Banking
CASE STUDY: REMUNERATION IN THE BANKING SECTOR
10th in a series
Conclusion
Eurosif wishes to acknowledge the support and direction provided by the Bank Sector Report Steering Committee: Bank Sarasin Domini Social Investments Fundación Ecología y Desarollo (ECODES) IDEAM Living Planet Fund Management Company S.A. Oddo Securities Pictet Asset Management Triodos Bank This sector report has been compiled by :
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September 2009
shown in Chart 2, banks have been significantly impacted by the crisis; in some cases, losses have approached their required Tier 1 capital levels. Thus, world and EU leaders utilised the G20 summits to push for tighter rules. Nevertheless, should the current regulation efforts fail to shift banks' models towards an approach favouring stable economic growth, the ultimate threat is a Glass-Steagall1 type of reform. Bank performances should now be primarily assessed in relation to risk profiles and be more focused on the long term. ●
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to charge the right price for credit. Using lending for client acquisitions distorts a key function of commercial banking, as price cannot guide capital allocation. The apparent aggregation of commercial and investment banking allows for crosssubsidisation between lending and needs to be reassessed. ●
Investment Banks. Investment banks are highly sensitive to market cycles and volatility. (Human) capital, funding and liquidity are the key features embedded in a structured risk management model. This industry will be the most profoundly affected by a tighter regulatory environment, and this will lead to lower leverage and ultimately higher capital charges, which will structurally lower return on equity levels.
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Wealth Management. This model could change, with two drivers
Retail Banks. The crisis has increased concentration and market
strength for retail banks, which are highly exposed to economic cycles. However, the crisis context has also led to reduced pressure from the European Commission's (EC) antitrust rules and consumer protection laws. Players such as telecom companies, media groups and retailers are showing renewed interest in providing financial services. Chart 1: Top 20 European Banks - Market cap vs total assets (2008) 140 000
Commercial Banks. A key issue is the ability of commercial banks
being introduced: 1) segregation between asset managers (AM) and networks; and 2) the separation of passive and active AM, which should help clients select the right product at the right price. Chart 2: Cost of the Crisis
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Total Assets ( m) 2008
Particularly bonuses paid to traders who are able to take on significant risks. The proposed revision of IAS 39 would also allow bonus pools paid to traders to be triggered only if the trade was priced at market value as this would ensure that the P&L was eligible for immediate bonus payments.
Stronger financial regulation is high on the world agenda. As
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The UK government has requested that the bulk of the bonus pool (GBP950m) paid to executives at RBS in 2008 be in the form of subordinated debt rather than capital and that this should be staggered over three years with a 100% claw-back provision.
BANKING TRENDS
Market Cap. ( m)
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Four major bank business profiles have been identified: - Retail Banks (RB) refer to banking institutions that handle transactions directly with consumers, rather than with corporations or other banks. This is a very mature business in Europe, and contributes to over 50% of European banks’
profits. Key drivers in this sector are loyalty and mobility. - Commercial Banks (CB) carry out traditional corporate lending activities and credit facilitation through a wide range of products. This is a competitive business segment that is highly exposed to economic cycles where access to capital and geographical representation are key issues. - Investment Banks (IB) carry out all financial market-related activities notably trading in securities, managing corporate mergers and acquisitions, originating, underwriting and syndicating both equity and debt, and insuring bonds (e.g. selling credit default swaps). - Wealth Management (WM) is an investment advisory discipline that incorporates financial planning, investment portfolio management and a number of aggregated financial services.
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Credit Suisse's (CS) plan does not include a malus/bonus system but uses debt rather than capital to remunerate employees. Under CS's scheme, employees of the Investment Banking business will receive the majority of their deferred bonuses in the form of partner asset facility awards (PAF). The PAF awards are indexed to a specified pool of illiquid assets based on the most illiquid loans and bonds on Credit Suisse's balance sheet. PAF holders will realise potential gains if assets in the pool are liquidated at prices above the initial fair market value. However, PAF holders cannot receive any payments for at least five years after the awards are granted, at which point participants will receive an annual cash payment.
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However, despite the new momentum, a consensus on limiting bonuses may not be achievable and it is possible that the most viable solution may come via tougher controls on capital requirements and a formal consensus on requiring bonuses to be based on long-term performance. This would allow national regulators to use Basel II to require financial institutions that continue to operate inappropriate remuneration policies that encourage unnecessary risk to set aside additional capital. The linking of risky remuneration practices to increased capital requirements would be a direct incentive for boards to implement long-term-oriented and sensible remuneration polices. However, defining relative risk tolerance levels will remain a key challenge.
The European Banking sector consists of 6,600 banks, with total assets of more than €23 trillion. The top 300 listed banks represent nearly 80% of the sector and account for about 15% of the major European index benchmarks. Banks directly account for about 5% of European GDP, their indirect impact is 50% and they are a key contributor to employment, growth and stability across the European Union. Chart 1 reflects their importance to the economy by showing the market capitalisation and total assets for the top 20 European banks.
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Remuneration Example – Credit Suisse
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Both President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany have publically stated their view that unlimited bonuses contributed to the excessive risk taking by banks and there is now growing impetus for greater international coordination to establish a common consensus on how bonuses are paid. The G20 summit in Pittsburgh in September 2009 thus offers an opportunity for France and Germany to convince the world's largest economies that mandatory bonus limits are needed to prevent the continuation of excessive risk taking by banks.7
his Eurosif sector report has been compiled using research by CA Cheuvreux. It describes the major environmental, social and governance (ESG) challenges facing the European banking industry and the associated risks and opportunities these pose for long-term returns.
BANKING OVERVIEW
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UBS's new model tackles head-on the primary issue for any reform of bank's remuneration policies, namely the payment of bonuses based on performance that is neither transparent nor sustainable over the long term. The new plan introduces a bonus/malus system under which a maximum of one-third of the bonus can be paid out in cash at year-end, subject to positive business development. The remainder will be held for five years in escrow in a bonus account. Should UBS's subsequent performance be poor, a negative award, or "malus", can result and the bonus account will decline, reducing any subsequent awards paid out.
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Remuneration Example - UBS
In our view, both shareholders and regulators should welcome the Credit Suisse plan, as it potentially removes risky assets from the balance sheet and preserves capital, while introducing this risk directly into executive pay over the long term. Furthermore, long-term participants have the opportunity to gain some upside in the event that the toxic assets6 return to value. Both the UBS and Credit Suisse remuneration structures have raised the bar in terms of challenging remuneration committees to meet the needs and objectives of shareholders and regulators. However, while we welcome these two remuneration plans, we are concerned by the potential lack of incentives for independent banks to adopt similar policies.
Designer: Catsaï - www.catsai.net / The views in this document do not necessarily represent the views of all Eurosif member affiliates. This publication should not be taken as financial advice or seen as an endorsement of any particular company, organisation or individual.
The financial crisis exposed the inherent weaknesses of the remuneration system used by banks. This system rewarded executives for behaviour that encouraged excessive risk-taking in order to earn bonuses that were dependent on an assessment of short-term performance which failed to account for long term risks. However, given the EU's failure to adopt a coordinated approach to the issue of remuneration, the best path to reform may in fact be market-based, with shareholder and government involvement where necessary. In our view, UBS and Credit Suisse's recent implementation of remuneration policies designed to encourage long-term performance supports this argument.
Market Cap.
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Glass-Steagall act was a 1933 United States national law separating investment banking and commercial banking firms.4/5 http://www.marisec.org/shippingfacts/worldtrade/