Fix Compensation for More Than Just the CEO

The Obama administration is right to aim its new executive-pay limits not just at bank CEOs but at what I call the front-office risk takers — the traders who have caused an uproar by garnering multimillion-dollar paydays at financial services companies. In fact, the public debate about executive compensation has been too narrowly focused on just the CEO; reforms need to apply to risk takers at all levels.

Following the lead of the G-20, the new rules on bank executives’ pay are expected from the Federal Reserve and the Treasury within the next few weeks. By restricting compensation plans that reward short-term gains, the regulations will be designed to limit excessive risk-taking by chief executives, loan officers, and traders, according to press reports.

The details of the new rules aren’t yet known, but reform is clearly needed. Research earlier this year by the Institute of International Finance, the global association of financial institutions, reveals several historical flaws in the compensation practices at financial services firms.

One of these is an insufficient connection between the size of individual performance bonuses and the riskiness of particular businesses. Fully half of the firms surveyed by the IIF use no such “risk adjustments” when creating and allocating bonus pools. As a result, many of the risk takers are paid out of proportion to their contributions to the firms’ economic value.

Another flaw is a lack of linkage between the pay of the front-office risk takers and their firms’ overall results. Over half of the firms surveyed by the IIF have only modest links between bonuses and overall company performance (as opposed to individual or business unit performance); that means there’s limited downside for employees if other areas of the firm perform poorly. And only 40% of the firms tie bonus payouts to the future performance of the firm, meaning that a minority have historically tried to assess how the bets pay off before rewarding the gamblers.

Compensation reform alone isn’t going to protect the financial services industry from future booms and busts; true protection is going to require better risk governance and risk management. But the current financial crisis offers an unprecedented opportunity for the industry to fix the problems in executive pay and to create compensation packages that will protect firms from out-of-control risk-taking while creating stickiness for the best talent, as the old partnership models used to do. When all is said and done, retaining and motivating top performers is — or ought to be — the primary goal of compensation.

Nick Studer is a London-based partner and head of the European Finance and Risk practice at Oliver Wyman, the international management consulting firm.