Friday, November 26, 2010

Managerial Compensation and Risk Incentives in the Financial System

By Olu Akanmu

Given our recent experience and the need to rebuild public trust in the financial system, we will need to reshape the values of managers of businesses in public corporations to which we have endowed our privileged trust, as customers, shareholders, government and the larger public. One of the most important lessons that managers need to re-learn is that an organization does not just exist to make profit for its shareholders alone. That a good company is that which has a social purpose for which making profit is the by-product of fulfilling that larger social purpose. Therefore, a good company is not that which posts bumper profits that managers celebrate but harms the larger interest of other stakeholders such as customers, the government and general public welfare. A good company is that which is able to optimize the interest of all its stake-holding groups of customers, shareholders, the state and the larger public. It provides great products and services that improve the quality of life of Nigerians, return good profit to shareholders while contributing to national economic development. A good company will not significantly externalize the cost of its business. When a company makes huge profit by destroying the environment, and gets away with it, because social institutions are weak to make it pay for it, it is externalizing its cost and betraying public trust. As we have seen all across the world, when managers of financial institutions take excessive risks, which endanger the financial system and have to be bailed out by their governments and state resources, they are externalizing the cost of their firm’s profit. In Nigeria for example, the opportunity cost of the money used to bail out our banks are the roads, schools, hospitals, power and public infrastructure that have to be forgone because public resources had to be diverted to save the financial system. Society has trusted too much. The fact is that firms will most always externalize their cost unless there are social institutions such as regulations and the tax system that prevent them from externalizing their cost or make them pay for it, when they do so. That is why we support the policy of the European Union that banks need to be taxed specially to build a pool of funds which shall fund the cost of future bail-out of the financial system when the need arises again.

The argument above however presupposes that if the interest of managers and the larger public interest are not always fully aligned, that at least managers are acting as true agents of their principal (their shareholders) and their interests are both aligned. This is not always so. Our compensation policy especially the big annual profit bonuses, tend to reward managers excessively for the short term over the long term. This tend to create a classic moral-hazard problem where managers take investment decisions with excessive long term risk, which may not crystallize in the early years when they cash in on their short term profit and profit bonuses. When these risks eventually crystallize in the future, the managers have moved on, leaving the firm, its shareholders and future managers to manage the consequences of fallen profit and collapsed share prices. This phenomenon has new lingo and acronym in behavioural finance called IBGYBG meaning I’ll Be Gone, You ‘ll Be Gone. Essentially, our compensation policy creates a perverse incentive that encourages a risk behavior that transfers the negative consequence of managerial risk decisions to someone else in the future while the manager appropriates the reward in the short term. When the reward of a risk could be appropriated by the risk taker, and the consequence of the risk is for someone else, there is a tendency by the risk taker to take excessive and sometimes unreasonable risk. This is the moral hazard problem in risk management. It plays heavily in the nature of our managerial compensation where rewards are heavily weighed in favour of annual profit bonuses and virtually nothing in long term share prices of corporations. With the benefit of hindsight, looking back at the downstream oil and gas businesses and the margin loans transactions of our banks in the period of financial industry exuberance, we could see clearly the IBGYBG syndrome manifesting strongly among our managers. We could see the way the perverse incentive and compensation of the industry for short term rewards, immediate profits and annual bonuses made our managers underplay or even ignore the long term consequences of their transaction risks. This will need to change to align managerial interest better with that of shareholders and strengthen public trust in corporations. Compensation of managers must carry a significant long term portion related to the future share prices and values of their firms, as a function of the long term impact of their managerial decisions.

We like to say however that we have no issue with size of the compensation of the manager as long as it is a function of the shareholder value created and it contains a significant long term portion that ties the compensation to the long term consequence of managerial risk decision. We recognize that there are short term pressures for talents in organizations that tend to encourage short term managerial rewards such as strong annual bonuses to keep valuable staff from competition. Given our recent experience and the need to rebuild trust in financial system, ensuring a better alignment of managerial interest with shareholders, our compensation policy must balance the need to keep our talents and the need to ensure that those talents kept and their executives are actually working for their shareholders in the long term.

Olu Akanmu
Novermber 2010