Motivational assumptions

I've argued before that, given the failure of various rounds of remuneration 'reform', it would be helpful in future if those proposing new incentive schemes set out the motivational assumptions behind them. At present this doesn't happen, and I think this is a big problem since incentive schemes must be based on some ideas about how and why the recipient will respond to them.

Well funnily enough I was reading through some of the written evidence to the Parliamentary Committee on Banking Standards (massive PDF here) and I came across Fidelity's submission, which is focused on  remuneration. Specifically it argues for longer timescales to apply to LTIPs and for a portion of awards to be career shares. However what caught my eye is that they seek to make the case in part by drawing on the PwC research on the psychology of incentives:

We would also like to refer you to work which has been carried out by Pricewaterhouse Coopers which shows that recipients of shares under LTIPs place a high value on certainty with highly conditional awards being valued at a material discount. In the case of Career Shares or ex-ante performance vesting, once shares are awarded they really do belong to the recipient and hence it should be possible to achieve the same motivational effect with a lower quantum of shares. This could make a contribution to reining in the overall size of awards which is another area which needs attention.

As I've written before, the PwC work is really starting to have an influence, even though if you've read any of the behavioural stuff about pay it shouldn't come as any surprise. It's all about who has said it, and here we see a mainstream asset manager citing it. Clearly the ground is shifting.

The only problem is I don't think what they say is quite right. The point about incentives is that the theory behind them (which, I never bore of repeating, is challengeable) is that they reinforce behaviour. As such the awards need to be made around the same time as the behaviour they are seeking to reinforce if they are to have any effect. The further we push the reinforcer away from the behaviour, the less likely it is to have an impact. This is exacerbated by hyperbolic discounting, which puts a lesser value on the award the further away it is. These are the core motivational problems that need to be addressed (as I noted previously, at least BlackRock's emphasis on short-term rewards is consistent with this even if we might not like it).

Fidelity seem to arguing that once the awards have been made there would be no more conditionality (no clawback?) so they would have a strong motivational pull then. But, that whole 'once the awards have been made' is a problem. If it's too far away from the behaviour it is supposed to reward I really do question how much of an influence it can have - even if we can crack the other problem of how to define what the behaviour is that should be rewarded. 

I think we ought to be a bit honest about all this stuff. It may simply be the case that we can't use financial rewards to incentivise people over the long term, perhaps they just don't fit together (we could, of course, use a series of short-term incentives, if we think the long-term is just a series of short terms). For the delivery of long-term objectives we might be better off trying to find other ways of ensuring commitment to them. I think I'm basically convinced incentive schemes are a dead end.

John Thurso, shareholder engagement and the regulatory turn

I've blogged previously with a bit on John Thurso's comments on the effectiveness, or otherwise, of shareholder engagement. It seems like it's something he is warming to. Today I was sent the following section from the banking inquiry's evidence session in late November. But I'm actually posting up a whole chunk as the discussion goes into the question of the role of shareholders compared to that of regulators. All emphasis below is mine.

Q13 Chair [Thurso]: I am sorry, I am going to throw this across. You and I are having a fascinating, almost private, conversation. It strikes me that there is a real problem with the Walker and Kay approach, of saying, “What we need to do is get the shareholders involved lots more”, for the very reason that you identified—the vast majority of large shareholders have less than 1%. This is not like an AIM company where five shareholders will own 75% and can act like owners. This is just a commodity called their stocks and shares.
Therefore, to say, “Let’s get them all involved”, really just adds complexity almost rather than providing any form of solution. I put this to you as a proposition: what one really has to try to do is look to the non-executives to act as if they were the owners and to take that stewardship on board as a primary task, much more than in companies where those owners are able to do that for themselves.
Professor Franks: I am afraid to say that, if that model would work, we would not need owners and we would not need capital markets. I do not think directors can substitute for ownership. If they could, capital markets would have very little role. Forgive me, but I think we have to look for structural solutions. That does not mean that we should not try to improve the governance of banks. There are lots of things that we can do but we have to have the structural changes as our main defence against systemic risk.
Q14 Chair: I am going to open that conversation up to the other three.
Dr Hahn: If we look at what happened in the crisis, there was a consensus between regulators, Governments and shareholders, that for large financial institutions shareholders did not know what was going on and couldn’t exercise governance. Why? Fragmented shareholders and those in a mostly passive investment world—index funds only are the major shareholders in banks. Many of the tasks that are bread and butter to a typical board of directors—choosing new chief executives, approving mergers, dividends, even bonus pools—are now subject to regulation. It is not just in the UK; it is EU-wide and the USA.
There has been a broad acceptance of the fact that shareholders are incapable of understanding what goes on in a complex financial institution. The question always goes to the board, trying to understand what the board should know, could know and what our expectations are of the board. Ultimately, there is a much bigger question, and that is the Andy Haldane question you raised about simpler regulation. Certainly some avenues: yes or no. Realistically, the only institution that can understand the risk that is being undertaken by a bank is its regulator. The regulator gets substantial inside information; it knows a lot more than the market place. The only one that can judge whether a board is monitoring the risks inside an institution is the regulator. We need to figure out in structure how a modern board works with regulation and with shareholder interest.

This is, of course, a bit of a theme of mine. For all the noise around stewardship, my own view is that the lasting outcome of the past few years is that the role of shareholders in the governance of financial institutions has been eclipsed by regulators. Pay, board appointments and even M&A are now seen as legitimate issues for regulators to discuss with banks, and the regulator is willing to step in where necessary. Shareholders get to have a look once the regulator has already kicked the tyres, as it were.

Thurso's comments are interesting as he seems to see shareholders as basically being speculators (hence his scepticism about engagement). But actually we might be about to hit a point where shareholders are, for once, actual investors, as we may well see rights issues this year. As I pointed out previously, the recent ABI report essentially sets out what their members expect if investing in banks, so it looks like they expect to be tapped up soon.

That aside, though, what's interesting about the above exchange is the sense of agreement that shareholders can't really do the job.  

Employees on rem comms - a few thoughts

I'm strongly in favour of the idea of employee representation on remuneration committees, so very pleased that it's a Labour policy these days. But if we are going to get it to work, in the hope that Labour gets back in 2015, we need to deal with a few practical issues. These are the sorts of questions I flagged up in my previous post.

There is an excellent TUC briefing on this subject which I won't seek to re-invent, especially as I agree with the positions set out in it, so I thought I'd set out how I think we could make this work.

Firstly, are we talking about employee reps on rem comms, or employee directors who sit on rem comms? The real question here is if we are going to establish the principle of employee involvement in UK corporate governance is a limited role in remuneration all that we should aim for? If we created employee directors who sit on rem comms then we're still meeting the policy commitment but as part of a much bigger shift in governance.

At present I personally think trying to establish employee directors across UK companies would be a real stretch. There simply isn't much support for the idea & as such it would also been seen as politically risky (although easy to counter with real-life examples like Germany). In contrast employee reps on rem comms alone could be achieved pretty easily (despite most mainstream corp gov people not being supportive) and shouldn't be a serious fight over it.

However I also think that if we are going to open this issue up it's a wasted opportunity if Labour doesn't look at the wider question of employee representation. So, some sort of review looking at the issue, as a way of fulfilling the commitment to employees on rem comms (which is the absolute minimum that should come out of the review!). If you think about it, this isn't too different to the Coalition consultation on executive pay - we knew a binding shareholder vote would be one result (because of the PM's public commitment to the policy) but there was an opportunity to look at other issues in the same territory.

Assuming we do end up with the reps rather than directors model, how do we achieve it? In common with the TUC I think any easy way in is to simply tweak the Corporate Governance Code to say rem comms should have employee representatives.* I would also definitely make it representativeS for the simple reason that one rep on their own may find it hard to speak out, so two at least.

In terms of appointment, I think where a union is recognised they ought to nominate the employee reps, as they are likely to be able to provide support (dealt with more below). Where there isn't a union, employees could put themselves forward with an election taking place if there more than the required number of candidates.

In addition, given the limited role envisaged for employee reps I again share the TUC's view that it's not obvious why they should face a shareholder vote, especially as below-board employees sometimes already participate in CSR committees.

Finally, who trains them? I think the unions would probably provide support to members on rem comms in any case, but it makes sense for there to be some arms-length bodies offering training too. It is obviously very important that this is a separate provider to any rem consultant employed by the company. In fact in general, I think rem consultants ought to be kept out of it.

I think the training itself should involve at least three elements. First, the ideas behind pay policies - in particular the theory behind the use of incentives schemes (obviously I would prefer this leans heavily towards scepticism about performance pay). Second, industry data and trends (in order to provide background info) and guidance on how to interpret the data. Thirdly, behavioural training - understanding the dynamics in the committee, what arguments to look out for, how to be avoid being hoodwinked etc.

I think some of the could be set up now and, if we want to make sure that this is a policy that is ready to be rolled out quickly, it might not be a bad idea to get some basic plans in place.


* This could set up an interesting situation. Assuming we did go down the 'tweak to the Code' route then companies could, of course, 'explain' any non-compliance. That in turn leads to the question of whether shareholders would challenge them if they did not comply with this provision - could vote against on the rem policy vote, for example. If shareholders in turn did not challenge non-compliance (because, perhaps, they don't accept an employee role in rem discussions) it would create an interesting problem. Shareholders (asset managers) might argue that they have no obligation to enforce a policy they don't agree with. But in turn if I was a trustee on, say, a TU pension fund or a Labour-controlled LGPS fund I might not be very impressed with my asset managers.   

A mini corp gov policy for Labour

I've been blogging a bit lately about the direction in which Labour thinking on corporate governance seems to be moving. Maurice Glasman seems to push the argument the furthest and explicitly advocates a co-determination model in the UK. I'm not sure how much support that has and it's worth noting that in the past the UK labour movement has been ambivalent about the idea of employee involvement in company governance.

Nonetheless there is a bit of a sense amongst people on the Left who think about such things that the 1990s vintage of corporate governance - which Labour did much to bring to life - has not delivered what was expected. In a sense the whole 'stewardship' debate in the UK comes from the realisation that even the biggest institutional shareholders did not exercise the kind of oversight that much theorising about corporate governance expects.

The response of the mainstream corporate governance community has been to push the existing model further - hence we now have a Code for the interaction between shareholders and companies. But some people on the Left are starting to look at other models, particularly with a greater role for employees.

In this context the existing Labour policy commitment - employee representation on rem comms - makes a bit of sense. It's a nod to the idea that other stakeholders should have a say in governance, but can (just about) be made to fit within the existing system too. There are some important issues that would still need to be dealt with - who appoints employee reps, should they face a shareholder vote too, do they count in an 'independence' assessment of rem comms, who trains them etc etc. This is an issue I'll come back to in a future post.

However, if the we're still basically straddling the two camps here's a micro policy idea - a future Labour govt make it easier for shareholders to file non-binding resolutions. Currently if you want to file you need to have either 5% or have 100 shareholders supporting the resolution with an average holding of £100. Given the supposedly* more fragmented nature of the share-ownership of UK PLCs these days, 5% looks like an awfully high bar to set. To put it in context, Legal & General, which manages billions on an index-tracking basis, usually holds about 4.5%. Only BlackRock could be confident of being able to file on its own (if it ever wanted to) in most companies. And what about companies with controlling shareholders? No single investor except News Corp held over 5% of BSkyB in the run up to last year's AGM.  

So why not drop the threshold to, say, 1% and allow investors to meet this threshold by co-filing (ie two investors with 0.5%, three with 0.35% etc)? Realistically, this would still mean that only institutional investors could file on their own, it would at least widen the pool of those who could file relatively easily. Bear in mind, too, that this would mean the process is considerably tougher than the US. But it would at least provide a new option to shareholder who wish to be proactive.

Of course some of the big investors - and representative bodies - won't like the idea. But then most of them didn't support the idea of a binding vote on remuneration policy (if you go back even further, some of them even didn't support the introduction of the advisory vote!) so opposition of that type shouldn't be seen as particularly important. In addition I know there was some discussion of an idea like this in corp gov policy land in 2009, but it was squashed, so it wouldn't be completely out of the blue.

It's a minor tweak within the existing system but, if we look at the US as an example, it could enable a wider group of investors to be proactive in putting items on the agenda of AGMs.


* I'm not sure this is actually true. I think the ownership base has changed, so we see more overseas names on the share register, and there's a different mix at each company. But if you look in the FTSE 100 at the average holding of the largest investor, or the number of notifiable holders, you can make a case that fragmentation is a bit of a myth.

A few links

1. This article dealing with Labour policy on corporate governance from (!) 1996 shows that actually there was some quite radical thinking going on immediately prior to Government. No reason why we shouldn't be as ambitious now, especially given a) the experience of the financial crisis and b) having had a seriosu crack at pretty manistream governance reform when in power.

2. This paper is worth a look. Not the first one I've seen that seeks to query the motives of union shareholder activism. Don't think these would appear if it was ineffective.

3. The Fair Pensions report on ethical funds is worth a read, low priority given to labour issues is notable.

The banks

A few weeks back I blogged about how the labour movement ought to position itself if the UK's banks need recapitalising. Since then we've obviously had the Bank of England saying the banks may indeed more capital and also making the point that they went into the crisis with too little (potentially £50bn too little), something which I'll come back to.

As I said before, if the banks need recapitalising then the UK public will likely be on the hook one way or another. The state may directly assist in the recapitalisation as it did before, or UK institutional investors, managing the nation's savings, could be tapped up via rights issues. It's the latter possibility that particularly interests me as this will be a key point at which the need for accountability within the financial system could be asserted.

It's notable that the ABI has already put out a document about the banking sector and what investor expectations of it will be. Already some have commented that they seem to have 'pre-crisis' ideas of what kind of return they can expect from organisations which many hope will operate more like utilities in the future. That aside, it is important that ABI has to some extent set its stall out.

Asset managers are only ever the intermediaries. As I never tire of boring on , they have views about, for example, what's reasonable in terms of executive pay that are completely out of touch with those of the people whose capital they invest. But whilst the responsibility for the assessment of such issues is delegated along with the managment of capital their views will dominate the investor side of corporate governance discussions.

And so it will be with the banks. I suspect a lot of ordinary punters think bankers could be paid a lot less and that banks should be cut down to size. But unless someone tries to get those views into the corporate governance microcosm pretty quickly we could see the banks recapitalised with our money without any reform demanded in return. If you think I'm overdoing this, consider how weak investor ideas about 'reform' of bankers' pay are. It's all about structure, not scale. When Paul Myners was City minister and wrote to the heads of the big asset management firms to ask them what they were doing about pay at the banks several of them wrote back saying they didn't want to put too much pressure on.

So what could we do instead? Why shouldn't we draw up a set of reforms that we wish to see enacted in return for supporting any rights issues. Retail and investment banking split? Pay freeze and no performance related awards for directors of any bank that requires extra capital (after all, management of capital is the core business of banks, so if they need a lot more of it they aren't doing the job very well)? I would actually make the list pretty extensive on the understanding that there will be pushback from vested interests. Therefore the the real point of the exercise would be to make the point that the asset managers are just the middle men and that their views are not the only ones that are legitimate.

The obvious groups who could do something like this are the TUs, in particular through member nominated trustees who are TU members, and Labour-controlled local authority funds. I recognise that it sounds a bit of an unusual idea, but then think, in contrast, how odd it would be if we don't do something. The banks may well be recapitalised with our money (again) without us getting any meaningful reform in return. This after a year when the UK's banks have been tied up in Libor manipulation, money launderings and sanctions busting.

A final related issue - let's consider the Bank of England's point that the banks went into the crisis with too little capital. One of the arguments for why this happened is because of the way IFRS distorts banks' profits (as I understand it this is principally through the way provisioning for bad loans now works). If that's the case, and the banks really weren't profitable in the late 2000s, that raises some serious questions - why were the directors paid any performance related rewards, why were dividends paid out (and were they legal), and why did auditors sign off the accounts?

There are some very big issues here that haven't yet been properly dealt with. Another reason, I would argue, why those on the Left should be on the front foot if we're expected to pump more money into the banks.

The psychology of incentives

There are a couple of encouraging signs that investors are starting to query the idea that redesigning incentive schemes yet again is likely to deliver any real benefits. Regular readers (yes, both of you) will know that this is an issue that I've been banging on about for a few years now, so I'm pleased that the argument does, finally, seem to be shifting.

First up, LAPFF has published a paper on employee engagement which basically argues that investors spend too much time focusing on a) board directors and b) financial incentives. It says that instead investors should be looking at how companies engage their employees, and that when this issue is looked at in depth it's pretty clear that monetary rewards are a small part of the story. If you've read any of the behavioural stuff in this area some of it will be familiar to you, but I think it's the first paper by an investor group that really pushes these ideas.

Separately, I just came across this paper by the Aus arm of BlackRock. What's interesting about this one is that it includes a big section on what motivates executives. This draws significantly on the recent PwC work on the psychology of incentives. I personally don't think the paper actually moves that far (and it may surprise some that it emphasises the role of short-term incentives, though this is where hyperbolic discounting points you!) but it's surely significant that a publication by the world's biggest asset manager even covers this territory.

A final thought - it's interesting how influential that PwC paper is turning out to be. No doubt it's in part because it draws on the views of executives themselves, but I can't help thinking it's also because of who is saying it. A remuneration consultant criticising incentive schemes is more powerful. It's same effect that we see when Sir Michael Darrington criticises the scale of executive reward. Sometimes, it's who delivers the message that matters. Lately the right people have been doing it.