THE SUBPRIME MESS: INCENTIVES THAT HELP

The objective was to examine the management of financial services industry and

determine the role incentives play in its success and failure. Specifically, we determined

whether key management personnel used proper incentives to:

a) Control risk (credit and reputation).

b) Create the right corporate culture.

c) Customize the compensation system.

BACKGROUND

Incentives are usually tied to performance. They can be long term or short term.

“Short-term incentives usually are very specific performance standards. Long-term

incentives are intended to focus employee efforts on multiyear results.”

Collateralized debt obligations (CDOs) are mortgages bundled into a pool and

securities sold against it. Securities sold by the mortgage pools were further bundled and

claims against them were sold. “Rating agencies went along certifying senior tranches

with the highest credit rating, even though they had little sense of their default

properties.” Due to the �savings glut’, these instruments were purchased by foreign

countries, pension funds and insurance companies looking for a good return on little risk.

So they thought.

Condition (1a). CDOs suffered from information risk. Because they were backed by

mortgages and the housing market became illiquid, information on the quality of those

mortgages became more important. Ratings were now less reliable.

Condition (1b). Some banks are already beginning to feel the cost of a tarnished

reputation. Using sound judgment and oversight is the responsibility of everyone in

financial services and it should start at the top. The industry should be experts at

managing risk.

Condition (1c). The compensation system needs to be utilized to reduce risk. This starts

with hiring the right people. “Level of pay and pay system characteristics influence a job

candidate’s decision to join a firm, but this shouldn’t be to surprising.” Recent

acquisitions to the chief risk officer (CRO) role at financial services are happening. “Both

National City and Citigroup tapped new CROs from internal ranks (Dale Roskom and

Jorge A. Bermudez, respectively) following mortgage-loss write- downs in the fourth

quarter.”

Cause. This condition occurred because incentives for a successful risk management

process have been placed incorrectly. At AmSouth which was recently acquired by

Regions Financial, the incentive plan for commercial loan officers rewards them based on

profitability of new business. “The officers have to generate a certain level of new

business before they qualify for incentives.” A risk management and control process is

essential to a successful company. This represents a real challenge for the financial

services industry. A lot of change and innovation has occurred. The fraction of financial

assets held by risk-transferring institutions such as mutual funds, pension funds and

various unit trusts has increased relative to those held in risk-absorbing institutions such

as commercial banks and other depositories. Managers are seeing less return on bearing

the risk of these loans.

The corporate culture at these firms needs an adjustment, particularly in risk

management. Undoubtedly the five competitive forces described by Porter have had an

impact on the competitive landscape of the financial services industry. “The collective

strength of these five competitive forces determines the ability of firms in an industry to

earn, on average, rates of return on investment in excess of the cost of capital.” A risk

control mentality aimed at reducing overall long-term volatility in profitability isn’t

working well in many financial service institutions.

Flawed compensation schemes are prevalent in many companies. They provide

incentives for management to focus on the short term. Earnings based compensation can

lead to over investment in capital. Return on Assets based compensation can lead to

under-investment in capital. Some individuals like Ian Dunlop, former oil and gas

executive, believe “the subprime crisis is a logical outcome ……of the failure to remove

pay-for performance after Enron.”

Impact. At Regions Financial Corp, WSJ reported “the bank’s loan-loss provision nearly

quadrupled to $181 million” and “loans the bank doesn’t think are collectible rose to

0.53% from .20% a year earlier, reflecting the company’s residential homebuilder and

home-equity portfolios.” A main European financial services company, Societe

Generale, suffered a $7.2 billion loss from a 31 year old rogue trader, Jerome Kerviel.

“JPMorgan finally filled a year long chief risk officer vacancy in November when it hired

former Goldman Sachs exec Barry Zubrow.”

Recommendation (1a). Broad risk management systems are a growth area in

management. Careful identification of factors that lead to volatility in performance is

paramount. Once those factors are identified, they need to be carefully managed. Dr.

Santomero, Professor of Finance at Wharton School, identifies four parts to such a

• Limits and controls on each of the factors and on each member of the organization

that adds risk to the firm’s performance profile.

• Guidelines and management recommendations concerning appropriate current

exposure to these same risks.

• Accountability and compensation programs that lead mid-level managers to take

the process seriously .

Recommendation (1b). Corporate Culture is about the values embraced by individuals in

an organization. It is a term widely accredited to Edgar Schein. His work led to the

identification of three cultures of management that he labels �the key to organizational

learning in the twenty-first century’. The three cultures are the operator culture; the

engineering culture; and the executive culture. He states, “Success is related to how all

the three cultures are aligned. It is a precarious balance, easily disturbed.” Having a

CEO who is an expert in the financial services industry would be less disruptive to the

overall culture than a CEO outside the industry. Promoting management from within

would be a powerful incentive for individual and company success. Both National City

and Citigroup promoted new CROs from within. Charles Bowman, Bank of America’s

principle Compliance executive in 1999 found a way to punch through to all employees

the message that compliance isn’t just for compliance officers. “A tagline that he and

many of his staffers use on e-mails: �Compliance: It’s Everybody’s Business At Bank Of

America’.” Employees in the last few years have seen an intentional increase in

compliance training. For instance, at Bank of America, “the heads of each principal

business unit make an annual presentation to the CEO concerning their units’ compliance

approaches, record, and all relevant statics.”

Recommendation (1c). Bruce Tulgan, author of Winning the Talent Wars, states that

“the old fashioned incentives – long term employment, steps up the organization’s

hierarchy, six-month reviews, annual raises, and standard benefits – are no longer enough

to motivate the best talent.” He identifies three factors that should guide incentives and

rewards:

• Control

• Timing

• Customization

Control: “Compensating high performers at a higher rate is not only fair, it’s the only fair

way. Rewards should not be wasted on people who fail to meet stated goals and

deadlines.”

Timing: With respect to loan officers, one bank has this perspective. “We manage for

the long haul,’ says Mickey Dry, chief credit officer at Winslow-Salem bank. “Having

compensation packages that are heavily weighted on a month-to-month, quarter-to-

quarter, or year-to-year basis – tends to push the organization to act for the short term.”

Bruce Tulgan recommends that “when contributors meet their goals within stated

guidelines and parameters, managers should cash them out immediately.”

Customization: “At Norwest Corp. Minneapolis, a sophisticated incentive plan for loan

officers rewards them through four different pools of funds. Credit quality is one of the

biggest factors considered in determining how much each officer will get.”

Martin Doyle, a Financial Times columnist, identifes the size and structure of bankers’

financial incentives as a problem. He suggests “bonuses paid in restricted stock

redeemable in instalments over 10 years.” Ian Dunlop, former oil and gas expert, goes

even further to say that executive incentives need to make a paradigm shift. Executive

References

Cocheo, S. (2006). Day of the Geek. American Bankers Association, 6, 25-30.

Dunlop, I. (2008). Executive Incentives are Chief Cause of Turmoil. Financial Times, Apr. 1.

Fest, G. (2008). Risk without Reward. Bank Technology News, 21, 26.

Kardos, D. (2008). Credit Quality Worsens at Regions. The Wall Street Journal, Apr. 15

online.wsj.com/article/SB120825930525415993.html

Lunt, P. (1991). Incentive Pay Needn’t Blow Up. ABA Banking Journal, 83, 46 – 49.

Milkovich, G. and Newman, J. (1999). Compensation. Boston: Irwin/McGraw-Hill.

Rainer, S. and Dearlove, D. (2001). Financial Times Handbook of Management. London: Prentice Hall.

Rajan, R. (2008). DAVOS: Former IMF Chief Economist — Time For Regulatory Soul- searching — Regulators Should Worry About Incentives, Liquidity And The Perverse Impact Of Past Regulations, And Seriously Re-examine Their Approach In The Light Of The Incoming Evidence Of Culp. The Banker, Jan, 1

Santomero, A. (1998). The Revolution in Risk Management. Financial Times Handbook of Management. London: Prentice Hall.

Tulgan, B. (2001). Winning the Talent Wars. Financial Times Handbook of Management. London: Prentice Hall.

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