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Wednesday, January 13, 2010

Banker Bonus Benchwarmers Beware! Financial Crisis CSR Lessons

Compensation practices in the financial industry remain a highly contentious topic outstanding from the 2008 financial crisis. For those interested in the concept of CSR, the current debate on what to do, if anything, presents a case study for considering the pros and cons of proactive stakeholder engagement and consensus building by corporations.

CSR has been called a form of "private regulation in the shadow of the law". Private regulation refers to rules that are established by non-government actors to govern themselves. The converse of that, public regulation, would involve a purely government imposed regulatory system with no private involvement. The reality is that there is rarely if ever a purely private or public regulatory process. Instead, regulation has been said to take place within a "normative arena", in which all relevant actors (government, business, NGOs, the public etc.) can battle it out to determine whether and/or how regulation and rules should be established to govern a particular field of behaviour. Within the arena, states and governments work "symbiotically" (cooperatively or competitively) with private actors in making regulatory and governance decisions. States also, however, play the role of "umpire" and are the overseer of private initiatives, with the capacity to intervene where such initiatives are seen to be inadequate. Moreover, states have the capacity to confer "legitimacy" on private initiatives that might otherwise be seen to fall short of "democratic" participatory expectations (for instance of the general public that have no ability to participate in standard setting processes driven by "experts").

By implication, the existence of competing norms is a given in the "normative arena". The only question is whether the existence of such norms will coalesce with a will on the part of capable actors (like government or corporations themselves) to formulate a regulatory or governance system that will guide or constrain the way actors behave.

The actual shape, structure, and tools used in a new system would depend on the outcome of the normative competition. For example, a private solution could be purely voluntary and enforced only through moral suasion or stigmatization of those that fail to participate. On the other side of the spectrum, a public solution could involve mandatory constraints with penalties and sanctions applied for non-compliance. In a globalized world, the public type of solution becomes complicated by multiple jurisdictions, which are often not coordinated. States may work together to harmonize standards and rules, or competition between regulatory regimes may result.

The normative arena is the backdrop to the banker pay debate. There are clearly a number of interests and normative perspectives battling it out for supremacy as we speak. Banks, rightly or wrongly, appear partial to avoiding public intervention that would regulate pay. As will be discussed below, they are not, however, unanimously opposed to new rules, but would prefer that such rules be minimally restrictive.

Governments are facing public backlash against what appear to be huge bonuses. This is in part what might be called a "moral panic", which occurs when legitimate concerns grow and morph to affect areas irrelevant to the original concern, due mainly to fear and resentment. An example of this could be criticism of banks by European legislators for "incentivizing" layoffs by tying bonuses to cost reductions. Such a link between compensation and cost reduction is not at all contrary to business best practices, and is entirely unrelated to the issues affecting the financial crisis. It is clearly an example of legislative over-reach leveraging legitimate concerns to justify unrelated criticisms. Nevertheless, it is undeniable that there are genuine legitimate concerns regarding system wide risk that are clearly unacceptable and must be addressed by responsible legislators. The question will be whether regulation and governance reform is focused on financial risk remediation, or is used to pursue other unrelated social objectives.

The response by the banks themselves in the UK, US and Canada could be grouped into three categories: (1) resist any suggestion of regulation as improper and unfair; (2) acknowledge concerns but wait and see; (3) accept change as inevitable and attempt to influence the consensus through self-regulation. Of these, option 3 is the most consistent with a corporate sustainability strategy.

Option 1 (resist) has appeared to be relatively popular in the UK and US. There are undoubtedly political reasons why this is the case, particularly the looming and at times hysterical spectre of public interventions that could be quite punitive in nature. It may also be that those appearing to employ this strategy are also involved in back channel dialogues to build consensus (through political lobbying etc.). But if that is the case it is not being done publicly or transparently. Time will tell whether such an approach is effective, but to date it doesn't appear to have achieved the desired result. If anything, it appears to have reinforced a belief that those espousing resistance "don't get it" (in the words of US President Obama), thereby making the consensus building process relatively futile, and making more coercive forms of public intervention seem inevitable. Since that is exactly the result this strategy hoped to avoid, it is clear that this approach may well fail dreadfully.

Option 2 (acknowledge, wait and see) has been used mostly in the US, and has had some clear success in appeasing public anger and abating the "moral panic" sentiment that could result in the most undesirable outcomes. It has not, however, done anything to ease the uncertainty or address the clear regulatory risks that hang over the head of the financial industry. For example, some of the US financial sector recipients of so-called TARP funds have been required to participate in a compensation review process with an Obama appointee referred to as the "pay czar", Kenneth Feinberg. The pay czar's job has been to review compensation decisions and practices. Participating banks were required to submit "arguments" supporting their pay decisions. Unfortunately for the banks, it does not appear that there were any specific rules or principles that could be used to guide such analyses, other than the broad objectives set out in the TARP legislation and regulations, which applied a "Public Interest Standard" that amounted to a direction that that banks should not pay "too much", and should defer compensation as a means of reducing risk. It is not clear whether the pay czar developed any further frameworks with banks themselves that take into account their legitimate operational needs, or worked with other experts and analysts to do so. In the absence of such a process, it is hard to conceive of how decisions could have been made in the first rounds of compensation review in anything other than an arbitrary and face-saving manner.

While supporting the "face-saving" exercise by participating in a contrite manner, "waiting and seeing" before undertaking earnest engagement and consensus building has meant that the banks themselves have contributed (by omission) to the uncertainty regarding what principles to apply to compensation decisions. Uncertainty is not a desirable situation for banks in any circumstance, and particularly not in some of the most financially unstable and politically uncertain times in the last century. The "wait and see" approach is tantamount to a player in the "normative arena" sitting on the player's bench and letting others battle it out for normative supremacy. If this is being done in hope that the game will simply go away, it would seem a risky strategy. There appears to be an unabating will to do "something". Moreover, the game isn't getting any less competitive. There would appear to be little benefit to sitting on the sidelines letting other players rack up points that may prove insurmountable. Wait and see strategies necessarily mean that a "first mover's" advantage is lost.

That brings us to Option 3 (build/influence consensus). A variation on that approach was taken by the large Canadian banks, each of which introduced their own self-imposed constraints on compensation practices in the wake of the financial crisis that attempted to address concerns regarding inappropriate incentivization of risk. This effort was not solicited, and it does not appear that the move was formally coordinated. It is also not clear the extent to which formal engagement processes were undertaken in the development of the frameworks. Nevertheless, the frameworks appear to address the most obvious concerns of stakeholders (particularly government, certain shareholders and the general public) regarding compensation practices. Each of these institutions have recently adopted "say on pay" votes for shareholders. It may well be that these frameworks were adopted and publicized in anticipation of such votes.

It should be noted that the Canadian banking industry is generally more regulated than the US banking industry. No Canadian banks failed, and as such there is much less public sentiment for legislative intervention. As such, the normative arena is much less contentious. Despite this, the banks were proactive in addressing legitimate concerns which may have been the subject of legislation if they were not effectively addressed by the banks themselves. This approach has, to date, been viewed favourably and has appeared to have been accepted as a legitimate solution to the risks revealed by the financial crisis.

What can we learn from all of this? First, that the competition of the normative arena may take place whether or not an individual actor chooses to play. As such, it may not be an effective option to "take your ball and go home", or to resent and resist the fact that the game is being played at all. Similarly, being a passive and humble observer to the game may also not be the best approach. While belligerence towards a normative dialogue may be inappropriate, that does not mean affected actors must absent themselves from the contest. Instead, it is appropriate, and in fact expected, that all players will show up and play the game to win. In the context of banker pay, a "win" might entail addressing legitimate systematic risk concerns while avoiding a slop over of regulation into unrelated and potentially detrimental aspects of financial operations. By not constructively and proactively participating in a consensus building process, banks that may be affected by new regulation are leaving themselves more exposed to an unfavorable consensus than may be necessary.

The Canadian approach could be seen as a model for other financial actors facing inevitable regulations. Formulating a private voluntary consensus that addresses legitimate concerns could well influence a public regulatory approach. It may not be enough however, and public regulation could well end up being more invasive and harmful to the interests of banks than it needs to be. But, at the least, efforts to influence the consensus could provide a sound position from which to criticize regulatory proposals that go "too far", while not appearing to be a stalwart - which is never a legitimate stance. Indeed, an engagement and consensus building approach enhances corporate legitimacy, and the likelihood that an inevitable normative discourse will result in an acceptable outcome.

Such a strategy is the essence of "sustainability" - which involves responding proactively to corporate social obligations, even if the "hard law" doesn't require it. Consensus building and engagement is an essential component of sustainability. Therefore, let the banker compensation debate serve as a lesson for us all - benchwarmers beware!

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