The 2007-2008 banking crash ushered in an era of austerity and pay freezes, but bank executives have continued to enjoy disproportionate rewards even though their institutions have been bailed out by taxpayers.
With a general election on the horizon, the UK government had to be seen to be adopting populist policies, and the response has been a consultation paper by the Bank of England on checking executive remuneration in the financial sector. The key populist proposal is that the payment of bonuses should be deferred for three to five years as a way of aligning risks, incentives and outcomes. The other half of the proposal is that in the event of misconduct the firm, with the help of regulators, should be able to clawback the bonus during another five to seven years after the payment.
The press coverage has been positive, but the proposals raise a number of questions. The finance industry been involved in scandals such as frauds on mortgages, pensions, precipice bonds, payment protection insurance, interest rates, tax avoidance/evasion and money laundering. Despite mounting evidence, there have been no prosecutions. Perhaps, the government would seek to deprive key executives of the gains made from predatory practices. But that will not happen either because the rules for clawback will only apply to bonuses awarded from January 2015.
The proposed rules are not an attempt to check the massive remuneration packages paid to bank executives. They only seek to claw back some portion of the previously declared bonus for misconduct. Once again the regulators have assumed that shareholders will check fat-cattery, something they have shown no interest in doing. The Parliamentary Commission on Banking Standards concluded that “shareholders failed to control risk-taking in banks, and indeed were criticising some for excessive conservatism”. It is difficult to see how they can shackle executives.
The clawbacks are supposed to be triggered by misconduct, but how will regulators become aware of misconduct? Bank executives are not in the habit of owning up to misdeeds, especially when it could hit them financially. All major banks have audit committees and ethics committees, but none informed the public about any of the predatory practices. In the period leading to the crash, external auditors gave a clean bill of health to all distressed institutions even though depositors were queueing outside some banks to rescue their savings. Audit fees depend on appeasing directors, of course. Unsurprisingly some accounting firms colluded with banks to enable them to massage their accounts.
The UK regulators also have a poor record. For example, following revelations of fraud the Bank of Credit and Commerce International (BCCI) was closed in July 1991, but to this day there has not been an investigation. The Bank of England went out of its way to conceal the identity of wrongdoers and it took five and half years of litigation to secure some of the names. In short, there is no clear mechanism for identifying misconduct.
Any allegations of misconduct will be contested. Investigations and protracted litigation could last for years. The arbitrary limit of seven years for clawback means that some will escape retribution. Why is there a need for a time limit?
These malpractices are the outcome of incessant market pressures on banks and other corporations to report higher earnings and meet profit forecasts. Executives have economic incentives to bend the rules as their remuneration is linked to profits. In western culture, the worth of a person is frequently judged by accumulation of material wealth and financial rewards. Such pressures will not be abated by the proposals for clawback. The finance industry will inevitably arbitrage the proposed rules with creative schemes. For example, executives could receive higher fixed pay and little in bonuses, thus reducing the amounts which are vulnerable to clawback. The consultation paper does not pay any attention to structural pressures for misconduct or the creative games which will surely be enacted.
The idea of clawing back financial rewards for failure is a sound one, but the Bank of England proposals are unlikely to work without a major reform of the system of corporate governance. For example, to ensure that financial regulators can’t bury the bad news, they should be supervised by a Board of Stakeholders representing a wide range of interests. All executive remuneration contracts should be publicly available. Employees, savers and borrowers have a long-term interest in the sustainability of banks and should elect directors and vote on executive pay and bonuses.
They are unlikely to sanction big remuneration packages when they are getting a poor deal on savings, borrowing and wages. In the era of globalisation and easy movement of money, regulators need real-time information about any misconduct. This would require real-time monitoring of financial transactions and possibly placing monitors at all material bank branches. However, the consultation paper pays little attention to any of the governance issues.