Andrew Haldane, an executive director of the Bank of England and member of the Financial Policy Committee, argued in a speech on 14 April 2012 that banks bonuses to be restructured to reflect the reality of the underlying risk cycle:
Races in financial sector pay can…be tackled, albeit indirectly, by placing restrictions on leverage and by avoiding linking remuneration to return on equity targets. Restrictions on cash distributions by banks to shareholders and staff can also help. This has been a favoured recommendation of the FPC over the past six months, as a means of bolstering UK banks’ capital defences against risks in the euro-area. In response, there is some evidence of UK banks having modestly reduced cash distributions to staff in 2011.
A more direct approach to tackling pay races would be to set remuneration codes. This can be justified as a regulatory means of leaning against excessive risk-taking incentives – incentives which might be fanned by remunerating in equity. These have already been developed by the Financial Stability Board internationally and by the FSA in the UK. They specify, for example, maximum ratios of cash distribution and minimum periods of pay deferral. Yet whether these codes go far enough in aligning pay and performance, in equating risk and return, is an open question.
For example, consider the issue of pay horizons. Bonuses are typically set on an annual cycle, with deferral or claw-back for maybe three or four years if guidelines are followed. But this return cycle is materially shorter than the typical risk cycle. The risk cycle might last perhaps 20 years. This duration mismatch means it is more likely than not that risk and reward may get out of kilter in the financial sector. The current environment is evidence of such a mismatch: while bank performance has fallen off a cliff, executive pay remains close to pre-crisis Himalayan heights.
Lengthening deferral or claw-back periods, say to 10 years or more on an internationally co-ordinated basis, would help close this gap in horizons, between risk and return. It would elongate the period of liability bank managers face when they take on risk. This would better align firm-level risk-taking incentives with the societal optimum. Avoiding relative benchmarks in the setting of remuneration would also reduce the risk of an upwards-only pay escalator.
There is scope, too, for a reconsideration of the instruments used for remuneration. The focus to date has been on non-cash distributions, often in equity. But paying in equity appears in some pre-crisis cases to have exacerbated risk-taking incentives, acting as a disincentive to raising new equity and encouraging gambles for resurrection. Remunerating in long-maturity debt, or contingent capital instruments, may do a better job of aligning risk-taking incentives with the public good than either cash or equity