Is Money the Root of All Evil?
A Look into Balanced Incentive Systems
This article investigates the role of balanced incentive systems and their significance in support of a sound risk culture. With the ongoing regulatory focus on this topic, the article provides an overview across global and Asia-Pacific perspectives and dives into some of the best practices in the market as an early benchmarking and heat map for the region.
Tackling the Culture Problem via Incentive Systems
Since the 2008 global financial crisis, numerous actions have been taken to enforce a more resilient and robust financial system. However, financial scandals with conduct as the root cause still remain rampant, evident from incidents of rogue trading or mis-selling of financial products. With culture and conduct identified as one of the biggest blind spots of the financial industry1, regulatory focus has shifted towards poor culture, insufficient risk management and weak internal risk controls to address the issue.
Since heavy reliance on training and awareness campaigns seldom instill long-term results, regulators are recently looking towards the redesigning of balanced incentive systems. Like all reward-based compensation models, a common pitfall faced by wealth management and private banks is the unintended consequence of incentivizing short-term profit of front office staff at the expense of client interests and the long-term financial soundness of the organization. A «financials-only» incentive system creates an intrinsic motivation for front office staff, where aggressive sales targets create either a pressure to deliver or spawn greed for hefty compensation that accompanies the achievement of these targets. This induces the wrong kind of risk-taking behavior. A well-structured incentive system with proper accountability mechanisms in place can prevent imprudent risk decisions and help to translate the desired risk culture, vision and mission of the organization into performance measures that can be consistently quantified and appraised.
Message from the Regulators
Despite the perverse impacts of generous incentives amplifying excessive risk-taking, most banks stood by the view that incentive payouts are largely unrelated to risk governance and management. Acknowledging these shortfalls in large global financial institutions, the Financial Stability Board (FSB) published a set of global principles2 and standards3 towards sound compensation practices, further supplementing this in 2018, to provide guidance4 on the role of compensation tools in addressing misconduct risk. They touch on the importance of effective governance where stewardship of compensation practices requires full range of responsibility from Board members to senior management, front office and control functions, in terms of both oversight and engagement. It is recommended that a well-structured incentive system should consider the integration of non-financial metrics into overall performance assessment. Variable incentives should be at risk of reduction as per the severity of misconduct and the time frame for the materialization of misconduct risk. Such policies should be consistently communicated to ensure transparency and fairness in reinforcing appropriate standards of behavior.
Authority (APRA) has further provided guidelines and recommendations, raising the bar on remuneration policies, governance and controls5. From a review in 2017, most financial institutions met minimum requirements but are still lacking adequate risk-adjustments on their overall performance assessment. Generally, the lack of consideration towards claw-back mechanisms gives evidence of a lack of consideration towards longer-term risks. The design and implementation of balanced incentive systems will continue to be a core focus to ensure that remuneration practices are aligned and supportive of a strong risk culture.
The Monetary Authority of Singapore (MAS) recently had a roundtable on Culture and Conduct Practices and Incentives Structures6, where it highlighted that incentive systems should not be overly focused on financial targets. The regulatory perspective7 is that remuneration policies must not only motivate sales or profit-driven performance, but also penalize poor conduct to deter bad behavior. In a recent March 2019 information paper8, MAS reviewed its outcome from a series of thematic inspections on selected private banks, focusing on the role of incentives in influencing misconduct and misbehavior. It was similarly observed that while all banks have frameworks and policies in place, there were gaps around the actual implementation.
The Hong Kong Monetary Authority (HKMA) initiated a Bank Culture Reform9 in 2017 and a follow-up self-assessment10 to be completed by mid-2019. In its three-phase supervisory plan, HKMA highlighted the importance of governance, incentive systems, and assessment & feedback mechanisms in banks. Given the strong focus on incentive systems, banks will have to reflect on the completeness of their compensation models and if it adequately considers the adherence to desired cultural and behavioral standards across various levels within the bank. Holistically, the aim is to promote a risk culture of doing the right thing with a robust risk framework and pre-emptively prevent misconduct cases with a balanced incentive system.
The banking regulator in Mainland China, the China Banking and Insurance Regulatory Commission (CBIRC), published its first and only guidance on conduct in March 2018. As stated in the guidance, the consideration of risk behavior should be factored into a bank’s incentive policies and processes, in relation to performance management, talent programs, career progression paths and financial compensation. However, in comparison11 to Hong Kong, staff conduct in Mainland China is, in most cases, managed by a «stick» that penalizes wrongdoing rather than a «carrot» that promotes the right behavior.
The following section will look into some of the best practices in the region and recommended steps in anticipation of further thematic inspections to come.
Balancing Risk and Reward
The real challenge in developing a holistic risk-adjusted incentive system is to achieve a fine balance between risk and reward so bankers do not obstruct the profitability of their banks in the long-term, nor compromise the attainment of their own revenue targets in the short-term. Not only must it be a top-down bottom- up collaboration between various roles and functions, but to garner acceptance from front office staff, it must also have a reasonable appetite for risk, «carrot and stick» approach, clear visualization of risk performance and most importantly, clear communication process to avoid being overly punitive and complicated ( 2).
Current state of Incentive Systems in Industry- Leading Banks
In H1 2019, Synpulse conducted a series of surveys and interviews with various C-level, front office supervisors and staff across different wealth management and private banks in the region to gather information on the existing set-ups of their incentive systems, risk frameworks and standards. From the data collected, the top four industry-leading banks are represented in a rating matrix to benchmark their current state against expectations from a regulatory perspective ( 3).
Results show that the leading banks have included risk-based considerations in their overall performance assessment of front office staff. However, the impact on actual bonus compensation pay-outs are either not communicated or are still unclear. Effectiveness of the established incentive systems can be improved as most have failed to meet either one or two components identified as key elements of a balanced incentive system.
With the increasing focus from regulators and some of the best practices gathered, these five key elements now create a baseline for all banks to assess and analyze the effectiveness of their own incentive systems.
Top-down Bottom-up Collaboration
«Vision without action is merely a dream. Action without vision just passes the time. Vision with action can change the world.»
- Joel A. Barker
While it is important for the Board and senior management to set the right tone for the desired risk culture, mission and vision to resonate top-down, effective risk management requires a common awareness, accountability and collaboration bottom-up. Therefore, sufficient resources, effort and cooperation across various functions must be devoted into the design, implementation and execution of a well-balanced and fair incentive system.
It is also observed that some banks still have their compensation policies lying solely with the Human Resources (HR) department. Instead, from the design to the execution of the incentive system, the entire lifecycle should be overseen by the Board and senior management in sponsoring and providing a clear direction to align with the organization goals and the risk appetite statement, while still having independent control from the finance, risk, compliance and HR functions, each with clear roles and responsibilities defined ( 4).
Defining an acceptable Risk Appetite
Risk is an integral part of business and cannot be eliminated, instead, risk exposure can be managed and balanced while pursuing strategic goals. A key step for all banks is to assess and analyze the effectiveness of the current risk control layers.
A formal assessment of key business processes across the first line of defense (risk function) and second line of defense (compliance function) should be conducted at regular intervals to ensure all potential risk events are identified, then mapped in a risk matrix in terms of likelihood of occurrence and impact to the organization. With this matrix, tolerance for risk events can be segregated and prioritized with various boundaries assigned in accordance to their severities. Based on the business objecti- ves, financial standing and size of the bank, an appropriate risk appetite statement can be defined and communicated to all front office staff, creating a reference point for the amount of risk-taking that will optimize risk and reward.
Clear communication on the risk appetite sets the tone for the desired risk culture and increases consciousness towards excessive risk-taking in daily business decisions. The risk appetite statement and tolerance-levels of risk undertaken should be a strategic decision made by senior management towards the operational focus of the bank. This further drives decisions on the impact of the risk towards compensation decisions when formulating a structural path to aggregate various metrics into a holistic performance assessment.
As per the rating matrix, all four leading banks have a well- defined risk control layer or a «risk-scoring» mechanism in place. But apart from them, some of the other banks surveyed still send mixed messages on their risk culture by continuing to reward top producers for their achievement of financial targets despite evidence of poor risk conduct. Inevitably, biasedness in compensation favoring top producers will still take place with a lack of formal linkage between identified risk metrics and the compensation model.
A «Carrot and Stick» approach
The risk control layer acts as an ex-post adjustment mechanism to capture known risk events and quantitatively measure misconduct incidents that have already taken place. But to ensure that unknown or eventual risks are accounted for, a qualitative element must also be linked to the quantitative model so supervisors can document detected risks that cannot yet be quantified. This also allows for ex-ante incentives, where qualitative evidence of good risk conduct can be accounted for towards performance appraisal.
With a framework of consequences and incentives, exceptional performance in all areas (financials, risk and behavior) can have a positive impact on compensation, reward and recognition, whereas disciplinary actions, promotion impediments and negative impacts on compensation can act as a deterrent to misconduct.
Most of the banks surveyed have a set-up that is purely formalistic in nature, tracking severity of misconduct then applying a deduction, or a maximum cap, on the variable compensation during year-end evaluation. This creates a culture of fear, where a lack of ownership and accountability may instead lead to the hiding of mistakes that impede identification of risk. Minor «careless» mistakes must be clearly differentiated from graver cases of «willful» misconduct and correspondingly, consequences issued out should also vary in severity to avoid over-punishing minor offenders. Of the four leading banks, only one has been noted to include a qualitative element of documenting evidence of good risk conduct for consideration into their overall risk performance evaluation.
Visualizing Risk Performance and Evaluation
The visual output of the various metrics that contribute towards performance assessment can make a significant impact towards the effectiveness of the entire incentive system. It allows individuals to track their own performance, while providing supervisory oversight for performance tracking and helps guide decisions on the monitoring and training of staff.
Before information can be displayed on a dashboard, a staging layer is necessary to prepare disparate data from various sources, blend and load them in a data warehouse before deploying onto a dashboard. This ensures data quality and consistency while maintaining a log on the data history for trend analysis and reporting, as well as leaving an audit trail on manual overrides and waivers that have been granted. For this purpose, role- based authorization must be implemented for tighter control and security.
A common finding from the surveys conducted was that most banks lack visualization tools that can provide transparency towards real-time tracking and management of risks in front office staff. Majority of them make use of monthly static reports sent out via emails to staff and their supervisors, but this is a laborious process and proves ineffective for governance reporting and data analysis.
Clear Communication Process
Rules and regulations alone are insufficient in preventing the onset of risk; regular risk-awareness trainings must be in place to constantly hone and equip front office staff with up-to-date knowledge in understanding and managing risks. Most banks have implemented new-joiner trainings and refreshers for existing staff, but apart from these, comprehensive post-training support should also be available to increase the knowledge retention of staff, such as readily accessible factsheets, frequently-asked- questions, quick-reference guides and help desk contacts. Regular web-based/classroom trainings, townhalls and meetings should also be held for all staff to keep up-to-date on new regulatory updates and process changes.
Effective communication plays a big part in driving collaboration, boosting morale, increasing productivity and instilling discipline. This applies across all levels in the organization — Board members and senior management setting the tone for the desired risk culture, business and middle management working together to disseminate these expectations downwards and front office staff in providing feedback for improvements.
Notably so, many banks in APAC have already embarked on the journey towards redesigning and enhancing the effectiveness of their incentive systems to positively influence the culture, values and ethics of their business operations. While this transition requires great effort and benefits of positive culture change may take time to materialize, the journey has become an imperative part of the risk management set-up of all banks.
Maturity of risk controls will require constant reassessment and enhancement due to the continuous evolving nature of new and existing risk challenges. Having a strong culture that is deeply ingrained in the bank will then become a competitive advantage to stay ahead of change.
How Synpulse can help
Synpulse is a trusted partner of many large private banks operating globally and in Asia. We have hands-on experience in delivering risk culture frameworks in accordance to local regulatory requirements, with a clear focus on the performance appraisal and incentives system, as well as the technologies associated.
Applying the Synpulse approach has enabled our clients to develop and deploy holistic mechanisms to:
- Support appropriate and controlled risk taking with enhanced risk monitoring
- Ensure effective supervisory oversight
- Provide transparency and allow for individual performance tracking
- Align incentives and rewards with ethical and sustainable performance
- Have clear change communication and training execution
This article is authored by Bernice Koh (Senior Consultant), Jingyi Li (Associate Consultant), and Marina Mai (Consultant).
1 In Search of Banks’ Moral Compass – How are Bankers Acting When Nobody is Looking? – July 2018
2 FSF Principles for Sound Compensation Practices – April 2009
3 FSB Principles for Sound Compensation Practices, Implementation Standards – September 2009
4 Supplementary Guidance to the FSB Principles and Standards on Sound Compensation Practices – March 2018
5 APRA «Remuneration practices at large financial institutions» – April 2018
6 MAS «Elevating Standards of Culture and Conduct in the Banking Industry» – March 2019
7 MAS «Culture and Conduct - A Regulatory Perspective» – March 2017
8 MAS «Incentive Structures in the Banking Industry – Fostering Sound Behaviour and Conduct» – March 2019
9 HKMA «Bank Culture Reform» – March 2017
10 HKMA «Supervision for Bank Culture» – December 2018
11 Hong Kong vs. Mainland China: A Series of Framework Comparison (Part 3) – July 2019