Sunday, 4 September 2011

Balancing base and variable pay - Banking Vs other industries

Variable pay is broadly intended as a cash supplement paid in one or more lump sums by an employer to its employees, in addition to base pay, to recognise their superior, sustained contribution to the achievement of the organizational aim and objectives, that is to say to the pursuance of its strategy.


Variable pay, which in contrast to base pay “needs to be re-earned” to be repeated, is habitually part of more complex reward packages, which are introduced and developed by employers according to a specific reward philosophy to induce their employees to perform at the required standard and exhibit the desired behaviour.

The question is whether this approach to reward management has been invariably used by employers in all of the existing industries and sectors and, more in particular, whether it has been traditionally adopted by the financial sector organizations. It can be maintained that to both questions the answer is: arguably no.

From the reward point of view we have basically witnessed two different approaches with the passage of time: one adopted by the financial sector institutions and the other one essentially embraced by all of the other industries.


Over the years and across the world, banks and financial institutions have not habitually showed to be particularly concerned with the design and development of sophisticated and craftily devised total reward models, cafeteria-benefits schemes or other similar programmes. On the other hand, traders and bank executives have hardly ever been expected to be offered by their employer neither the opportunity to choose amongst a variety of possible benefits which to pick nor prospects for career, development, involvement and growth. This particular type of professionals has invariably been interested only in one kind of reward, to wit: financial reward and more specifically bonuses.


It could be argued that this conclusion is wrong in that traders are actually interested in both basic pay and bonuses, but this really seems not to be the case according to what has been, relatively recently, claimed by a former senior HR Professional at an investment bank in London, who recounted that the bank he was working for employed individuals receiving bonuses worth £5 million on a quarterly basis, whereas their basic salary was of £100K/£150K a year. In one occasion, by reason of a problem occurred with the bank’s payroll system, some of them did not actually receive their pay for six consecutive months, but none of them did even realize that. In fact, it was the HR department which later found it out and informed the individuals concerned (Smedley, 2011).

Whether we consider that traders are actually used to earn bonuses which are much higher than their base salary, this circumstance should not actually come as a surprise. During a hearing with the Treasury Selected Committee, for instance, a UBS Executive told that the bank was used to reward senior investment bankers with bonuses whose value was between five and ten times their basic pay. UBS did not really represent an exception in that this practice was absolutely in line with the industry standard.

Reward professionals working in other industries may wonder about the appropriateness of the financial institutions reward strategies and philosophies. These should be indeed designed and developed to enable organizations to attain their overall business strategy, encourage a specific behaviour and foster the company core values and beliefs. How could hence such type of reward strategy be developed and executed by HR?


Clearly based on bonuses, this type of reward strategy was indeed sorely consistent with banks strategy and values, and encouraging the behaviour these actually intended to foster and endorse.

The anonymous former senior HR professional mentioned above claimed that the individuals in the bank he was working for were assessed according to the immediate profits these were able to generate. The organization’s culture was clearly essentially and exclusively inspired by reward, or to be precise by financial reward (Smedley, 2011). Traders were encouraged to attain just one aim: make as much money as they could insofar as overlooking the risks associated with their delicate activity. The case of French trader Jérôme Kerviel, former employee of Société Générale, represents just one of the most glaring examples of that.

The system was, to put it mildly, really murky. Traders were encouraged to make the most money they could, receiving a lot of cash when they were successful. After all, even though banks were paying large sums of money in bonuses these were calculated and paid as a percentage of what traders had brought to their institution. It was not a problem hence for banks paying such huge bonuses; at least as long as the system was flowing without any major inconvenience.

The flip side of the system was that, for uncanny it might appear to be, in the event traders were not bringing in money for the bank and were rather losing it noting would have happened. The sooner traders were making money for the bank, the sooner they would have had their bonuses paid; in case of good performance they received very large sums of money, otherwise it would have occurred nothing.


Since the riskier a financial transaction is, the larger the profit it can potentially generate, traders were encouraged to take more than their fair share of risk in order to make staggering profits. All of that rigorously in the short run in order not only to earn a lot of money, but also to do it quickly. Once again, former Société Générale trader Jérôme Kerviel is a striking example of what a single person could be able to do, but also an amazing example of how true is that at superior level nobody was able to comprehend the transactions traders were performing on the bank behalf; never mind to assess the risk, which was never subject to appropriate control.


As suggested by the Independent Commission on Banking, reported profits on the basis of which traders were paid were clearly neither risk- nor time-adjusted. The reference to the inappropriateness of the timing refers here to the emerged lack of consistency between the overall bonus system mechanism and the banks long-term interest. The system was essentially designed to “encourage excessive-risk taking” (Stiglitz, 2011) or even gambling.


Could have HR and reward specialists helped to avoid the impending disaster caused by excessive bonus payment? Either we consider bonuses as a contributory factor to the global financial crisis or, as claimed by Cotton, as a “symptom rather than a cause”, we could agree with Williams (2011) which it is very likely that HR could have done little or nothing to avert the disaster. Trying to persuade banks boards to change their bonus payment system could have been tantamount to pure madness. When in 2008 RBS (now state run) changed its bonus system, shifting from cash bonus to fully deferred bonus, it experienced a brain drain phenomenon causing attrition to double and attaining after an 18-month period the average rate of approximately 16 percent.

Smedley (2011) suggests that the real point was that nobody was considering the risk associated with “high-value reward for short-term risk-taking”, the problem was hence caused by the way the system was operated and banks used to generate profit.

Wright (2011) contends that the major risk was not associated with the payment of bonuses for transactions made in the short run, but rather with the circumstance that bonuses were paid before the final outcome of the transaction was known. Deferred bonuses actually existed already, but banks did not have recourse to this bonus payment method in that they would have otherwise immediately lost their talents. What it would actually happen whether Real Madrid, Arsenal or Inter Milan should propose their soccer players a £200K salary a year? Lured by the staggering pay offered by Barcelona, Chelsea and Milan, players would immediately change employer and thus team.


The anonymous former senior HR professional claims that as long as traders were enabling the bank to collect large sums of money, these could do whatever they wanted. Nobody, for instance, dared to dismiss a manager, who had received several final written warnings on his personal record, as this alone accounted for the 10 percent of the bank profit.


After the financial crisis burst, the way banks and financial institutions were paying bonuses to bankers publicly emerged and once everybody was acquainted with the issue, as expectable, regulators come to play.


In the UK, the Companies Act 2006 included already specific rules concerning the disclosure of the reward packages received by the banks and financial institutions boardrooms members, but bankers and senior executives’ pay was not included in the provisions. The UK Financial Services Authority Remuneration Code and the European Capital Requirement Directive III (CRD III) were subsequently promulgated and some significant restraints introduced. More in particular, the FSA Remuneration Code introduced some rules prescribing that:

- No less than half the amount of the agreed bonuses should be paid by employers in the organization’s shares or in other equivalent non-cash means;

- At least 40 percent of the incentives paid to “code staff”, that is to say senior managers, risk takers, staff in charge of control functions and other staff receiving a remuneration package at senior management level, had to be paid over a period of at least three years;

- For the individuals whom receive an annual pay higher than £500K this ratio (40 percent) of variable pay or incentives had to be raised to 60 percent;

- Firms could no longer offer guaranteed or retention bonuses of more than a year.


The EU CRD III directive went indeed further afield ruling that, in their annual report, organizations need to provide:

- Information about the way remunerations are decided and reward systems developed;

- Explanation of the link established between pay and performance;

- Elucidation of the reasons and underlying principles for the employer deciding to have recourse to variable pay;

- Thorough details of the senior managers and risk-takers remuneration.

In order to avert the risk typically associated with traders’ activity, banks are now reinforcing their risk control systems and developing some KPIs enabling them to assess individual performance in a systematic way, taking account of risk exposure. Whether proposed by the HR function, such measures would have been tantamount to HR bureaucracy and would have been definitely rejected by the banks boards (Williams, 2011).

Despite it would have been virtually impossible to do it in the past, by reason of the way the overall system was operated, banks are now turning towards more traditional performance management processes and developing engagement strategies (Wright, 2011). Reward specialists are hence clearly gaining a major role within banks and financial institutions. Their role, notwithstanding, is everything but straightforward, they have to design, develop and implement practices capable to attract and retain individuals who are used to earn large amounts of money, and even quickly, no more exclusively relying on financial rewards (albeit it is likely that cash will firmly remain amongst the most appealing components of the banks total reward packages).


The EU blueprint for the CRD IV Directive, drafted with the stated intent of preventing the risk of other international financial crisis, stresses the need to introduce rules setting a bonus-to-salary ratio. The recent Greek’s crisis and the dangerous knock-on effects it may produce upon other European countries are likely to be part of the reasons behind this plan. The FSA and the other European institutions concerned could then be shortly prompted to establish mandatory rules concerned with the bonus to base pay ratio.

As claimed by Gosling (2011), whether the European Commission is back to the topic is because the conundrum is far from having being definitely addressed. Gosling (2011) claims that whether a rule imposing a bonus-to-salary ratio should be debated it will cause a “vigorous discussion” about how prescriptive it should be. There has already been a certain degree of concern in the UK for the way the FSA may amend the Remuneration Code currently in place in that the FSA is habitually imposing more stringent and cogent regulations compared to its European counterparts. The circumstance that the largest number of European banks is in London and that, as claimed by some commentators, the FSA could hence set the standard is not enough. Whatever the case, the new rules can produce the desired effects only and only whether at least all the European banks will have a common, shared regulation or different regulations substantially similar. As Nava (2011) pointed out, European countries need to have all the same rules and this objective can be attained only by means of a common regulation. Differently, it is very likely that there will be a considerable number of traders’ relocations across Europe. International extra-EU mobility invariably remains a viable option, but perhaps slightly less likely to be taken into consideration by many traders.


The CRD IV, drafted in a bid to make more unlikely or less significant the eventual governments intervention in case of other financial crises, is aimed at introducing regulations prescribing banks stricter capital requirements and better liquidity management, basically imposing banks and financial institutions to keep part of their equity capital and set a ratio of equity to risk weighted assets. The meaning of these rules is clearly that to force banks and financial institutions to keep on board some parachutes. The problem is that banks have essentially to pay for these parachutes, with the immediate consequence that these will have less cash to invest available to them. In order for banks to continue to be productive or not reduce the productivity levels to which these are used, these should attain better ROI rates. All of that, nonetheless, as aptly suggested by Wright (2011), could have the effect to increase the “temptation” to favour short-term risk investments.


To attract new and retain current talents banks could opt to increase the fixed component of their financial value proposition. Increasing traders’ base salaries, notwithstanding, would clearly impact the institutions fixed costs, which will make it in turn harder for organizations to eventually face future downturn periods. This move in fact entails that in case of a recession, in order for banks to reduce costs these will have no other option but to make employees redundant.


Balancing overall pay towards variable pay does not potentially pose the same threat; banks can also pay individuals large sums of money, but only when and whether the business performs well.

The question is whether rules and regulations can be actually capable to definitely address the problem of their own. According to the former City senior HR professional, traders will always strive for cash and very generous bonuses. These will hence constantly seek the best, that is to say more rewarding, opportunities and are unlikely to stay any longer in a bank whether there is another bank offering more generous bonuses. Traders currently do not stay with the same bank for more than 3/4 years so that changing employer for this type of professionals is considered somewhat of normal already.


According to Cotton (2011), regulations can have a limited effect in that these are invariably retrospectively drafted, in other words they tend to settle problems which have already occurred, but are unlikely to prevent the impact which unexpected new circumstances can produce. The new regulation may thus prove to be ineffective to prevent the future occurrences caused by different reasons.


In terms of reward and of how employers balance the ratio between fixed and variable pay, it can be averred that, once again, we will witness two completely different scenarios. Whilst the aftermath of the financial crisis seems to prompt banks to redress their views about the composition of their reward packages, or rather, of the ratio of fixed to variable pay, the other industries are recently doing and planning to do exactly the opposite move. In general, private sector employers, contrary to banks, are the more and more incline to contain base salary and to offer more generous variable components of financial reward to their staff according to their actual results. Used in such a way, bonuses could actually be considered fairer than they might apparently seem to be. This is also the conclusion emerged from the findings of a relatively recent investigation carried out by Farmer (2010). The study, which covers the period from 2003 to 2007, when the new regulation imposing big companies to disclose their top management remunerations had been introduced, includes the salaries of 200 UK’s big organizations such as Tesco, British Airlines, GSK, BT and WHSmith.


The findings of this investigation revealed that only 38 percent of CEO’s bonuses were received automatically, that is, without any correlation with their organizations’ actual performance. In the remaining 62 percent of the investigated cases, the CEOs received higher financial reward packages if, and only if, they had done a good job enabling the business to increase its profits or share price. By contrast, in case of the organization negative performance, CEOs underwent a salary reduction (Tobin, 2010).


Farmer’s investigation showed that when examining financial reward it is particularly important to consider its different components separately, rather than the overall compensation package. Whereas long-term share incentives aim at rewarding individual success, for instance, basic pay is not clearly habitually offered to attain the same objective (Tobin, 2010). The study also revealed that the reward packages of private sector executives are designed more properly than those of traders and senior bank executives. During the period from 2003 to 2007 these salaries have in fact increasingly aimed at rewarding long-term achievements, rather than short-term success.


Over the period investigated, the proportion of variable reward linked to long-term incentives increased from 22 percent to 28 percent. Yet, CEOs aiming at receiving higher levels of variable pay had to show their shareholders that they really deserved it by achieving better results than their industry competitors (Tobin, 2010).


Farmer could not extend his investigation to banks for a whole range of reasons; amongst these, as claimed by Farmer himself, the circumstance that a thorough and reliable investigation would have required access to senior bankers pay in addition to that of boards members. The Author also stressed the circumstance that at the moment of the study bankers bonuses were “used synonymously" with executive pay. Additionally, as discussed earlier, many bankers habitually earn much more than banks executives (Tobin, 2010).


Farmer acknowledged that the way bonuses are managed within banks is typical of the banking and financial industry only and that the same approach is not used by the employers of the other industries.


An example of an exception to the rule that CEOs earn their reward packages according to their real contribution to their organization’s success is definitely represented by the Australian BlueScope Steel case. Despite the business concluded the year 2010 posting a more than considerable $1 million loss and 1,000 jobs went lost, the steelmaker’s CEO was granted a staggering $721,000 bonus (Jacob, 2011).

The national secretary of the Australian Workers Union, Paul Howes, sharply criticised the move and Nick Xenophon, Australian Independent Senator, defined the event as a “dark day for corporate governance” and as “something particularly obscene” considering that the organization had to cut 1,000 jobs. The BlueScope Steel’s spokesperson later revealed that in the fiscal year 2011 executives’ bonuses were reduced by more than 10 percent (Jacob, 2011). This represents hence the exception which proves the rule; the organization in fact promptly reviewed its executives’ bonus system. 

Longo, R., (2011), Balancing basic and variable pay - Banking Vs other industries, HR Professionals, [online].