There is a current conversation surrounding how CEO compensation is determined and how it relates to a bank’s risk threshold. Now, having experienced a global pandemic, we’re left wondering how has compensation changed since January 2020? Let’s find out in CEO Compensation and Risk Threshold: How They Relate.
CEOs: The Basics
A bank’s CEO is typically seen as the backbone of the company. CEOs are responsible for making decisions about the bank, its customers, stockholders, goals, employees, products, the list goes on.
The bank’s shareholders and its board of directors also play important roles; however, the CEO tends to be the face of the decision-making process. According to Harvard Business Review, “shareholders rely on CEOs to adopt policies that maximize the value of their shares [and] like other human beings… CEOs tend to engage in activities that increase their own well-being.”
This considered, it’s a tricky position to be in. The decision surrounding whether or not your bank decides to take on more risk or decides to be more risk-averse falls into the CEO’s lap. Therefore, the level of compensation a CEO is contracted could inadvertently have an impact on a bank’s overall risk exposure.
When Does Excessive Risk-Taking Occur?
Research shows that compensation influences a bank’s tendency to take risks. In fact, following the financial crisis of 2007–2008, The Institute for International Finance found that compensation plans were one of the factors underlying the [financial] crisis.”
So, when does the majority of excessive risk-taking occur? Larry D. Wall, executive director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta, puts it best: “The complications come when the firm is partially financed with debt. In this case, shareholders can benefit ex-post from the CEO taking more risk than is optimal if the increased risk is not anticipated by the debt holders. The shareholders get to keep the gains if the firm does well, but the debt holders bear part of the costs if the firm fails.”
Debt holders, however, as Wall explains, typically anticipate that a bank will take on a higher risk and as a result demand a higher risk premium. This then gives “shareholders an ex-ante incentive to commit to not taking excessive risk.”
How to Minimize Risk
In “Executive Compensation and Risk Taking,” financial experts explain the way to minimize a CEO from taking excessive risk: provide them with a contract that depends not only on equity returns but also on creditors’. This way, the bank’s CEO will opt for being risk-averse while also maximizing shareholder value.
Other incentives that keep CEOs from taking excessive risk include bonuses, pension plans, and deferred compensation plans. Although this is not the end-all-be-all solution, financial incentives for CEOs are a great starting point to keep them away from the dangers of excessive risk.
How COVID-19 is Changing Compensation
While many industries, the banking industry included, were affected by the COVID-19 pandemic, the biggest compensation challenges remain the same. In fact, Flynt Gallagher, president of Newcleus Compensation Advisors, says the core compensation problem remains the same as it has for years: tying compensation to performance.
This has become especially challenging with the influx of people who worked from home in 2020. “With the significant expansion of employees working remotely, which I believe will continue at a greater level even when the pandemic eases, measuring individual performance will be more challenging than at any time in recent years,” says Gallagher. “A greater emphasis on team performance will probably emerge, with less focus on individual accomplishments as we see the workplace undergo drastic changes this year and next.”
Across the Atlantic, however, the European Central Bank (ECB) asked many banks to postpone paying annual dividends or buy back shares for a time period in order to “boost banks’ capacity to absorb losses and support lending” as a result of COVID-19.
What We Do Best
Providing powerful compensation incentives is what sets you apart in the hiring and retention game. Rely on us to design deferred earnings packages that bring value and envious returns on your investment in your prized asset—your people! Contact us at Newcleus today to learn more.