afterwards, citing complaints from several concerned stakeholders. This regulatory u-turn illustrates the global debate and confusion on whether or not, and how best to respond to the challenges of executive pay in banking: should executive pay be (aggressively) regulated by government and other regulatory agencies, or should individual firms and “market forces” be left to determine pay systems and levels? In this paper, we attempt to bring some clarity to this topical issue, narrowing in on some tough questions: What aspects of executive pay should be regulated? Why (and why not) should bankers‟ pay regulated? How should pay regulations be implemented? Who should take the lead responsibility in the regulation process? Drawing from recent developments in the US and UK, two countries where the executive pay and corporate governance debates have arguably been most intense, the paper attempts to provide a balanced view of the pros and cons of various rational choices and factors to consider in executive pay regulation. What Exactly to Regulate One issue that remains somewhat contentious is what specific element(s) should be regulated: base salary, bonuses, perquisites, short-term incentives, or long-term incentives. Whereas some critics are concerned with the total pay package of executives, many focus narrowly on annual bonuses and short-term incentives, others on the generous perks executives enjoy (which

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sometimes includes corporate jets - even in Nigeria), while a few argue that equity-based executive compensation schemes are in urgent need of reform. The reason for the narrower focus is not far-fetched. The problem with most executive compensation plans is usually not with the overall pay level, but the composition or mix of the various elements (Conyon, 2006). We illustrate this point with an example. Two executive directors in different middle-tier banks may “earn” the same total pay package in a given year, say N160 million. For one executive, 50 per cent of this amount may be in the form of long-term equity plans, and another 20 per cent from an annual bonus plan. In contrast, 90 per cent of the other executive‟s compensation package comprises of base salary, benefits and perquisites. Obviously, the two executives have significantly different pay packages, and ascertaining the “right” element(s) to regulate for each of them will be a bit challenging. Should regulators be more concerned about the second executive or the first? Should they even bother with the details/structure of the pay package, or only be concerned with the total amount? The downside to regulating just one or two elements of executive pay is that it may lead to unintended consequences. “Smart” executives/organisations will resort to “padding up” the elements that are not being targeted by regulators, to make up for any (envisaged) shortages in overall pay. For example, the current trend in the UK and other countries of imposing “punitive” tax rates on bankers‟ bonuses may lead to executives demanding higher base salaries in a bid to maintain the status quo. Why Regulate Executive Pay? Many academics and experts have argued for a stricter regulation of executive pay, citing inefficient and unreliable talent market mechanisms, the need for internal equity, the weak link

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between pay and performance, excessive risk-taking, and the need for more transparency in the pay determination process. We discuss some of these issues below, highlighting as well some of the (counter) arguments against executive pay regulation. Inefficient and Unreliable Talent Market Mechanisms For a long time, the traditional economic viewpoint that the “invisible hand” of the marketplace is the most efficient and reliable determinant of prices has influenced the thinking of regulators and other stakeholders towards executive pay regulation. Even when there are seemingly obvious excesses and distortions in executive pay, hard-core free market advocates insist that the market mechanism will even out pay levels and structures, based on the value and scarcity of talents, and other factors. Hence, if executives‟ skills or positions are indeed not worth the money they are paid, a “market correction” will rectify this “error”. Supporting this notion, Core and Gauy (2010) assert that the fact the process of executive pay determination has improved in terms of transparency and accountability over the years, and yet pay levels have been rising indicates that it is market forces (competition) that is driving executive pay. However, this received wisdom has come under intense scrutiny in recent times. Many critics argue that bank executives are overpaid “fat cats”. According to them, a conspiratorial alliance between executive compensation/management consultants and executive directors, has inflated bankers‟ pay in the last one decade or so. In the US, where this debate has been very fierce, the national House of Representatives has investigated the conflicting role of the big management consulting firms; one of the interesting findings from their investigation is that while the executive pay advisory units of the large management consulting firms actively seek (and actually undertake) considerable non-executive compensation related businesses with

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executives‟ firms, they also provide advice on the pay levels and arrangements for these executives. In particular, executive pay consultants have been accused of manipulating the firms and executives they benchmark their clients against, resulting in a situation where there is always a justification (an excuse, really) for an increase in the pay level. The fundamental argument here is that the notion that market forces are an efficient means of determining prices (pay levels) is flawed in the case of executive talent markets. Executive pay is not determined by the so-called “invisible hand” of the marketplace, but by the (very) “visible handshake” between executives, their compensation/management consultants, and bank directors. Regulating pay is therefore necessary, to correct the failures and distortions of the market mechanism. Internal Equity Considerations Over the years, the issue of internal equity has gained popularity as the gap between the highest and lowest paid employees in organisations has risen (Bowers and Whittlesey, 2010). In the US, for example, CEO pay has risen from 36 times that of an average worker in 1976 to 369 times in 2005 (Pfeffer, 2007). In several Nigerian banks, CEO pay can be as high as 300 to 400 times that of an average worker. The issue of internal equity however goes beyond the “average worker”, as inequity is evident among managerial talent as well. In one middle-tier bank, for example, the CEO pay was almost double that of some executive directors, most executive directors were paid two or three times general managers, and up to eight times what assistant general managers received. In this same middle-tier bank, the eight executive directors‟ pay accounted for over 12 per cent of the total compensation package of a workforce of over 2,000 professionals. Critics argue that this 6

creates a tournament-style, winner-takes-all situation, and that the most senior executives benefit at the expense of other employees. It is this wide variation in pay that makes critics argue for regulation of pay levels. Advocates of internal equity maintain that the issue of fairness, or at least the perception of it, is very important, and companies need to find a delicate balance between the imperatives of external competitiveness with employees‟ tendency to be demotivated by wide pay gaps (Bower and Wise, 2008). On the other hand, there are those who maintain that the high level of pay for bank executives may actually be a (true and fair) reflection of the competitive dynamics and inherent risks of the market for executives, and that such competitive pay is necessary to attract, retain, and motivate such talented executives (Conyon, 2006). Weak Link between Executive Pay and Performance Many debates on executive compensation today centre on whether bankers‟ pay is tied to “performance” – usually narrowly defined as total return to shareholders as measured by changes in stock prices (Pfeffer, 2007). There is a widespread belief that there is a weak link between pay and performance in banking, as executives continue to receive the same generous pay packages (and in some cases, higher pay) even when share prices are falling and shareholders are receiving little or no returns on their investments. There was widespread public outrage in the United States, for example, when several firms that had been bailed out by the government still had the “audacity” to pay bonuses, or maintain the compensation packages of senior executives. As a matter of fact, one of the notable requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010 is that

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publicly listed firms should disclose in detail the relationship between the compensation executives received and the firm‟s financial performance (Heim, 2011). Resisting this popular viewpoint, some argue that in periods of crises and uncertainty it is important (and maybe even necessary) to maintain (or actually increase) the pay levels and incentives offered talented executives, to motivate them to double their efforts to turn around the company. Further, it is often argued that competitive pay is a useful retention lever (golden handcuffs of sorts) in periods of crisis, encouraging (highly mobile) executives to “stick with the sinking ship”. Excessive Risk-Taking Advocates of pay regulation assert that the structure of executive compensation for bankers promoted short-termism and excessive risk-taking. The argument here is that the short-termism that characterises stock markets and the general business environment, and the desire of executives to maximise their short-term (annual) performance incentives, often drives them to make rash decisions that do not take into account or enhance the sustainability of their organisations (Milkovich et al., 2011). To handle this problem, some have even proposed maximum pay awards to executives, to reduce their incentive to take dangerous risks that may yield a higher compensation pay-off for them. Others have suggested bonus clawback provisions in executive compensation contracts, so that companies will be able to recoup (some of) the bonuses they have disbursed if a longer time horizon shows performance results actually were poor. More radical proposals include, reducing or eliminating short-term incentive pay, and replacing them with long-term incentives and restricted stocks, to make executives focus on building sustainable businesses.

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However, not everyone agrees with such efforts to limit risk-taking by banks. The argument here is that it is not risk-taking per se that led to the financial crises, but excessive and/or unmitigated risks. This viewpoint further asserts that aggressive measures such as bonus clawbacks and reduction of short-term incentives may lead to bankers becoming too conservative or risk-averse, stifle innovation, and eventually have a negative effect on corporate growth and shareholder value creation.

Enhanced Transparency Reforms aimed at improving disclosures on executive pay levels and the pay determination process have received a lot of attention in recent years. The United States, for instance, has stepped up legislations to enhance transparency, most notably with the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Barack Obama in 2010. The (Securities and Exchange Commission‟s) proxy disclosure rules in the United States (which became effective in 2007 and was recently revised with this act) requires companies to draft a Compensation Discussion and Analysis (CD&A) that discloses all information that is material to shareholders‟ understanding of the company‟s compensation practices and programmes. The recently revised provisions now require companies to disclose whether executive compensation policies and practices create risks that are “reasonably likely to have a material adverse effect on the company” (Heim, 2011). This global trend towards enhanced transparency may have informed the CBN‟s decision in 2010 to compel banks to disclose the details of their executive compensation. The uncharacteristically speedy reversal of the new guidelines by the CBN, due to complaints from banks that it constituted a security or “kidnap and ransom risk”, illustrates the very political and

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sensitive nature of executive pay disclosures (and may also explain why the National Assembly is having challenges disclosing their real pay). On a more serious note, there are credible arguments that in some cases, public awareness of pay levels and practices, rather than curtailing excessive pay, may lead to a race to the top as competing firms often seek to aggressively benchmark their executive pay against the market (i.e. market leaders) (Pfeffer, 2007: 2). Like we earlier mentioned, there is the viewpoint that enhanced transparency does not “work”. Core and Gauy (2010) point out that in spite of increased monitoring and transparency over the years, pay levels have been rising. Hence, if the objective of transparency is to curb the excessive level of pay, the argument is that it may not produce the intended results. How to Regulate Many countries are still struggling on how to respond to the popular outrage on executive pay in banking. The major challenge for politicians has been how to balance the political expediency of aggressively regulating bankers pay with the need to stimulate financial institutions (and the economy) out of the prolonged and uncertain economic recession. Below, we highlight some of the measures adopted by two leading economies, the United Kingdom, and the United States. In the United Kingdom, executive compensation governance reforms have been introduced in the last ten years or so. With the government bailout of banking giants such as The Royal Bank of Scotland Group and the Lloyds TSB Group costing an estimated £1.5 trillion, some radical measures have also been taken in the last two years. -

Disclosure: Starting in 2002, publicly traded companies are required to disclose details of executive pay in their annual reports.

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‘Say-on-pay’: The 2006 Company Act gave company shareholders the right to have a vote on executive pay (though the votes are merely advisory and not legally binding).

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Taxation/fiscal measures: The UK has one of the world‟s highest tax systems of 40% for the highest income brackets. Also, in 2009 the UK government announced plans to impose a 50% „supertax‟ on bankers‟ bonuses.

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Spreading of incentive payments: In 2009, an agreement was reached with the five largest UK banks to not only publish the total pay of their most senior staff but to also spread bonus payments over a three year period. In the United States, where casualties of the financial crisis included the once-mighty

Lehman Brothers and troubled giants such as Citibank, the Obama administration and the Congress have had to introduce reforms, albeit at a measured pace, to regulate pay. Some of these measures have already been discussed, and include improved transparency on not just executive pay levels and how they are determined, but how pay relates to performance. Shareholders also have (non-binding) “say-on-pay” votes. The government introduced more stringent regulations for banks and other companies benefiting from the Troubled Asset Relief Program (TARP). Some of the key regulations are: -

Salary caps: Salary payments higher than $500,000 are encouraged to be in the form of vested stock with sales restrictions.

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Bonus limitations: Bonuses are limited to one-third of total compensation and must be paid in restricted stock.

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Claw-back provisions: Any bonus deemed to have been earned based on questionable financial statements or performance metrics can be retrieved by the company.

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Disclosure: Increase disclosure requirements on perquisite consumption, and require firms to put in place a luxury expenditure policy.

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Prohibitions on severance pay: Eliminate the so-called “golden parachutes” for highly compensated individuals.

Compared to these two countries, Nigeria clearly has a relatively weak regulatory regime, as virtually none of the items discussed above in the wide range of repertoires have been adopted. The CBN‟s intervention last year was meant to address the essentially “liberal” and “voluntaristic” approach to executive compensation determination. One key issue that must be highlighted in the current disclosure of executive pay for publicly traded companies, is that the amounts published are grossly understated. We reckon that in some cases only 25 per cent of the total compensation package for banks is disclosed, with the boilerplate language caveat: “this excludes certain other benefits and allowances”.

Who Should Regulate Executive Pay in Banking? While many people agree that some form of executive pay regulation is desirable in the banking sector, there is no consensus on who should have the key responsibility: the national government, securities regulators, and/or bank regulators. We discuss the pros and cons of having each of these parties take the lead role in regulating bankers‟ pay below.

The (National) Government as Executive Pay Regulator Around the world, politicians and governments are under increasing pressure to regulate executive pay in banking. This is understandable given the huge amounts of taxpayers‟ money governments have committed to bailing out troubled banks, particularly the so-called “too big to

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fail” institutions. In situations where governments provide a lifeline to banks, it is reasonable (and politically expedient) to expect some level of regulation of executive pay, as the US did for banks accessing the TARP. After all, “he who pays (or in this case, owns!) the piper dictates the tune”. Many legislative chambers have played a leading role in investigating and reforming the process and governance of executive pay, and scenes of executives being summoned to explain the rationale for paying bonuses or certain incentives have become somewhat familiar. Digressing just a bit, in Nigeria, legislators have (expectedly) not been at the forefront of this regulatory debate. Their own self-determined pay, which is purported to run into tens of millions of naira (more than some bank executives “earn”!), has been the subject of public outrage, with the CBN governor confronting them about their unreasonably high compensation levels. Returning to the issue of national governments‟ involvement in regulating pay, the challenge is usually that there is so much heterogeneity across sectors, states and regions within a country, that it may be difficult or impossible to accommodate these idiosyncrasies with a single legislation. However, a national response is important in setting the agenda, and dictating the minimum acceptable standards. Some G20 and other global leaders have even sought an international response to executive pay following the recent financial crises. The benefits of a national (or an internationally) co-ordinated regulatory response is that it creates a level playing field for all companies, and prevents a situation where executives or organisations embark on “regime shopping” – looking for sectors, regions, or countries that have relatively weak pay regulations.

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The Securities Regulator as Executive Pay Regulator Many executive compensation reforms have focused on empowering securities regulators to monitor pay in publicly-listed firms, and ensure compliance with stipulated standards. Since it is only publicly-listed firms that are under the purview of securities regulators, disclosure and other regulatory enforcements for privately held banks are not possible. This can be a big issue when the objectives of executive pay regulation include curbing excessive risk-taking, and ensuring financial system stability. In Nigeria, however, this is not an issue as most banks (that are “too big to fail”) are now publicly listed. Another disadvantage of having the SEC regulate executive pay – particularly when there are radical regulatory reforms – is that it encourage some firms to delist and go private.

The Central Bank as Executive Pay Regulator The CBN took the lead on the issue of executive pay regulation in Nigeria, following global trends and best practices. The problem, however, is that the challenges and problems with executive pay and corporate governance are not peculiar to the banking sector, and require a wider, cross-sectoral response to be effective. It is also not clear if the CBN has the authority to dictate the level and structure of pay in banks, or the “power” to effect radical compensation changes. It is therefore perhaps not surprising that the regulator succumbed to pressures to reverse the guidelines it introduced last year. In summary, effective regulation of executive pay in banking requires concerted and orchestrated efforts of several stakeholders: the federal government, the national assembly, the securities regulator and the CBN.

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Conclusion The problems of executive compensation arise from a basic corporate governance problem. Under current arrangements, directors’ incentives to enhance shareholder value are not generally sufficient to outweigh the various factors that induce the board to favour executives. Thus, the problems of executive compensation can be fully addressed only by adopting reforms that would confront boards with a different set of incentives and constraints. Bebchuk and Fried (2004: 1)

The problems of executive compensation in the banking sector are legion. And there is no shortage of proposals to address these complex challenges: from enhanced transparency and disclosure requirements, bonus clawbacks, deferred compensation payouts, salary and bonus caps, shareholder empowerment (e.g. say-on-pay votes), and stiff penalties for offenders (including jail time). However, as Bebchuk and Fried (2004) asserted in the quote above, these remedies are usually symptoms of deep-rooted corporate governance failures, particularly the failure of boards to bargain at arm‟s length with executives. The implication of this fact is that regulation of executive compensation as highlighted in this paper is necessary, but not sufficient to tackle the current problems. A lot of attention, therefore, needs to be paid to ensuring the fundamental corporate governance challenge: ensuring that decisions made by directors (particularly compensation committee members) on pay level and structure strive to serve the best interests of shareholders. This is somewhat ironic, given that many economics and corporate governance scholars have traditionally argued that executive compensation is a useful tool for managing potential agency problems, (perfectly) aligning the interests of managers and shareholders. We now know, after many high-profile scandals, that it is simplistic to make such assumptions. To be sure, executive compensation contracts are determined by directors and compensation committees that

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may have conflicting incentives to align with the CEO and other executives, which according to Conyon (2006) leads to suboptimal contracts and excessive pay. The challenge, therefore, is to find ways to incent directors and compensation committee members to deal at arm‟s length with executives. Providing well-designed, equity-based compensation programmes can tackle the agency problems directors face. This is especially relevant in the Nigerian context, where bank directors‟ remuneration is usually low compared to the payoffs they can receive from “dealing” with executives on their pay and other issues. Beyond providing equity compensation plans for directors, improving board procedures, giving shareholders a better understanding of the benefits and limitations of various compensation arrangements, and introducing additional shareholder approval requirements for specific (“exceptional”) compensation plans, can all help address the corporate governance challenges (Bebchuk and Fried, 2004). Implementing these measures is by no means easy, and we cannot even guarantee that it will completely eliminate future executive pay abuses and failures (bankers are too smart, right?); but given the critical role that executive compensation plays in banks, and banks in the global economic architecture, inaction is simply not a viable (or rewarding) option.

Acknowledgements I would like to thank Olusegun Olomofe for excellent research assistance, and Chioma Okoro for her encouragement, patience and editorial guidance. I am especially grateful to Sir Chris Ogbechie for helpful comments and suggestions which contributed significantly to the final shape of this manuscript.

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References Adeleye, I. (2009) “Risk management and reward systems: taking HR governance seriously”, Human Resource Management Journal 1 (2): 13 – 26. Bebchuk, L. (2010) “Compensation in the Financial Industry”. Written testimony submitted to the Committee on Financial Services, US House of Representatives, Available online from