Executive compensation in the modern business world in general and in financial institutions, in particular, has been the subject of public controversy for a long time. The issue is complicated by the fact that the extant research in the fields of accounting, finance, law, business studies, and economics, among others, is characterized by numerous opposing opinions. For example, a study by Fang shows that there is a positive relationship between the performance of a company and the amount of compensation paid to its senior executives (2).
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However, another research study on the link between executive compensation and performance reveals that the relationship is relatively weak (Collins et al. 67). There are also proponents of the view that the problem with executive pay lies in it not being tied to executive performance. Therefore, when discussing the Chief Executive Officer (CEO) compensation, it is of great importance to consider all key perspectives on the issue.
The aim of this paper is to analyze a case study on the compensation of the Royal Bank of Scotland’s CEO, Stephen Hester. The paper will also discuss performance measures used for the evaluation of senior executives and the feasibility of current approaches to compensation in value-maximizing organizations.
Summary of the Case
The chief executive of the state-owned financial institution became part of a social scandal after foregoing a massive bonus. The bank’s chairman was pressured to turn down a £1 million bonus, which was only a fraction of the monetary incentives received by his colleagues in the banking industry (Noe 569). Specifically, in the same year, the heads of America’s and Germany’s biggest banks received £7.7million and $21 million in bonuses, respectively (Noe 569). Mr. Hester argued that he deserved the bonus for the progress made by the bank under his command. However, there were those who believed that the CEO was unfairly rewarded for the poor performance of the organization (Noe 570).
Compensation practices in the finance industry should be influenced by performance measures to discourage excessive risk-taking. An additional reason for introducing performance-vesting provisions into CEOs’ contracts is to ensure that they are not rewarded for poor performance (Croonen). To evaluate the efforts of Mr. Hester, it is necessary to use several performance measures such as stock prices and net income. The evaluation of stock prices is especially important for shareholders, who need to ensure that the CEO provides them with a higher return on their investment (Pandher and Currie 24). It follows that if the bank’s shares are falling, the shareholders can take corrective actions such as restrictions on senior executive rewards.
To determine Mr. Hester’s compensation, it is necessary to take into consideration the net income of RBS. This has to do with the fact that increases or decreases in net income result in fluctuations in the bank’s profit that should be reflected in executive compensation. Furthermore, increases in profits translate into higher earnings per share, which benefits shareholders. In addition, earnings per share indicate the performance of the financial institution, thereby signaling to investors the level of its attractiveness.
The more investors want to spend, the higher the compensation of the CEO should be. A positive relationship between net income and executive reward has been established by a number of independent studies (Pandher and Currie 22).
Other performance measures that should be used to evaluate the CEO are total assets, employees, debt ratio, market capitalization, market-to-book ratio, interest rate, return on assets (ROA), and return on equity (ROE) (Croonen). It has to be borne in mind, however, that whereas net income and stock prices can be positively connected to Mr. Hester’s compensation, there should be a negative relationship between the debt ratio and his bonuses.
The reason for this lies in the fact that a high debt ratio will make the bank a risky investment. If the institution is perceived as risky by potential investors, its stock prices will drop. Similarly, to better understand the CEO’s performance, it is important to measure the profitability of RBS by analyzing ROA and ROE. By assessing these two percentages, it is possible to understand the degree to which the bank is capable of generating income for its shareholders.
The decision of the Board
Senior executives are often offered shares as compensation. Stock options are commonly used to ensure that CEOs are properly incentivized to look after the financial interests of shareholders (O’Donnell and Rodda). It can be argued that the board’s decision to change the CEO’s performance measures was dictated by the need to ensure that he was invested in the success of the organization. Option-based compensation is a well-known method that was developed in the 1990s for making executives more interested in the financial performance of their organizations (Pandher and Currie 22).
There are a large number of scholars who would take the opposite view of the board’s decision (O’Donnell and Rodda; Martin et al. 451). By awarding stock options to executives, financial institutions incentivize them to take unnecessary risks (Martin et al. 451). The risk-taking behavior of senior executives can be explained by agency theory, according to which “equity ownership and stock options, in particular, encourages executives to take more risks in the expectation that risk positively affects the value of their equity in a firm” (Martin et al. 451).
RBS made the right choice by offering executive option-based compensation. Even though there is the downside of excessive risk-taking that allows the CEO to reap the gains without having to share the losses, this option has the potential of magnifying the bank’s income. There is a wealth of empirical evidence showing the effectiveness of this approach to executive compensation (Lim and McCann 262).
The case study compares the compensation of Mr. Hester and rank-and-file employees. This comparison is especially relevant at a time when executive compensations continue to rise disproportionately. A study on executive compensation trends points to the fact that from 1978 to 2013, senior executives experienced a 937 percent increase in their income (Mishel and Davis). Typical workers, on the other hand, saw their pay drop over the same period. Whereas in 1978, the CEO-to-worker pay ratio was 29.9 to 1, in 2013, it grew to 295.9 to 1 (Mishel and Davis). A similar trend can be recognized in the compensation of high wage earners.
There is no denying that the steep growth of CEO compensation over the last several decades has been noticed by workers who do not occupy executive positions. The extraordinary difference in compensation has led to a desire for smaller pay gaps that is regularly expressed by rank-and-file employees around the world. Sorapop and Norton argue that there is a need to achieve an equal distribution of wealth, thereby fulfilling people’s desire for justice (2).
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The analysis of the case study helped the student to learn that there is a discrepancy between executive compensation and executives’ productivity. Earnings of CEOs do not always reflect their contribution to organizations. Therefore, option-based compensation offers an effective solution for ensuring that increases in executive income only follow stakeholders’ gains.
Another lesson from the case study is that additional executive compensation from stock options is associated with unnecessary risk-taking behaviors that can damage financial institutions. From this vantage point, it is clear why some CEOs are inclined to make financial decisions to increase personal wealth at the expense of their companies. In such cases, risky behavior on behalf of banks who award their senior executives with stock options should be restricted by the boards.
The case study also helped the student to understand that there is a large pay gap in the banking industry. Current wage disparities are commonly attributed to responsibility and skill differences. However, the demand for more equitable compensation approaches continues to rise, which shows that rank-and-file employees are not convinced by the argument. Sorapop and Norton offer support for this claim by showing that a preference for reducing the pay gap is held by workers across 40 countries (3).
Human Resources Perspective
From a human resources (HR) perspective, excessively high senior executive compensation undermines the people’s agenda of RBS. This has to do with the fact that HR practitioners are supposed to create proper incentives for all employees. However, the presence of a pay gap can make non-executive workers feel unrecognized. A lack of sufficient rewards can result in diminished motivation, which will inevitably decrease the performance of the institution. It follows that the HR professionals of RBS should use their influence on the size and structure of executive compensation to make it fairer.
Unfortunately, HR specialists in many companies are not involved in the creation of executive pay and reward systems (Martindale). The low degree of involvement can be explained by the strong influence of external consultants and shareholders on compensation decisions (Martindale). A failure to eradicate the pay gap shows that not all HR professionals are able to balance the needs of the business with those of its employees. Unfair reward structures can damage a company’s long-term interests. Therefore it is important to strengthen the role of HR practitioners in remuneration committees.
Executive compensation in the banking industry has been a point of contention for a long time. The focus on profitability has instigated many banks to reward their executives with short- and long-term monetary incentives. The size of Mr. Hester’s compensation is not unique in the industry. For example, Jamie Dimon, the CEO of JPMorgan Chase, the largest American bank, was paid $20.3 million in 2013 (Noonan et al.). Furthermore, Dimon’s compensation was increased even further in 2015 to $27.6 million. The bank’s decision to review the compensation of Dimon should be viewed in the context of the delivery of consistent returns on investment by the executive. When compared to the performance of RBS’s CEO, it is clear that the two boards had a similar rationale for setting high compensation rates for their senior executives.
Recommendations and Suggestions
The financial institution should revise its compensation and reward practices toward a higher degree of fairness. It is extremely important to ensure that stock ownership guidelines of RBS require a higher percentage of a defined amount of the bank’s stock. Furthermore, clawback provisions should be introduced to recoup incentive payments if the CEO’s behavior results in negative financial outcomes (O’Donnell and Rodda).
RBS can benefit from the innovative compensation policies that have been applied by some banks. Pledging policy can “prevent or limit executives’ and directors’ ability to pledge company shares as collateral for loans” (O’Donnell and Rodda). A post-vesting stock holding requirement can be used to ensure that long-term shareholders’ interests are aligned with those of the CEO. In addition, this practice helps to enforce clawbacks (O’Donnell and Rodda).
To decrease the pay gap, RBS should use a wide range of performance measures for chief executives. The selection of these measures should reflect the strategic direction of the bank. Moreover, performance expectations should be aligned with the interests of shareholders. Therefore, a holistic approach to the evaluation of CEO performance is recommended. Both earnings and return measures have to be applied for evaluating the long-term success of the organization. The bank also needs to adjust for the relationship between its historical performance and that of industry peers. It is especially relevant for performance cycles that last several years. This approach will help RBS to ensure that its compensation practices do not contribute to the persistence of pay inequalities.
The paper has analyzed the case study on executive compensation in RBS. It has suggested that the appropriateness of the current compensation program should be reviewed by the bank’s board. To reduce the pay gap, the financial institution should review the performance measures it uses for determining the size of senior executive compensation. By employing innovative compensation policies, the bank will ensure that it delivers high shareholder returns without increasing pay inequalities.
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