A June 28, 2009 article entitled “Treasury Expands TARP Compensation Rules to All Bank Employees, Puts Focus on Risk Management” published in FinCriAdvisors.com, discusses recent Treasury rules intended to manage risk at TARP companies. The article says: “The rules require the bank’s compensation committee to limit features in pay plans to ensure that senior executive officers (SEO) and others “are not encouraged to take risks that are unnecessary or excessive and that the TARP recipient is not unnecessarily exposed to risks.”
The Treasury’s effort draws the first line in what will likely be an ongoing battle. The result will lie somewhere between a steady, perhaps even stodgy, financial services industry and a more volatile version that rewards innovation. In our view, compensation is an effective tool for guiding behavior but also one that can come with many unintended consequences if there is not a deep understanding of the messages embedded in different compensation elements.
Moreover, risk management is clearly a PROCESS, not an event. TARP companies and Treasury will not think that simply changing a few aspects of pay plan design will fix the problem. Risk is incredibly difficult to define, to measure and manage in financial services businesses, with many moving and interrelated parts. Identifying, mapping and managing cause and effect can be an enormous challenge. Do risk managers and executives understand the dynamics here? We think they do but we also know that there are limitations to what is possible given the current risk modeling technology, methods, etc.
The management of enterprise risk has a long history initially focused on fraudulent financial reporting. The Treadway Commission (COSO) published an integrated framework of internal control in 1992 and then as a result of the high profile business scandals of Enron, Tyco and WorldCom among others expanded that framework to providing a more robust and extensive focus on the broader subject of enterprise risk management.
And even with 25 years under their belt as the experts on internal controls and enterprise risk management, COSO admits “that while enterprise risk management provides important benefits, limitations exist. Enterprise risk management is dependent on human judgment and therefore susceptible to decision making. Human failures such as simple errors or mistakes can lead to inadequate responses to risk. In addition, controls can be circumvented by collusion of two or more people, and management has the ability to override enterprise risk management decisions. These limitations preclude a board and management from having absolute assurance as to achievement of the entity’s objectives.” YIKES!
Based on this, one might think it is best to “start small and work your way up” as risk management catches up with oversight capabilities. But clearly the incentives are too large, the enterprise risks too great and the consequences at the individual level too small.
In the financial services community some risk management functions are notoriously strong while others are weakened by overly segmented structures and fragmented decision making. In addressing ineffective risk management the theme that has developed over time is individual accountability at the executive level. Treasury rules would reinforce this movement through their attempt to use executive compensation as a lever.
A standard industry response to the new rules cite the near-impossible task of retaining the best talent, widely viewed as those individuals capable of managing risky enterprises to generate consistent profits, while sidestepping financial landmines. For better or worse, if Treasury is serious about limiting risk at banks, losing this type of talent might be a benefit as banks evolve into transaction oriented, low volatility enterprises.
However, we suspect that the image of a simple, stodgy financial services industry is too plain even for Treasury. On the other end of the risk spectrum lays compensation for financial innovation, one by-product of risk taking and an essential element in health of our economy.
Striking a balance will be a tough task made tougher still if the Treasury is not fully equipped to understand the true messages embedded in some commonly used incentive programs. Even compensation consultants’ reports rarely address the risk exposure of varying programs, perhaps other than to state the obvious that stock options are riskier than restricted stock. In fact, any uncapped payout that doesn’t have some sort of negative component through clawbacks, high water performance marks or delayed payout subject to multi-year performance has an extremely high sensitivity to volatility.
Whether the Treasury will be able to get their hands on the root of the problem and understand exactly where motivations for excessive risk taking are coming from remains to be seen.