23 February 2016 by Henry Ker
John McFarlane talks to Governance and Compliance about the misplaced value in bonus culture and why the board must be sceptical
John is Chairman of Barclays, and was formerly Chairman at Aviva and a non-executive director at RBS.
The purpose of the company is to serve customers profitably in order to produce superior returns for shareholders. There is, therefore, a degree of commerciality that is needed for a board that we can easily lose sight of. The priority of the board is the future direction and strategy of the firm, the appointment of management, the measurement of performance, and initiating action based on the feedback to that.
The board needs to have proper oversight, but it does not necessarily need to be done by the board itself. Certain aspects can be delegated to committees to deal with in more depth, and they will make comprehensive reports back to the board. The role of a committee is important in picking up large chunks of the company’s governance agenda so that the board can spend more time on strategy management and performance.
Initially you need to think about the future agenda and current performance of the company. That gives you a forward view which may be different to the actual situation – and that tells you the journey that you need to go on.
The first thing, therefore, is to determine whether the board and the management have the right priorities for the company going forward. Secondly, you need to ensure that you have the right management – in particular, the right chief executive and finance director. Thirdly, you need to see the board in action. Although you have feedback from historical reviews, your insight depends on the quality of those reviews. I like to see the board in action to determine whether we have the right size, mix and quality of participation. That is difficult unless you have some experience with the board.
Non-executives can get quite frustrated if all they do is bless management recommendations. They want involvement in decisions but sometimes you get a situation where management will bring a matter that is already resolved to the board that they do not agree with. That disagreement is better coming out at an earlier stage so that management’s response can take account of the board’s input. On the other hand, if management keeps consulting the board before it makes decisions, the board may learn to ask for every decision to be run past them. A balance between the two should be achieved. The last thing you want is a management team that does not bring solutions.
I tend to use the secretary as the chief administrator of board matters – often beyond the traditional role of the secretary. For example, seeking advice on the mix of the board and to oversee the recruitment of non-executives and the chief executive. They can play an active role in setting the future agendas of the committees and the boards in conjunction with other executives who might be more specialised in the committee area. The company secretary is also useful in making sure that you are getting feedback from directors on various initiatives and nothing falls between the cracks.
Boards are getting smaller. The number of executive directors on boards is decreasing because people want smaller boards and because companies are trying to get a percentage of women on the boards. Executives tend to be male and therefore the more executives you have on the board, the bigger the challenge of getting a balance of non-executive women to meet the requirement [Lord Davies’ recommendation for 25% female representation on boards].
The board has a responsibility for ensuring the future quality of management. You cannot just let the CEO determine who they appoint because at some point you need to be assured that you have a pipeline to replace them. They may not see that responsibility as sharply as the board might, and therefore you need to oversee that process.
It is the chairman’s duty to have the best people available to fill those roles. It is nice to have internal succession, so there should be a process of ensuring the feeder group is there. You want the strongest category of people inside, but nevertheless you should be prepared to look outside diligently.
This tends to be done initially by the nominations committee, but also by the board in determining the quality of management succession. The chairman plays a significant role, making sure there is the right balance and quality of directors, although they do take input from the nominations committee. It tends to be the senior directors on the board that are a subgroup that facilitate the review of the board and management.
That is a process whereby you are re-appraising the shape and structure of the board on an ongoing basis. Barclays do annual board reviews and as part of that we seek input from the directors on these matters, and also on the quality of the individuals on the board.
Executive remuneration seems only to go up – particularly in the case of the CEO. I am convinced that the surveys of the marketplace act as a vehicle for inflating executive salaries.
It is the responsibility of the remuneration committee and the chairman has a role in that. This upward pressure on executive remuneration has to be stemmed and it really needs to be connected with the creation of value, part of which is influenced by the management and partly by the market. You need to have a serious evaluation of performance to determine whether it is the management’s interaction that led to the outcomes or whether they were swept along by a rising tide. Half of all CEOs are average to great, and half are average to awful. You need to make sure that the people who are not performing do not get paid, and then to make sure that the people who do perform do get paid.
The bonuses in commercial banking are a fraction of the bonuses in people-based businesses, such as fund management and investment banking, where individuals matter more than big processes. The problem with this is that in the early days base remuneration was small and heavily geared towards incentive remuneration, the logic of which was to keep your variable costs related to your contribution to the company. When the company’s contribution is weaker, the costs are lower, and when the contribution is stronger, the costs are higher – it was not fixed.
As a response to regulation, we have ended up inflating the fixed element of remuneration so that it is within European requirements. These tend to be inflexible downwards so if the investment bank is not performing as well, the highest quality individuals are likely to get attracted to jobs elsewhere and bought out of their present arrangements. If you cut their incentives, even though the company may not have performed, you tend to lose your best people. The only remedy for that is that the whole industry has to be more realistic in terms of its remuneration levels in subdued times.
The industry coming together is the solution. People are reticent to do this because of antitrust legislation, but it is in everybody’s interest that the unreasonable levels of compensation come down. There should be a way for the industry to admit that it got it wrong in order to establish a more balanced position. I would not hold my breath on this – it takes a lot of courage to be the first to speak out.
Nevertheless, bonuses should be based on excess returns. First, shareholders should get their cost of equity back and thereafter anything that is in excess of that can be shared proportionately and reasonably with management. Where there are no excess returns it is not clear to me what the logic for bonuses is.
It is important that senior executives are measured over time to truly reflect the consequences of their actions – one year does not do it. Three to five years is about the right territory. Having that aligned to shareholder interests is the principle. I prefer using deferred stock as reward, however governance bodies will not have it. I used to rank the people according to value and I would give the most valuable people more deferred stock than the less valued people. If they were not valued at all, I did not give them anything.
This would be a proportional investment: a third would be invested in year three, a third in year four and a third in year five. If someone is not there to collect it, they should not get it. In other words, the stock does not belong to the individual – the company will decide whether in year three, four or five if it should be paid. This system works because the stock is contingently allocated – it would not be paid if in the meantime that person was not as valuable to the company.
Unfortunately there is not enough trust in the system for that to be the way forward. Instead we have these torturous schemes that only the CEO and finance officer can understand, such as claw back and other complicated mechanisms. Rather than give them a bonus and then find a way of taking it back, I would just not give them it. We want success to be rewarded, not to handle failure.
There is a correlation between successful companies and good governance. However, shareholders are focused on less successful companies’ governance. Once a company is beyond a respectable degree of success and it has reasonably traditional governance mechanisms, there is not a problem to be solved.
The problem arises when there is a failure, as the banking industry did in the global financial crisis. It was to do with the importation of America’s aggressive bonus culture, incentive compensation sales systems in retail banking, PPI mis-selling and so forth. There was either a lack of supervision by management in terms of the degree of risk that the company ran, whether that was an overextension of the balance sheet and its inability to fund it, and/or the level of risk implicit in its activities. There must have been a lack of board oversight of the overall process.
I went into RBS as part of the rescue and found two things had happened that caused the problem there. One was that the investment bank went out of control, which was not reigned in by the chief executive or the board. Two, the acquisition of ABN AMRO at the top of the cycle compounded each other’s effect. So, instead of the company having a serious problem, it had a terminal problem. If the oversight forces had been more effective, then other decisions would have been made. Individual directors should stand up and be counted and the board should heavily scrutinise the behaviour of management and their results.
If you are in a very successful country, a company is likely to get carried by the current. Therefore part of a company’s success is being in the right place at the right time and swimming downstream. In some ways that context can be helpful, but it could be unhelpful.
I have been in business for 46 years, and in that time I have never ever seen a proposal, whether it is a loan or an investment, where the cashflows do not go up. I have never seen a business plan that builds in a downturn of the economic cycle. Management is therefore inherently optimistic – there needs to be a deposing force which says that the board should be sceptical, to offset this inherent force.
Businesses must give something up in good times for the preservation of value in difficult times. If they overextend themselves and take too much risk, the consequences in difficult times are more severe and this is deeply felt in banking. For example, if a bank gets into difficulties in a downturn, it takes seven to 10 years for it to normalise, and by normalise I mean earn its cost of equity. For example, seven years after the global financial crisis Barclays is trading at 0.6 times its book. And RBS is still partly owned by the government.
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