CEOs of Australia’s largest banks receive the lion’s share of their pay through incentives, such as cash bonuses, stock options and shares.
Incentives primarily exist to align the interests of CEOs and shareholders. Shareholders invest in companies because they expect superior firm performance, and therefore CEO remuneration should reflect the level of firm performance they deliver.
However, these incentives can take on a life of their own, incentivising excessive risk-taking, with limited repercussions for CEOs. In the quest to outperform rivals, does incentive pay encourage CEOs to take excessive risk?
Our Monash University research team identified a direct link between ASIC (Australian Securities and Investments Commission) investigating or penalising a company, and the way CEOs are paid.
A recent study is among the first to directly link CEO incentive pay to adverse firm events such as fraud and money laundering of Australian banks.
The research found that adverse firm events are 42% more likely to occur when the majority of CEO pay comprises stock options and shares.
Take, for example, Ian Narev, the former CEO of Commonwealth Bank Australia (CBA). In the financial year 2017, he received total statutory remuneration of $5.7 million, including $3.1 million attributed to cash bonuses, stock options and share incentives.
In the two-year period following Narev’s departure amid fraud and money-laundering concerns, CBA, among other measures, was required to:
- repay $89 million for fees for no service
- pay $15 million for rigging the Bank Bill Swap Rate (BBSW)
- repay $9 million for failure to comply with financial advice licence conditions
- refund $10 million after selling more than 65,000 customers unsuitable insurances.
Commonwealth Bank isn’t the only bank Australian regulatory authorities have penalised in recent years.
At each of these banks, the CEOs were heavily incentivised to deliver superior financial performance above other non-financial metrics.
Here’s why CEOs are financially rewarded to take on excessive risk.
Those who determine CEO pay aren’t always impartial
The board of directors on ASX-listed companies traditionally determine CEO pay through a “remuneration committee”. This is because the board is perceived as being neutral.
However, evidence suggests there’s a link between highly-paid boards of directors and highly-paid CEOs. As a result, mutual back-scratching exists, where directors may not want to bring attention to a company culture of excessively paying executives, due to the potential for their own excessive pay to also be critiqued.
In addition, boards are often stacked with friends of friends, and directors who sit on multiple ASX boards. Why criticise friends and colleagues if it may limit personal relationships or future job prospects?
Incentive pay accounts for the majority of CEO pay
Our study found that incentive pay was up to 90% higher than the amount received as a fixed salary. This is partly down to the remuneration policies of each bank – ANZ, for instance, in 2019 gave its CEO the ability to earn up to 200% base salary through incentives.
CEOs can maximise their salary through a focus on meeting financial performance metrics
The majority of Australian banking CEO pay comes from stock options and shares, and there are certain key performance indicators CEOs can focus on meeting in order to maximise their pay.
For example, financial metrics play a major role in determining how many stock options and shares bank CEOs receive, which is different to other forms of pay such as cash bonuses that place greater emphasis on non-financial performance metrics.
This means that for CEOs to maximise their remuneration, they can focus on improving company financial performance, as opposed to other non-financial metrics such as corporate social responsibility, quality of service, and governance.
So what? Well, this is exactly what the Australian Prudential Regulation Authority (APRA) is trying to stop
APRA has known for years that the way CEOs are paid influences risk tolerance and decision-making.
In its 2018 Information Report, APRA found a key factor leading to the Global Financial Crisis (GFC) was misaligned incentive structures, resulting in “poor risk cultures and undermined risk management, leading to unbalanced and ill-considered decision-making”.
Fast forward to 2021, and we know CEOs are 42% more likely to fall under ASIC investigation if the majority of their remuneration comprises stock options and shares.
Similarly, we know that to receive these, CEOs need to meet performance metrics largely driven by financial performance.
Despite APRA’s best attempts, CEO incentive pay continues to encourage moral hazard, where CEOs take undue risks because they benefit from their pay structures, while shareholders bear the costs.
Without change, Australian companies, shareholders and customers will continue to be affected by aggressive lending practices, as well as shortcuts and lapses in adhering to compliance procedures.
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