Lessons from Europe banking bashing

By Simon Ferry

Since the start of the financial crisis, bankers and the financial industry have come in for considerable criticism from the public and press in many developed countries around the world.

The basis of this may perhaps be understandable. Loans were given freely to those who could only just afford repayments if times continued to be good. These loans were pooled together and passed on as a form of investment product and when the U.S. housing market bubble burst, the whole house of cards came tumbling down. We all know the story from there, with significant economic downturns in many developed markets and governments forced to inject massive sums of tax payers’ money to support institutions either directly through taking equity stakes.

Even countries not directly affected by the initial crisis have seen the impact through lower economic growth. This has resulted from the drop in demand in Europe and the U.S. as governments, companies and individuals have all tightened their belts and cut back on spending to weather the economic storm. Korea certainly saw this impact given it’s heavily export-based economy.

Much of the public backlash from the financial crisis has been focused of late on a perception that trading conducted within many large financial institutions is equivalent to not much more than gambling. There have certainly been several high profile cases of so-called “rouge traders” — individuals who have taken on trades of such scale and level of risk that they have caused significant losses for their employers. Such cases have helped perpetuate an image which has become political capital in Europe allowing for potentially easy vote winning policies of attacking bankers.

There have been many developments in corporate risk management over recent years, especially in the financial industry. These often arise from past crises, such as improving the way decisions are made within companies, increasing independence of auditors and increasing transparency for shareholders. For example, the Sarbanes-Oxley legislation in the U.S. was introduced in 2002, partly as a result of the Enron accounting scandal. More recently there have been developments in capital requirements for financial institutions i.e. the amount and type of assets they are required to hold to reduce the risk of insolvency in the course of normal business practice and all but the most extreme financial conditions. These continue to develop as a result of the 2007/08 financial crisis, with a new set of standards, Basel III, being developed in 2010-11 and due to be implemented by G20 countries over the coming years.

One of the most recent developments in the ongoing saga is that the European Union also very recently agreed to impose a limit on bonuses of bankers equivalent to their base pay, or twice base pay if shareholders vote to do so.

However, this may well just be self-defeatist for the EU and be missing the fundamental point. There have been many observations about banks changing their pay-mix to reflect these limits, but increasing base pay.

I’ve also seen commentaries on the potential implications of bankers flocking to Hong Kong or New York, so I’ll not go dwell on these aspects here. What seems to be missing is a realization that it’s not actually the amount of bonus bankers are potentially paid which is a problem — the problem is more with how bonuses are constructed in some financial institutions.

Any form of well designed bonus or long term incentive, such as stock options, should be based on meeting a balanced set of individual, team and company objectives. This should be well aligned with the company’s strategic objectives, which are not just about short term revenue or profit, but also reflect the company’s risk management policy. After all, no major company would willingly want to run their business in a way that has a significant risk of going bust over a reasonable timeline. Ultimately, company directors and managers are accountable to their shareholders. Shareholders who will want a clear understanding of the potential level of risk they are carrying by investing in the company’s stock.

Nature of investing that there will be losses at some point - it’s inevitable, but a large, stable company should be able to absorb these losses over the near term without going bankrupt in all but the most extreme cases.

So how about Korea? What relevance does the way bankers are compensated in Europe have here? Many Korean companies have been changing the way they reward employees, introducing increasing elements of performance related bonuses. As this trend continues, all companies should take care to note the impact on behavior that performance related bonuses can have. Bonuses are a great way to motivate people and reward those who have contributed the most to a company’s success. However, if bonuses are based on a very narrow definition of performance, then people will naturally focus on the few areas which will maximize their own bonus. Taking a more holistic view and reflecting a more balanced range of objectives which are well aligned to the company’s goals should be critical for any bonus to be an effective tool to drive company growth in a sustainable way.