We've all read the headlines, 'Bankers 'bonuses to be capped', 'Board rejects management's compensation plans'. This article summarises the international regulatory pressure on banks and financial services organisations that have taken place since 2008. In particular, we'll look at how these changes are affecting banks in the Middle East, what competitive advantages these regulations create for Middle East banks and most importantly what lessons can be learned.
First, let's go back to 2008. Bear Sterns is acquired (with some help from the US Treasury) by JP Morgan; Lehman Brothers goes bankrupt and the world is on the edge of a financial meltdown not experienced since 1927.
In 2008, the G20 Finance Ministers met to establish common regulation around compensation in financial services. The Financial Stability Board (FSB) was established to manage this initiative and all of the G20 members agreed to implement regulations that were in line with the FSB recommendations. One of the key rationales for the FSB was to ensure that regulatory arbitrage did not happen among the world's 20 largest economies. Fast forward to 2014, and we see Europe capping bonuses for bankers at one times salary, while the other G20 countries outside of Europe have established much less prescriptive regulations.
In the Middle East, Saudi Arabia is the only member of the FSB. Compensation regulations in the Kingdom were put forward in 2010. These regulations only apply to commercial banks and their subsidiaries (the Capital Markets Authority which regulates investment banks has yet to put forward any regulations) and have been fairly light touch in relation to other G20 countries. A few other Middle East countries have put forward similar regulations to those in Saudi Arabia.
It is important to note that the issues that caused the world financial crisis took place in the US and to some extent Europe. Banks in the Middle East have been fairly conservative in terms of the products they deal in and how they compensate their staff. As such, many Middle East banks have argued for lighter touch regulations.
There are some competitive opportunities that banks in the Middle East can potentially leverage relative to their international counterparts. More importantly though, there are some clear lessons that Middle East based banks can learn from, in what is now becoming global best practice in the management of bank compensation.
GOVERNANCE OF COMPENSATION
Perhaps the best take away for banks in the Middle East is the governance of compensation. Having a Remuneration Committee of the Board of Directors that is made up of experienced Non- Executive Directors and at least one Independent Director is a critical first step. The Remuneration Committee should review and approve all of the bank's compensation plans. The Remuneration Committee should also determine and approve the CEO and ideally the CEO's direct reports' compensation on an annual basis and ensure that this is linked to short and long-term performance goals.
SAY ON PAY
While say on pay is a fairly blunt instrument, where shareholders simply vote to either approve or disapprove senior executive compensation levels; we think the concept of giving shareholders some say on pay is a good one. However, when a firm has a well-functioning Remuneration Committee, shareholder say on pay should not be problematic.
In addition to a well-functioning Remuneration Committee, Middle East banks should consider voluntarily providing more transparency on pay levels of board members and senior executives. Senior management pay disclosure is an important part of a well-functioning capital market, and we believe this would send a strong message to shareholders, research analysts and credit rating agencies.
Effective in the 2014 performance year, European banks on a global basis and all foreign banks operating in Europe now have to cap bankers' bonuses at 100% of salary for anyone earning more than Euro 500,000 (it is possible to move the cap to 200 per cent of salary with shareholder approval). This effectively means that firms will shift some bonus to salary or allowance. While it is not clear yet if European total compensation levels will fall as a result of this regulation, in time it may create a competitive disadvantage for Middle East banks when trying to recruit talent from European banks, as European banks' fixed pay (i.e. salary plus allowance) will be significantly higher.
Traditionally it has been common for international banks to offer one and sometimes multi-year bonus guarantees to attract talent. International regulators now do not allow bonus guarantees beyond one year. In most Middle East countries, banks are still able to offer multi-year guarantees, though these are not common in the market. Nonetheless, we believe that banks that use bonus guarantees should ensure the guarantees are linked to the achievement of key performance metrics, rather than simply being a blank check.
FORMULAIC PAY PLANS
International regulators have frowned on commissions or formulaic pay for staff working in banks (for example, bankers selling credit cards, insurance or mortgages). Interestingly many banks in the Middle East have moved in the opposite direction in the last few years, towards more formulaic plans. We believe this gives Middle East banks a competitive advantage over international banks (people generally want a clear line of sight on their pay) though we recommend that Middle East banks thoroughly review their commission plans to ensure they do not drive the wrong behaviour.
Internationally banks are now required to defer a significant proportion of annual incentives (e.g. 40 per cent to 60 per cent typically over a three to five year period for a large proportion of staff. This deferral is often "at risk", meaning the firm can claw it back if:
??The firm or a business unit suffers a material downturn in its financial performance in future years;
??The firm or a business unit suffers a material failure of risk management; or
??Individual employee misbehavior or material error (e.g. exceeds trading limits) takes place.
Given the short term nature of many expatriates' assignments in the Middle East, three years may seem like a long time for many. In many Middle East countries, banks can still provide staff with an all cash compensation package which can be much more attractive than a larger total compensation package, with a deferral.
Nonetheless, we still recommend that staff who are taking significant long- term risk with client or the firm's money should have some portion of their annual incentive deferred and that deferral is subject to claw back, should the firm or business unit suffer a material downturn in its financial performance or there is employee misbehaviour.
RESTRICTED STOCK VERSUS STOCK OPTIONS
Deferrals and other forms of long- term compensation are now typically required to be in the form of restricted stock - most international regulators now frown on the use of stock options.
Many firms in the Middle East stopped providing long term compensation in stock or stock options since 2008, given significant declines in stock market valuations. However, as we've seen in the technology space, stock options have been demonstrated to be one of the best ways to align the interests of employees and shareholders. In an upward market, they are also one of the cheapest forms of compensation as the market pays for the upside growth.
With Middle East markets improving, we think banks that have a long-term growth plan should now reconsider stock options as a key component of pay for their senior executives.
While current international regulations around bank compensation creates some competitive advantages for banks headquartered in the Middle East, we believe there are important new global best practices that Middle East banks should consider. In particular, these best practices include having a proper remuneration governance system in place, deferring compensation that is linked to long-term risk and appropriately paying for short and long- term performance.
The Remuneration Committee should also determine and approve the CEO and ideally the CEO's direct reports' compensation on an annual basis and ensure that this is linked to short and long-term performance goals.
Ray Everett is Partner at McLagan, an Aon Hewitt Company. Ray is a member of the firm's Executive Committee and Heads the Asia Pacific, Middle East and Africa practice, based in Dubai.
McLagan works exclusively in the financial services industry, and provides compensation and performance benchmarking, advisory and consulting services.