Design and Justify an Optimal Compensation Scheme to Reward Bank CEOs
INTRODUCTION
In today’s competitive world many Banks have initiated the best negotiated compensation for their CEOs to retain the valuable employees but this is it affecting financial health of the company as well as the global economic system?
Compensation refers to wages, salaries or tips whereas Benefit emphasizes on employee needs and the overall objectives of the organization. To motivate and satisfy existing employees and attracting new employees an optimal compensation scheme plays a vital role. The compensation systems have changed from traditional ones to strategic compensation systems for key positions like CEOs, compensation paid to them is decided at higher rate since they are directly associated with company’s goal and shareholders. CEOs of the largest U.S. banks were highly paid at the time of good economic condition in 2007. A Compensation package of $250000 offered by Citigroup to its CEO (http://money.cnn.com). An effort has been made in this project to understand the current scenario of compensation provided by Banks to its CEOs and the justification of the proposed package by Govt. in India and abroad.
The following points have been discussed regarding the above mentioned topics: (1) Incentive Features and Compensation in the Banking Industry, (2) The interaction of leverage with corporate governance and managerial alignment, (3) The study of CEO compensation, (4) Difference between Financial sector and non-financial sector, (5) View of RBI in India, and (6) Conclusions.
INCENTIVE FEATURES AND COMPENSATION IN THE BANKING INDUSTRY
The corporate governance in general and top management compensation in particular, has received enormous attention in recent years. Although an increasing literature has found various aspects of the corporate governance of manufacturing firms in the United States and abroad, the corporate governance of banks and financial institutions has received relatively less focus. Alignment of the incentives of top management with the interests of shareholders has been characterized as an important aspects of corporate governance (John et al., 2009).
Managerial ownership of equity and options in the firm, as well as other incentive features in CEO’s compensation structures (such as performance-related bonuses and performance-contingent promotions and dismissals), serves to align managerial incentives with shareholder interests. In fact, there is a large theoretical and empirical literature on the role of incentive contracts in solving agency problems.
For example, supervision plays a major role in monitoring the activities of the banks and ensures that the banks comply with the regulatory requirements. Regulation and corporate governance go hand in hand. If structured well, ensure smooth functioning of corporate governance in banks. An effective incentive structure in banks will enable the top management levels to take steps to ensure effective compliance with the regulations (John and Qian, 2003).
For example, if the top level officers are assured of equity interests in banks, they might even get motivated to undertake high-risk investments like heavy loans or real estate investments even if they involve a huge amount of risk. Banks as compared to other industries play a significant role in the economy, accompanied with an attractive remuneration package with higher perks. They offer comparatively more lucrative jobs as any other sector (John and Qian, 2003).
THE INTERACTION OF LEVERAGE WITH CORPORATE GOVERNANCE AND MANAGERIAL ALIGNMENT
In a bank, the management compensation structures have been examined through data from 1992 to 2000. Based on these findings, one comes to a conclusion that the firms have also caught up pace with the idea of regulated compensation packages accompanied with some very high incentives and a decreasing debt ratio and firm size. The same rule should be followed with the regulated firms and other regulated utilities so that the debt ratio and pay-performance sensitivity can be compared in case of banks, manufacturing firms and regulated utilities. It can be concluded from these tests that banks are highly regulated and organized as compared to the manufacturing firms.
The so-analysed relationship indicates that banks should have lower pay-performance sensitivity than manufacturing firms. The empirical evidence found is also in agreement with these assumptions. The study made by Barro and Barro (1990) was one of the earliest empirical evidence on bank –management compensation. It has been found that CEO’s compensation is performance based and can be calculated on the basis of stock returns and yields. Houston and James (1995) wrote that as a bank CEO gets less cash remuneration, is less likely to participate in stock option plans. As a result, they hold fewer stock shares and get minimum stock returns as compared to the CEOs of other industries. Ang, Lauterbach and Schreiber (2000) have studied the compensation structures of top-management levels in 166 U.S. banks from 1993 to 1996. They highlight the fact that the salary package (with perks), of CEOs is higher than the other top-level managers.
The idea here is to compare the pay-performance sensitivity of the firms with the pay performance sensitivity in banks.
The theory of pay-performance sensitivity of CEO compensation depends upon the capital structure of the firm, firm size and risk factor. John and John (1993) comment that firm’s debt ratio determines the magnitude of incentives for the top-management. When a debt is outstanding, CEO is allowed incentives for risk-shift on behalf of equity holders, which means that higher the pay performance sensitivity, higher the risk-shifting incentives.
Compensation with low pay-performance sensitivity acts as a device for minimizing the costs of debt. A high compensation structure at the managerial level in large firms indicate a low pay-performance sensitivity and restricts the risk-shifting incentives also, thereby, reducing the debt ratio of the firm. As banks have very high debt ratios as compare to the manufacturing firms, pay-performance sensitivity in banks is also lower than in the manufacturing firms. John, Saunders, and Senbet (2000) support this argument and suggest that bank regulation and pricing of FDIC insurance premiums should also entail the incentives at the top-level management.
These arguments give rise to the following testable assumptions (John et al., 2000):
- The pay-performance sensitivity of a firm should be a decreasing function of its debt ratio.
- Given their high debt ratios, banks should have a lower pay-performance sensitivity than manufacturing firms.
Researchers have also said that pay-performance sensitivity should be inversely related to firm size and firm risk.
For example, Jensen and Murphy (1990) argue that political influence might lead to smaller pay-performance sensitivity in large firms. Schaefer (1998) presents a model and offers empirical evidence that pay-performance sensitivity declines with firm size. The commercial banks in our sample are, on average, larger than the manufacturing firms, implying lower pay-performance sensitivity for banks. The optimal performance-related compensation component (pay-performance sensitivity) for risk-averse managers should be inversely related to firm risk.
Under this argument it is assumed that the effectiveness of a manager’s effort is independent of firm risk. If managerial effort is more effective in riskier firms, then the above result may be overturned and a negative relationship between pay-performance sensitivity and firm risk may not obtain.
In addition, the pay-performance sensitivity of the compensation structure in banks could be lower than it is in manufacturing firms because banks are regulated institutions and regulation could be a substitute for monitoring and incentivizing managers. Chidambaran and John (2000) argue that pay-performance sensitivity in opaque firms should be larger than it is in transparent ones.
In transparent firms, monitoring is cost effective, while in opaque firms, monitoring is prohibitively costly and alignment of managerial incentives through high pay performance sensitivity is more reliable. One can argue that many aspects of the business of banks are more transparent than those of many manufacturing firms, say, high-tech firms. Large banks are typically followed by a large number of analysts, which may also give rise to a relatively higher degree of transparency, implying lower pay-performance sensitivity in banks.
THE STUDY OF CEO COMPENSATION
The first measure, referred to as direct compensation described below (1) and (2), is the sum of salary, bonus, other cash compensation, option grants, and grants of restricted stock. The second is a broad measure of the CEO’s changes in wealth from all sources related to his firm.
This measure is referred to Two Compensation Measures:
(1) Direct Compensation (a) Salary; (b) Bonus; (c) Other cash compensation; (d) Option grants; (e) Restricted stock grants
(2) Firm-Related Wealth Change (a) Salary; (b) Bonus; (c) Other cash compensation; (d) Value change of option holdings; (e) Value change of restricted stocks; (f) Profits from exercising options; and (g) Value change of direct equity holding
As firm-related wealth change and described as (2). It is the sum of salary, bonus, other cash compensation, change in value of option holdings, change in value of restricted stocks, profits from exercising options, and change in value of direct equity holdings.
Two issues merit further discussion. First, we use the value change of in-the-money options to approximate the value change of total option holdings. We do so because the value of the existing options is reported only for those options that are currently in the money.
Second, we include the value change of direct equity holdings in the second measure of compensation. There are debates in the literature over whether to include this component as part of compensation. Some researchers argue that it should not be included because equity holdings can be viewed as an investment decision. However, there are restrictions on insider stock sales. In addition, insider sales are costly because of the negative market reaction. Moreover, regardless of its name, the value change of direct equity holdings will certainly affect the CEO’s wealth and hence his incentives.
Therefore, we include it in our most comprehensive measure of compensation: the CEO’s firm-related wealth change.
DIFFERENCE BETWEEN FINANCIAL SECTOR AND NONFINANCIAL SECTOR
Banks Versus Manufacturing Industry
If we compare the pay-performance sensitivity of CEO compensation structures in banks with that of manufacturing firms, we can examine the possible sources of differences in pay-performance sensitivity between the two groups.
We obtain a sample of 5,659 CEO-years from 1992 to 2000 for 997 manufacturing firms (defined as firms with SIC codes 2000 to 3999).
When researcher considers the change related to organizational wealth sensitivity of pay performance is higher in manufacturing industry than it is in banks, with or without the inclusion of 1999. However, when it comes to direct compensation, sensitivity in manufacturing firms is higher than it is in banks when 1999 is included, but lower when 1999 is excluded.
VIEW OF RBI IN INDIA
The move of Reserve Bank of India (RBI) to restructure salary with business performance for private sector banks’ CEOs is likely to be declared next month. The expected time when draft paper will be out could be by March 2012 with an aim to create an outline to describe how banks should pay compensation to its CEO and other top executives (www.financialexpress.com).
RBI governor D Subbarao told that the Central Bank is concentrating to come out with a plan as mentioned in Financial Stability Board for a healthy compensation, in midterm policy review he also indicated that these policies will ensure reasonably good compensation structure of private and foreign banks. It was pointed out by the Governor that compensation practices by leading financial institutions could have been one of the factors which lead to global financial crisis. The governor had highlighted compensation practices, especially those of bigger financial institutions, as one of the factors that contributed to the recent global financial crisis (www.financialexpress.com).
The leaders from the world commented in G-20 meet held in the previous year issue on the high compensation packages of top bank CEOs, As per the leaders point of view this is a negative sign which may hinder to make our financial system healthy. For the purpose of lining up, G-20 leaders asked the central banks to design compensation policies and also in order to get long term benefit. Every country has to represent its own rule. The experts from different parts of the world commented that Bonus to be paid to the CEOs as per their performance and contribution made by them individually, even the agreement of G-20 summit also expressed its reluctances of Bonus guarantees extending more that an year (www.financialexpress.com).
“The intension of RBI is to reduce the remuneration of CEOs and other Top level managers in private and foreign banks to justify the compensation to keep the firm’s financial health sound and also the economic system. As per the existing system the approval of salaries of the top executives in private and foreign banks is done by central bank along with the decisions of the board from respective banks, when salary proposal comes. RBI gave instances of minimum three private sector banks and observed that the compensation packages provided by them are not as per the market standards (http://www.financialexpress.com).
The strategies would be implemented from 2012-13.
“Since, till then Multi National Banks and Private sector banks in India need to get regulatory approval for grant of compensation and benefit to full time Directors or CEOs in terms of Section 35B of the Banking Regulation Act, 1949,” RBI said in a notification.” “The Financial Stability Board (FSB) Principles to be complied with when compensation policies and practices are in the process of approval and will also require a thorough evaluation.” It remarked (http://zeenews.india.com).
CONCLUSION
It can be concluded that like Fortune 500 firms made a salary disbursement to its CEOs which is 42 times the average worker’s pay during 1980, clearly means 364 times more than the average. The study of Berkeley economist Emmanuel Saez at University of California revealed that the top 1% of tax payer took three-fourths of all income growth during most recent expansion from 2002 to 2006. He also commented that it was an outcome of “an explosion of high salary and wages” (http://www.inthesetimes.com). An optimum compensation package designed for those who have high degree of responsibilities like CEOs not only increases the interest of CEO with its shareholders but also indicates a benefit plan to other shareholders for which top management made risks.
Commercial banks have an exclusive image for its depositors and claim holders having elite class. More risk in debt would make bank’s capital more costly to the depositor. Pay-performance sensitivity should decrease in debt ratio and in firm size for highly leveraged and regulated firms like banks which are bigger than manufacturing firms, this is what existing theory says. The industry norms of paying fixed salary at reasonable rate while considering other factors to be followed by bank also. Any compensation policy for CEO to be made after considering the fixed pay and variable pay. Proper balance between fixed pay and variable pay must be ensured i.e. variable pay should not exceed 70% of fixed pay in a year to justify the package.
REFERENCES
Ang, J., Lauterbach, B. and Schreiber, B. (2000), “Pay at the Executive Suite: How Do U.S. Banks Compensate Their Top Management Teams?” paper, Florida State University.
Barro, J., and Barro, R. (1990), “Pay, Performance, and Turnover of Bank CEOs”, Journal of Labor Economics 8, no. 4, pp.448-81.
Chidambaran, N. K., and John, K. (2000), “Managerial Compensation, Voluntary Disclosure, and Large Shareholder Monitoring.” Paper, New York University.
Houston, J., and James, C. (1995),“CEO Compensation and Bank Risk: Is Compensation in Banking Structured to Promote Risk Taking?” Journal of Monetary Economics 36: 405-31.
Jensen, M., and Murphy, K. J. (1990), “Performance Pay and Top Management Incentives”, Journal of Political Economy, 98, pp.225-64.
John, K. and Qian, Y. (2003), “Incentive Features in CEO Compensation in the Banking Industry”, FRBNY Economic Policy Review, April, pp.109-121.
John, K., Mehran, H. and Qian, Y. (2009), “Outside Monitoring and CEO Compensation in the Banking Industry” Journal of Corporate Finance, December, pp.1-42.
John, K., Saunders, A. and Senbet, L. (2000), “A Theory of Bank Regulation and Management Compensation.” Review of Financial Studies 13, 1, pp.95-125.
John, T. A., and John, K. (1993), “Top-Management Compensation and Capital Structure.” Journal of Finance, 48, no. 3: 949-74.
Schaefer, S. (1998), “The Dependence of the Pay-Performance Sensitivity on the Size of the Firm”, Review of Economics and Statistics, 80, pp.436-43.
Web sources
“Give CEO Pay the Pink Slip — In These Times”. [Online] accessed on 17th Jul., 2015 from www.inthesetimes.com/article/4306/give_ceo_pay_the_pink_slip
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