Executive Compensation in Investment Banks - Essay Example

"In recent years, investment banks have paid large bonuses to many of their employees. The collapse of several well-known organisations indicates that executive compensation schemes are inherently flawed, and that requirements to disclose these in the Reports & Accounts of listed companies do not provide shareholders with useful information about companies' long-term prospects." Introduction: This financial crisis, the biggest since the great depression of the 30s we are told, started early 2008 and several large organizations with big names like Bears Steins, Lehman Brothers, and AIG have collapsed. This has led to an unprecedented bail-out to companies by governments, which under normal circumstances are not eligible for such. Initially it was the investing public that was greatly affected, but as the crisis grew and the state had to intervene, it was the common man who stands out as most hurt, not only in the US, but across Europe and the world. Apart from bearing the full force of the crisis in terms of recession, unemployment, it is his money that is being used to bailout companies from the mess created for which he is in no way responsible. The media, the public and the politicians are busy naming the culprits for the crisis. The state regulators are trying hard to exonerate themselves by saying it did everything to prevent it and academicians are busy trying to analyse and suggest solutions. The analysts and executives who are being seen as the immediate malefactors are facing the media and public ire for the alleged role they played in the process. The important thing about this crisis is that it is not something that happened by a set of circumstances which developed overnight. There have been two similar occurrences, though of lesser magnitude in the last decade, the stock market bubble in the mid nineties and the crisis following the dot.com bubble burst in the earlier part of the century. At both times the reactions of the media, public and regulators have been similar, but apparently whatever remedial action taken by the regulators and the industry does not seem to have prevented the recurrence of the present crisis. Questions are still being asked on how this has happened Can these be prevented Are these inherent risks in a capitalist and market economy and therefore these are unavoidable If so, how should they be mitigated What and who is responsible for the present crisis What has been the role of the state and regulators The questions being attempted to be answered in these area are more specific namely if the executive compensation in investment banks are flawed and whether disclosures made in Reports and Accounts have given information to shareholders about long term prospects of the company to justify such high compensation and how these have affected shareholders wealth erosion in the present crisis. There is a universal agreement across academicians, industry, regulators and media that executive payments in investment banks are indeed very high. "Firms make lots of money, and use about half of it to overpay their employees."(Brown, 6) CFA UK's analysis of pay structure of employees of investment banks (Annexure A) and concedes that they are very high compared to other business sectors. Even if we concede for the moment that the remuneration and incentives paid to employees and CEOs of investment bank is disproportionate to what they really deserve, and this had a bearing on the crisis, this cannot be the reason for the crisis. Three articles have been chosen from three different sources-the media, academic research and industry association to see how much they agree with the statement. These have been taken from three different periods of time, one immediately after the previous crisis of 2002, one midway between the last two crises (2007) and one not more than a month ago after the full impact of the crisis was beginning to unfold (2008). The first one is written by Gretchen C. Morgenson et al. (2002) appeared in May 2002 in the Money and Business/ Financial section of New York Times. This was soon after Eliot L. Spitzer, the New York attorney general, released "hundreds of documents, including e-mail messages, written by Merrill Lynch analysts deriding companies whose shares they were simultaneously recommending to investors." (Morgenson et al. 2002). Scores of analysts were implicated and the wrath of the community was on the employees in the investment banking, from the analysts to the CEO and the board members, all who were alleged to have made huge money out of blatantly dishonest practices. The article is not so much about the role of analysts but the conflicting roles they are asked to play when working in the investment banking industry. The second article is a working paper of National Bureau of Economic Research, (Malmendier and Shantikumar, 2007), dating just before the recent crisis. This is a serious research academic paper which gives evidence and proof of bias by analysts in their reporting and the reasons behind it. The final article chosen is the letter written by the CEO of Financial Services Authority of UK (FSA) to all CEOs of Investment Bankers on employee remuneration policy to be followed. The Financial Services Authority (FSA) is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act 2000 and regulator of all providers of financial services in the UK. This reflects the response of the regulators to the popular sentiment of investors, share holders and public on the role of employees of investment banks. Role of the Analysts, CEO, and the board: The compensation paid to the executives, CEO and the analysts have been a subject of intense debate. Even before the crisis of 2002 occurred, people have been noting with alarm the changing role of analysts. They were becoming salesmen and saleswomen for their investment banking department, notes Morgenson. She quotes dramatically the words of a senior analyst, Mr. Abrams as saying ''Forty years ago, when I joined this business, to be an analyst was an honorable job.'' and adds her own comment "No more." The entire tone of the article seems to suggest the blame for the improbity of investment bankers rests entirely on the analysts, a cultural change that took place by which honest impartial analysts became mercenaries to the organisation they worked. However there seems to be a case to say that analysts were more led by the industry they worked and not otherwise in their actions. Very often doing otherwise was not compatible with the expectations of the organization and the management structured bonuses and incentives on how cooperative the analyst has been in getting business. Therefore there was a role conflict within the functioning of investment analysts. On one hand they were supposed to be advising investors appropriately and on the other hand play a primary role in helping bank to generate business from its corporate clients. Investment analysts are often rated by the bank on the extent to which they have been "helpful" to the bank to generate business. For his own professional advancement, as well as a requirement from his employer, the investment analysis has to have a good ranking his community. He has therefore an additional role to satisfy institutions in this rating. He cannot antagonize an institution which has a large investment in a portfolio by writing negatively about it, especially during the period when rating is done, notes Morgenson. All this affects objectivity in analyst's report and perpetuates a system of artificially propping up value of shares in the market. In order to strike the right balance, this article for the sake of completeness should logically examine everyone in the decision making process of the organisation, mainly the CEO and the board. The CEOs role in the loss sustained by shareholders and the related matter of CEO compensation has been a matter of intense debate and after the recent events. There is clamour for regulation of CEO's payments. Various countries have recognized the ineffective role played by board in reigning in companies and protecting shareholders interests and have taken steps to make functioning of board and its members more effective. In the United Kingdom, a new Combined Code for Corporate Governance has followed the Higgs Report (2003). It requires boards to 'be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties.' However the effectiveness of this seems to be questioned. " However it is noted that a board composed of more independent directors, a board composed of directors that are more independent may actually perform worse" (Kumar,Sivaramakrishnan,2008) Vickers et al. (2002) in their article in Business week note, "It would be an exaggeration to say analysts alone are to blame for Wall Street's woes. There's a much deeper problem involving everyone from credulous investors to deal-happy investment bankers and execs looking to fatten their wallets." Golding (2001, p 59) also confirms this by saying that professional investment managers were well aware of the bias involved in the recommendations and forecasts of analysts in investment banks (sell side analysts) and "no longer trust the analysts employed by the investment banks". The role of analysts in the crisis is only a small part in the chain of events, believe. And not to be entirely blamed as the article would imply. In their article Malmendier and Shanthikumar basically examine the issue "Why do security analysts issue overly positive recommendations One explanation is that analysts pick their favorite stocks and are truly too optimistic. An alternative explanation is that analysts distort recommendations to maximize trade commissions and underwriting business, particularly if affiliated with an underwriter." For this they categorise analysts into two categories, those affiliated (to investment banks) and those who are independent. They examine two aspects of analysts report, one recommendation and other forecast updates. They examine how two different sets of investors use the recommendations and forecast updates namely, small (individual) investors and large (institutional) investors. They explain how affiliated analysts strategically appear optimistic in recommendation, but abstain from doing so in forecasts; while the unaffiliated are consistent when optimistic about recommendation and forecasts. The paper shows how affiliated analysts, knowing how different investors react to recommendations and forecast, literally speak in two tongues. It shows that sophisticated institutional investors who have their own buy side analysts will escape such distortions and how it will be the small investors who will be most affected They therefore conclude "While overoptimistic unaffiliated analysts may thus be expressing their true beliefs, affiliated analysts appear to react to incentive misalignment". This is a clear indictment on analysts and directly relates their actions to woes of small investors. This is a research paper done on the basis of actual data. The conclusions seem convincing. The conflict that the analysts face because of the conflicting expectations on them namely to investors and to clients of the investment banks whom they serve is well recognized. That they get abnormally high wages and their links with investment baker is the reason for the distortion in their reporting is implied in the article. But the extent of their role in loss to shareholders in the overall context is unanswered. Golding (p 199) says that sell side analysts (those with investment bankers who advise investors) who are willing to speak their minds boldly and independently are becoming rare. He notes that such analysts are more found in small independent smaller stock broking firms. This corroborates the finding of the study. The last article addresses the many regulatory gaps that caused so much of anguish to shareholders. Why the employees are paid so much, especially when the long term prospects of the company are not clear Are investment banks not bringing out the justification for high pay by not appropriately relating it to long term prospects of the company The letter of FSA tacitly agrees that the answer to these questions is "yes". FSA seems to be compelled by need for action based on recommendations of two reports namely the Counterparty Risk Management Policy Group III report, 2008 (CRMPG III) and the Final Report of the IIF Committee on Market Best Practices, July 2008. These are high level expert groups and both of them have raised concerns about flawed remuneration system as one important factor to be corrected. Even though FSA says that the letter is more a guideline and "does not constitute formal Guidance from the FSA", the tone of the letter makes it clear that FSA expects immediate action on compensation practices by the companies. It seems to be specifically targeting investment banks though it says its scope is larger and part of corporate governance of companies in UK. Specifically it says that the remuneration of employees is to be aligned to the risk management policies of the company. It still gives a large scope to justify compensation policies by allowing companies to define their risk management policy. It says that companies should have compensation policy that is performance-adjusted, and with deferred compensation arrangements, though agreeing that these are difficult to design. Here it seems to be addressing the issue of lack of linkage between long term prospects of the company and the current salaries of executives. The executive compensation will always be linked to performance. But it will be the company that decides performance. It could still define performance as the level of cooperation extended to other business opportunities in the bank and compel the executives to act exactly the way they were performing earlier. This article implies that it is in complete agreement with the statement that executive's compensation in investment banking is indeed very much flawed and needs to be corrected. For most part the dos and don'ts mentioned in the annexure is vague. Some of the specific and clear cut recommendations are in the areas of the say the board has to have in remuneration for senior executives and the CEO, the compensation structure (fixed amount, bonuses, payment in cash), linking compensation to past and future performance rather than on the current years, deferral bonus. However there is no concrete proposal to resolve the conflict investment analyst's face. The SEC and NYSE in US have regulatory rules in US to see that an investment analyst is insulated from other functions in the bank, so that he can work independently and without bias. FSA's recommendation, "Compensation for staff in risk and compliance is determined independently of business areas." does not seem to be enough Overall all the three articles reviewed agree that executive compensation structure is flawed and needs to be addressed. They have reacted to a large public reaction to the immoral earnings of the few, even as companies were beginning to fail and share holders were affected. Analysts and executives in investment banks were often led to act as per the demands and requirement of the industry they were working in and not leading the industry. To this extent they were less guilty than the company they worked for. While the FSA's letter clearly agrees on all points of the statement on top and goes about providing solutions, the articles by Morgenson and Malmendier confine themselves to only the abnormal remuneration and its reasons and effects. Revlin (2008) says that channeling individual drive for personal economic gain to the larger economic good is fundamental to market capitalism. In that way employees of investment banking aspiring to earn what the market offers is not wrong. Not having controls that make this yearning go out of control and harming economy is what is wrong. In her testimony before the House Committee on Financial Services US in October 2008 she says that she would not point blame malfeasance, incentives and remuneration to executives and regulatory lapses as primary reasons for the crisis, by saying that the role played by these factors in the present crisis is relatively small. Rather she would blame it on the ethos of living beyond means "individually and collectively" style of Americans. This should put the issue raised earlier in the correct perspective. Annexure A CFA Institute's 2007 Member Compensation Survey U.K. Reported Median Total Compensation by Years of Experience for Selected Occupations (in British Pounds) Total Less than 5 Years Experience 5 to less than 10 Years Experience 10+ Years Experience Portfolio manager (equities) 170,00 160,000 165,000 189,000 Portfolio manager (fixed income) 148,00 110,00 160,000 237,000 Portfolio manager (indexed/other) 94,000 66,000 190,000 Buy-side research analyst (equity) 117,000 90,000 155,000 180,000 Buy-side research analyst (fixed income) 109,000 85,000 Investment banker 178,000 140,000 250,000 Sell-side research analyst (equity) 160,000 106,000 200,000 Appendix Brown. Aaron, Book review of The Greed Merchants: How Investment Banks Played the Free Market Game by Augar Phillip, http://www.eraider.com/images/articles/BookReviewAuthorInterview1.pdf, viewed 15th November 2008 CFA UK News, http://www.cfauk.org/news.htmlarticle=MTUw, accessed 15 November 2008 Golding, Tony, The City: Inside the Great Expectation Machine, Financial Times, Prentice Hall, Pearson Education Ltd., 2001 Kumar, Praveen, Sivaramakrishnan K, Who Monitors the Monitor The effect of Board Independence on Executive compensation & firm value, Review of Financial studies, vol 21, 3rd May 2008 Malmendier, Ulrike and Shantikumat, Devin Do Security Analysts Speak In Two Tongues NBER working paper series, no 13124 (2007) http://www.nber.org/papers/w13124 accessed 15th November 2008 Morgenson, Gretchen, Requiem for an Honorable Profession, The New York Times, 5th May 2002, http://ptg.djnr.com/ccroot/asp/publib/story_clean_cpy.asparticles, accessed 10th November 2008. Revlins, Alice, Testimony before the House Committee on Financial Services, http://www.brookings.edu/testimony/2008/1021_financial_regulation_rivlin.aspx, accessed 10 November 2008 Sants, Hector Financial Services Authority 13 October 2008 Remuneration policies http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf accessed 15 November 2008 Vickers Marcia, and Mike France, with Emily Thornton, David Henry, and Heather Timmons in New York and Mike McNamee in Washington, How Corrupt Is Wall Street May 13 2002, http://www.businessweek.com/magazine/content/02_19/b3782001.htm Read More