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Reputability LLP are thought leaders in the field of reputational risk and its root causes, behavioural risk and organisational risk. Our book 'Rethinking Reputational Risk' received excellent reviews: see www.rethinkingreputationalrisk.com We help business leaders to find these widespread but hidden risks that regularly cause reputational disasters. We also teach leaders and risk teams about these risks. Here are our thoughts, and the thoughts of our guest bloggers, on some recent stories which have captured our attention. We are always interested to know what you think too.

Friday, 24 January 2014

Bankers’ Bonuses - solving the risk conundrum

The reputation of the banking industry has been battered harder, and for longer than any other industry in the last 5 years. For many, the root cause has been the bonus culture which produced perverse incentives and very high levels of pay.

The advent of the bonus culture can be traced back to the "Big Bang” in 1986, which reformed the way the stock exchange worked and which allowed the banks to buy the member firms.

Originally bonuses looked like a sensible way of handling the very volatile revenues in stock brokers. They allowed the employees of stock brokers to participate in the years when revenue was high, but kept salaries and fixed overheads down for the lean years. Individual success could be rewarded by a discretionary bonus paid by the partners, but everyone got something in the good years, but equally, very little in the bad years.

Post "Big Bang” the world changed, not simply the nature of the parent bank’s business, but the risks it faced. Gone were the small unlimited partnerships where the partners had joint and several liability for all the firm’s debts. Under the old rules, the risk taking allowed or even countenanced by partnerships with limited financial resources was always going to be very modest. But these partnerships were now swallowed up by merchant banks and in due course they in turn were swallowed by the bigger clearing banks and big international banks. Competition became intense; hardly anybody made any money out of equity broking, so they diversified into new areas, which developed in the wake of the City reforms in the “Big Bang”. Big banks began to throw capital and funding at their investment banking subsidiaries in an effort to squeeze out the competition. And the pell-mell expansion in the decade after the “Big Bang” needed a massive expansion of personnel, which drove up salaries and bonuses.

The scene was now set for the bonus culture to take off. New rich parents allowed individuals to settle into a style of behaviour which maximised their personal income. Increasingly employees began to appreciate that for the risks which they took on, it was a case of heads I win a big bonus, tails the bank picks up the loss. But this style of behaviour involved the parent bank’s reputation in an unexpected way. Not only did the parent supply capital to its investment banking subsidiaries, but they provided cheap funding to oil the wheels. This cheap funding came from the parent bank which on-lent funds raised in the wholesale money markets, at fine rates where the parent bank had a well-established market reputation.

Investment banking subsidiaries could make good use of abundant cheap money whilst things went well, but in 2008 question marks began to emerge about the quality and value of the assets held in the investment banking subsidiaries. This led to a massive haemorrhage of liquidity from wholesale money markets, which not only threatened the supply of cheap funding to their investment banking subsidiaries, but the funding of the parent itself. Without help from the government, disaster beckoned.

Now the banks are under pressure to undo the bonus culture, but to date there is little evidence that bonuses have really been cut back. Are the banks in denial? Don’t they understand how much they are loathed for bringing the country to its knees?

But it would be a brave bank which radically reduced its bonus structure today. The haemorrhage of staff to banks which were not doing the same thing would be evident within a year. The investment banking business may not be making as much as it was pre-2008, but it would still be a big chunk of profits to leave at risk. If all banks were to take action together, and at the same time, it might be possible to cure the bonus cultural problem. Is it conceivable that all the world’s investment banks would agree to take action at the same time? Probably not; but there are signs of a belated recognition of the damage of recent years. Things are changing in ways that should help reduce bank risks if not public outrage.

Following Goldman Sach's example would require top management to hold up to 75% of bonuses as share awards until they leave the company, with many senior staff similarly obliged to hold 25% of any bonus award as shares.

HSBC has followed Goldman’s example, requiring bonus shares to be held to retirement with a clawback arrangement. UBS not only has a bonus/malus system but pays most senior bonuses in bonds and shares and requires Executive Board members to hold at least 350,000 shares and the CEO to hold 500,000. At about twenty francs apiece this means holding from 7 to 10 million francs in UBS shares. And it has just emerged that Credit Suisse now pays part of bonuses in "bail-in-able” bonds that have to be held for 3 years and can be converted to equity or wiped out in the case of trouble.

Progress towards reforming the bonus system is late and slow, but there are signs that the banks are responding. Putting years between the award and the realisation of the bonus helps weaken the perverse incentives arising from a ‘heads I win tails you lose’ approach to risk taking. Bad consequences have time to arrive. It could to lead to regulators seeing such banks as less risky.

Paying bonuses in shares puts bank leaders in the same currency as shareholders, who have still not recovered from the terrible beating of recent years.  Paying bonuses in bonds that 'bail in' is even better.  So may be be the leviathans are starting to get it, and more importantly are doing something about it.  In a way that probably reduces risk.
 
John Tyce
Reputability LLP
London
 

Thursday, 23 January 2014

Behave yourself; Someone is always watching!

The media spotlight focussed on President 'Malchance' (or Hollande as we Brits know him) illustrates perfectly how individuals and their organisations become overwhelmed by unwelcome attention as soon as a story captures the public's interest.

What started as a report of a personal peccadillo soon gained traction as the beleagured President made a desperate attempt at his news conference to focus interest on his economic policies. This worked with the generally compliant French broadsheets for about a day. Since then, journalists have had a field day, using the ongoing saga as a basis for 'breaking news', 'in-depth features and opinion articles ranging from an examination of the cultural differences between the French and British media to more lurid pieces on the libidos of powerful men. Photographers and cartoonists have joined in with relish!

This damaging episode illustrates a truth, more relevant now than ever before, which is that nothing, but nothing, is private. We may have laws that purport to protect privacy, but anyone can publish information. This information may or may not be accurate, but if redress is to be had, it often comes after the event, giving mischief-makers another opportunity to rake over the embers of the original story.

This reality of modern life is as true for business as it is for individuals. If the media get scent of a story, then their investigative processes are just the same. In our era of complete accessability there is now no part of business life that can genuinely be considered confidential. We may think of something as private or secret, but as News International's former executives, the Care Quality Commission, BBC Trustees, the NHS, the Coop Bank, MPs and even the USA's National Security Agency know, unpalatable stories will eventually emerge.

So, if you are doing something of which the public might not approve you must assume they will eventually find out -and probably in the most inconvenient and embarrassing circumstances. There has never been a better time to renew that commitment to ethics in business - and in life!


Jane Howard
Reputability LLP
London

Tuesday, 14 January 2014

People Risks - Achilles' Heel strikes again!

Behavioural and organisational risks have caused yet another corporate crisis despite a risk management system described as top quality.  Why does this keep happening?  And what are the lessons for boards?

Last week RSA, the UK’s second largest general insurer, announced the results of reviews by KPMG, PwC and its own Internal Audit function into the £200m black hole in its Irish business.  Revelations of the debacle had led to the resignation of Group Chief Executive Simon Lee in December and a share price drop of over 25%.  The reviews describe how senior managers in Ireland had ‘inappropriately collaborated’ in the accounting of premiums and reporting of large claims so the accounts did not reflect the true financial position of the business. The managers involved have since been dismissed.

Fortunately for RSA, the reviews confirm that the problem is confined to Ireland and that other parts of the Group are unaffected. They go on to say the Group system of governance includes a control framework built on the ‘good market practice of three lines of defence’. They emphasise that it is appropriate in terms of structure and design for an international insurance group of RSA’s size and complexity, and elements of its design compare favourably across the market.

So why did a conventional risk framework, in this case apparently as good as it gets, fail to pick up such a key risk to an insurer? After all, improper manipulation of premiums and claims reserves is hardly a new phenomenon.  Those who know the history of the insurance industry will remember many other examples including Michael Bright’s Independent Insurance and HIH; some memories will go back as far as Emil Savundra’s Fire Auto & Marine in the 1960s.  Analagous ‘financial irregularities’ regularly occur in other sectors. 

An important pointer can be found in 'Roads to Ruin' the seminal Cass Business School report for Airmic and in Reputability’s follow-up report 'Deconstructing Failure'.  The root causes of almost all the catastrophes studied emerged from human behaviour and the way in which humans are organised within a firm – behavioural risks and organisational risks or ‘people risks’ for short.  These include people risks right up to people at board level. 

Unfortunately it has recently become clear that conventional risk frameworks, including the ubiquitious 'three lines of defence' approach, provide no systematic defence against people risks.  They just don’t to go there.  This is partly because conventional risk management hasn’t evolved far enough.  But it’s also because the area is far too dangerous for anyone below board level to delve into.

As the Parliamentary Commission on Banking Standards put it, the officially approved and widely used ‘Three Lines of Defence’ approach gives firms ‘a wholly misplaced sense of security’.

The Financial Reporting Council is one of many regulators that has tuned into the importance of behavioural and organisational risks.  Their latest proposals require companies explicitly to disclose and describe significant risks with their origins in behavioural and organisational issues; and they list dozens of practical questions for boards to ask themselves about behavioural and organisational risks.  The aims are to help boards oversee the practicalities of managing such risks below them and to recognise that such risks surround and permeate boards themselves.

RSA's crisis provides a timely warning to all boards.  Few if any risk management systems have behavioural and organisational risks systematically in their sights let alone under control. These potentially devastating risks are unrecognised and thus unmanaged.

Boards need to gain a deeper understanding of the underlying issues before they can lead their risk teams in the right direction to bring these dangerous risks under control.  Board leadership is essential.  Specialist education for boards is the first step.  

Anthony Fitzsimmons
Reputability LLP