1. The Global Financial Crisis
As with any war, crisis or other historical event, the most important thing to do is to learn from it and ensure history isn’t repeated. The global financial crisis of 2007/8 has provided those who seek, with many well worth lessons to be learnt. The four most important of these lessons are discussed in detail in this report, as they relate to various key stakeholders in financial institutions.
In the past two years the financial sector has witnessed many high profile corporate bankruptcies and hundreds more smaller insolvencies. This financial crisis has been noteworthy due to the global scale and impact of these bankruptcies despite the increasing levels of international regulation, such as Basel, and advancements in financial modelling. The lessons discussed within are discussed with regards to preventing future episodes of mass insolvencies.
2. Chairman of the Board of Directors
Financial services firms are unique in that its employees are one of its most important assets, they are the revenue drivers. All employees must be rewarded for their effort and it is a typical fashion in the industry to reward employees who have performed, with a bonus. The design of the remuneration structure is crucial in determining the attitudes the employees will take on.
It is the duty of the board of directors and the chairman to ensure the interests of the employees & management of the company are aligned with that of shareholders. However, recent remuneration structures of financial institutions have achieved anything but this. It has been argued that excessive risk taking encouraged by inappropriate remuneration structures played a key role in the financial crisis. This demonstrates the importance of a well designed compensation structure.
Remuneration and bonus incentives must align employees’ interests with the long term profitability and goals of the firm. Evidence suggests that this is not the case; CEO’s remuneration has not closely followed company performance . Schemes such as share and option bonuses that have a minimum holding period should be used. If the percentage of remuneration that is payed out through long term performance bonuses is not high enough, it will fail to achieve its goal.
Performance based bonuses that is typically payed to senior management must be based on a risk adjusted or cost of capital basis. There is a moral hazard with a commission structure that does not take this into account – employees/management will be encouraged to take large risks that produce large returns, despite the potential negative consequences of bringing on that risk. This has been evident at UBS , where bond traders favoured holding higher yielding subprime mortgages to lower yielding better quality mortgages in an effort to boost their bonuses.
The third key area of improvement in terms of remuneration structure is transparency. The compensation payed to senior management should be made available...