Smarter incentives: Turning the regulatory shake-up to your advantage

The regulation of reward is intensifying and fragmenting as more staff are brought into the net and the rules in the EU and other parts of the world continue to diverge. Short-term tactical responses are still possible, including raising fixed salaries. But the growing fragmentation of reward arrangements within the business and impact on costs are going to be harder to sustain over the longer term. While the initial focus has been banks, the deferral and governance requirements are being progressively introduced in insurance and asset management.

‘Smarter incentives: Turning the regulatory shake-up to your advantage’ looks at how clients can address the changes in the short-term, while at the same time putting incentives on a more realistic, sustainable and forward looking footing. This includes aligning incentives into the wider strategic rethink within the business and ensuring they reflect the more modest returns being made.

Why is reward regulation already proving to be such a headache?

Fragmentation

There is little or no consistency in application approach around the world. The EU is applying stringent rules based on how much of the variable pay should be deferred and taken in shares. This contrasts with the largely principles-based approach adopted in the US and Asia, under which incentives should be broadly aligned with the risk appetite and risk-adjusted returns.

Operational headache

For global groups, there is the operational and talent management headache of running multiple and potentially conflicting approaches to reward.

How has it been possible to mitigate the impact?

Few affected

So far, the rules have only applied to a limited number of so-called ‘material risk takers’. These are people who have a major say on risk decisions, such as board members and heads of risk or trading desks, rather than the bulk of traders.*
*Definition correct at the time of going to press (5.12.12). 

Paying more as basic

For the ones who are affected, it’s possible to ease the impact of restrictions on bonus arrangements by increasing fixed salaries as a proportion of overall pay.

Why is the situation going to get harder?

Tighter restrictions

Planned new rules in the EU would impose a bonus cap on banks of no more than two times pay. Some, notably the Netherlands, are set to impose even tighter curbs (no more than 20% of basic pay across all FS sectors).

Broadening the net

The definition of material risk takers is also being expanded to include what is in effect all ‘high earners’. The rules will now apply to around 5–10 times more staff in an investment bank than under the previous definition and 2–4 times more staff in a corporate, retail banking or asset management business.

Is it still possible to mitigate the impact?

Strategic headache

With more people affected, decisions over where to locate key operations are going to be more complicated and it will be harder to attract staff in highly prescriptive jurisdictions. Less incentives and higher fixed costs: If basic pay as a proportion of the total goes up, there will be less incentive for exceptional performance and it will be harder to control fixed costs.

Eroding organisational cohesion

As the variations in bonus arrangements between regions become more marked, it will be harder to maintain organisational cohesion and align incentives with group-wide business objectives.

What’s the longer term answer?

A more durable and forward-looking reward model built around a new ‘bargain’ with staff:

  1. Bringing reward into the wider strategic re-think
    A strategic approach to reward will look how to adapt or concentrate roles that attract regulated responsibilities as part of the wider decisions on what business is core/viable and where it should be located.
  2. Paying what you can afford
    The division between bonuses and shareholder return needs to be re-balanced to encourage much needed investment.
  3. Trade-off for location
    If people want to live in highly controlled jurisdictions for family or lifestyle reasons then they can’t necessarily expect a higher fixed salary to make up for all of the lower bonus potential.
  4. Restoring cohesion in incentives and motivation
    This could include creating explicit career steps for an international cadre of staff, who move between the more and less prescriptive jurisdictions over the course of their careers.