A compensation proposal currently under scrutiny at the European Council intends to crack down on big bonuses and the culture of short-term profits widely held to have toppled capital markets, says Patrick Pearson, head of the Commission's banking unit. New research from America's top business schools is being shared with the European institutions hammering out the directive.
"The root cause of the crisis lies in the breakdown of shareholder monitoring and ill-conceived managerial incentives," according to a theory put forward in a joint paper from the world-renowned universities of Chicago and Harvard.
The notion of 'short-termism' - banks hedging their bets on risky assets for a quick buck - has been floating around as a major systemic problem since the Enron scandal in 2000.
Another study from the Marshall Business School in southern California adds fuel to that fire by showing that risky banking was not just down to the typical kind of shareholder pressure experienced in companies, but related to a specific model of outsider ownership which bore specific disadvantages.
This study, covering 306 publicly-listed companies in 31 countries, came to two main conclusions.
Firstly, banks with more independent boards and institutional ownership - mutual funds, pension funds and other institutional investors – incurred the greatest losses during 2007-2008. Independent boards have long been held as a prerequisite for accountable business, but the results suggest that a focus on independent boards may have diluted the level of expertise on corporate ones, making it difficult to monitor risks carefully. Banks that had insider ownership – e.g. employees who bought shares in the company – incurred fewer losses as these owners were less likely to take risks.
Secondly, consistent with the view that big bonuses encouraged risk-taking, the study found that while annual bonuses were associated with larger losses and increased risk-taking, long-term equity-based compensation was associated with smaller losses and less risk-taking.
Financial firms also used the bonus structure more than firms in other sectors, according to the study, which looked at financial institutions in both the US and Europe.
'Policing' bonuses key
"We need to get compensation right," Patrick Pearson, head of banking at the European Commission's internal market department, told EurActiv. The EU proposal would need to make the right choices between fixed and variable compensation packages, he added.
Pearson confirmed the proposal would see bonuses tied to performance and would include a deferral to stock options. Some "key pay" would also be made public, which means either the top ten salaries in a company or the board-level salaries would be made available for public scrutiny.
'Policing' was identified as key to the success of such a regulation, and to that end, the legislative proposal would include a new layer of corporate governance in the shape of remuneration committees.
However, question marks remain over the scope of the proposal as well as which institutions will be subject to its terms. It is still unclear how the regulation will affect large holding companies.
A study from California's Marshall Business School shows a strong link between wayward bonuses and the banks that incurred the highest losses during the crisis. At Citigroup, which was bailed out in November 2008, a salary of $1.3 million annually was boosted by a $13.2 million bonus. At Deutsche Bank, a $1.7million pay check was sweetened with a $10.6 million bonus.
Banks that have come out of the crisis with fewer write-downs on average paid bonuses that matched average salary. This was the case at Barclays, which paid a bonus that was double net salary.
Bonuses did not cause the crisis
In the wake of last month's G20 summit in Pittsburgh, EU leaders prepared a joint statement on financial regulation, including bonuses, which was largely accepted in the Pittsburgh communiqué.
The G20 had been expected to touch upon a swathe of proposed regulations. However, the only two decisive agreements to emerge from the summit's talks on financial services were on increasing capital requirements at banks and curbing bonuses. The focus on bonuses has been widely criticised in the financial sector amid claims that bonuses played no part in the crisis, and politicians stand accused of using the issue to garner electoral support from an angry public.
The sticking point between Germany and France's leaders (Angela Merkel and Nicolas Sarkozy respectively) on the one side and UK Prime Minister Gordon Brown and US President Barack Obama on the other was bonus caps, with the latter arguing that this was an inflexible policy. The idea of bonus caps appears to have been dropped since the summit, but the communiqué stipulated that countries should adhere to guidelines drawn up by the economic policy arm of the G20, the Financial Stability Board.
The FSB guidelines on compensation include disclosure of pay levels, deferral and vesting periods on share-related pay, independent oversight, and clawbacks of unfairly-earned pay.
Pearson confirmed that the Commission intends to implement the FSB's guidelines in its current regulatory proposal. The Swedish EU Presidency will be seeking agreement among member states on the proposal before the end of the year, he added.
