Another RWA, another dollar: Capital pressures prompt questions over pay

Much of the discussion following the trading losses at JP Morgan’s chief investment office (CIO) last year has focused on failures of risk management and strategy. Traders and senior management have been lambasted as overconfident, naive or inept. Less attention has been paid to the bank’s bonus scheme – but it has a walk-on role in JP Morgan’s own report into the debacle, published on January 16.

Told in late 2011 to cut risk-weighted assets (RWAs) at the CIO by $30 billion, the unit concluded that actually unwinding the trades was the only safe way to do so. However, by early January, that strategy had resulted in a $15 million hit, and estimates it would result in a $500 million total loss were circulating. Soon after, the strategy changed, focusing more on the unit’s profit and loss. Rather than getting rid of the original positions, the CIO added new ones, in a misguided attempt to cut the capital consumption.

The report ponders the extent to which this was driven by fears among CIO staff that their year-end pay would be cut if the unit lost money. It concludes that it may have been a factor – senior management should have reassured the team that losses resulting from RWA reduction would not count against them when the time came to carve up the bonus pool (see box below).

This is a long-standing problem, says Gerry Pasciucco, currently a private investor and formerly the chief operating officer for AIG Financial Products, who later took charge of the firm’s wind-down of a $2.7 trillion notional portfolio of legacy assets. “Revenue-based bonuses have been a problem for a while, because they can result in perverse incentives. In 2006, there were plenty of traders in the industry who raised concerns about the quality of collateralised debt obligations, for example, and advocated shorting them to recoup some value if the market nosedived. In many cases, it was decided that shorting them would cost revenue in the short term, and the bonus system currently rewards this kind of short-term thinking – compensation schemes had been mostly one-year based, so as long as things were going to be fine for the current year, who cares? No attention was paid to consequences for revenue two or three years down the line,” he says.

As the JP Morgan example shows, this old problem is gaining new relevance as a result of the regulatory pressure banks are under. With minimum capital requirements rising and return on equity targets receding into the distance, cutting RWAs has become a matter of life or death for some institutions – but how should they reward staff that are involved in these efforts?

In theory, given that the target is to cut capital consumption, bonuses should be determined directly by the amount of RWAs that can be shed, one banker argues – and the result could be a goldmine for the individuals involved. “If I was thinking purely about compensation, I would bite your hand off if you offered me the stewardship of a dedicated, RWA-reducing team, because the opportunity to outperform is massive,” says one capital markets expert at a large European bank. “You can make a lot of gains with regulatory lobbying and internal RWA methodology changes before you get to the really tough stuff. If you had a reduction target of $50 billion, you might be able to cut $40 billion out with very little cost.”

But because these teams lack mature pay schemes, the individual rewards may not be as big as some outsiders imagine. According to one senior trader, now at a European bank, who has been involved in concerted RWA reduction efforts, traders focusing exclusively on capital release were on average paid 10–20% less than their peers who were generating revenue on the trading floor.

The industry needs to fix that, says the trader. “I’m sure firms across the Street will struggle with the compensation issue. It’s not an easy one to get right, but firms need the best people for this hugely important task, so you have to get the pay structure right,” he says.

That, in effect, means finding a way to close the 10–20% pay gap between the cutters and the traders, which may not be as easy as it sounds. “There is, as yet, no set way of thinking about compensation for RWA-reducing teams,” says Bruno de Saint Florent, a partner and compensation expert at consulting firm Oliver Wyman in London. “There are far more variables to consider than the usual revenue-based remuneration system for traders. You need to take into account acceptable impacts on revenue as well as RWA reduction, the return on equity of specific RWA-reducing activities, and the future impact on quarterly and annual results. It cannot be a mechanistic solution.”

Some bankers have mixed feelings about the remuneration systems already put into place. “We took a pretty simple approach – we worked out the capital savings we had made for the bank during the reduction process, which was easily in the hundreds of millions of dollars,” says the senior trader now at a European bank. “We created a basic bonus pool from that figure, and augmented it with some assessment of the market value that each of the guys represented. It wasn’t perfect, but it did a job for the first year of this RWA reduction project,” he says.

With the benefit of hindsight, this senior trader believes other approaches may have worked better: “I think it’s worth taking a serious look at specific, pay-as-you-go cash rewards for RWA reduction, rather than giving out a lump-sum bonus at the end of the year. It may seem a bit mercenary, but it does make sure staff can see a specific link between their efforts and the pay they receive, rather than being subject to some vague bonus formulation.”

The main danger of this approach is that it throws the incentives entirely in the other direction. Rather than being reluctant to burn up revenue and cut RWAs, staff could reduce RWAs as fast as possible to secure the cash rewards.

According to the senior trader, the comparatively short life span of an RWA cutter will work against this instinct. “When a bank sets an RWA reduction target for the year ahead, and assigns a bunch of people to that task, it’s only natural that there is uncertainty around job security once the target is hit. That fear will rise if the team burns through RWAs very quickly. We put a lot of time and effort into finding senior roles outside the group for people to move to, and reassuring people they weren’t going to get dumped when the year was up. I had a pretty good comfort level about the unit’s future existence, but the anxiety was still there,” he says.

The short-term focus of RWA reduction could also serve to reduce the year-end bonus pool for dedicated teams. “In this industry, it has long been the case that trading staff are paid based on their future value,” says the trader. “So, last year, you got paid for the work you’re doing this year. It’s unlikely that a tremendously high forward value is going to be placed on RWA reducers who met or exceeded their target this year, but won’t have as much to reduce next year. That’s why a more direct, immediate link between bonuses and RWA reduction is probably a better way to go.”

Though there is no set view on the best remuneration system, there is recognition that the JP Morgan CIO fiasco is a cautionary tale for the governance of RWA reduction. “If you want to bring down the RWA weight of existing assets, the first lesson is to split this effort into a separate business unit,” says one dedicated RWA cutter. “You can’t ask traders to maximise revenue and cut RWAs at the same time. It just doesn’t work. With a separate unit you can act for the firm as a whole without getting bogged down with smaller concerns.”

Perhaps the biggest of these small concerns is the influence of the sales desk, which can put up strong resistance to the sale or unwinding of trades involving treasured clients. “If they are being incentivised on short-term revenue, why should salespeople put time and effort into something that doesn’t generate them any revenue, or that upsets a client they have worked hard to cultivate and do business with?” says Pasciucco. “When I was with AIG FP, we had the luxury of going out of business once the existing assets had been gotten rid of, so we didn’t have any dissent from an internal sales force. We did have trouble with sales guys at counterparty banks, though. Even if a trade was risk-reducing, they’d come up with excuses not to unwind it if it was not going to generate revenue – ‘it’s complicated, it involves a number of different business desks, we’ll get charged by back office if we cut a trade’. If all the reduction is done under one business line,  with clearer, non-revenue-based targets, there are fewer arguments. Sales guys shouldn’t be incentivised to contest what is in the best interests of the firm,” he adds.

The questions now being confronted in the context of dedicated RWA-reducing teams may produce answers that filter through to the rest of the bank. Long before capital became a binding constraint, risk managers and consultants had called for risk-taking businesses to adopt compensation schemes based on some kind of risk-adjusted measure – balancing revenue earned with the amount of capital or liquidity traders are using, for example. To date, banks have tended to leave the old, revenue-based schemes in place but spread the bonus over a longer period of time, pay more of it in stock and put in place clawback schemes, for example. But more sophisticated measures are also being considered.

“Banks should have compensation systems that are flexible enough to make traders behave in exactly the way they want them to behave. Whether that means they are tied to RWA usage, or general funding usage, or return on equity, will depend on the demands of the time. RWAs won’t be the flavour of the month forever,” says Pasciucco. “Whatever the solution is, bonuses can’t be so crudely tied to revenue anymore. That kind of a system is almost laughable. People will look back in years to come and they won’t believe how blindly we followed such a bad system. Investment banking is a complicated, nuanced and subtle business, and compensation arrangements need to reflect that.”

HSBC started down this road two years ago, when it introduced a scorecard remuneration scheme based on qualitative parameters – such as general responsiveness to instructions and interaction with other business areas – and quantitative parameters such as revenue generation, return on RWA and compliance with caps placed on RWA consumption.

Some warn this solution isn’t foolproof. “The scorecard system lives or dies on the quality of the management in place. If that management is patently concerned only with revenues, it’s obvious that nothing but the revenue will be given any importance. But if management is clear that you will not get paid if the non-revenue parameters are not met – even if you have made stacks of money – then it trickles down into traders’ behaviour,” says the capital markets expert at a large European bank.

Others believe that for this behaviour to fully right itself, the bonus system needs to be wiped away in its entirety. “It is not fit for purpose,” says a senior treasury manager at a large UK bank. “All the bad stuff that has emerged in the City over the past 10 years is there because of the pernicious influence of the bonus culture. It has turned decent, honest people into Libor riggers and swap mis-sellers, purely because they knew they’d be financially rewarded.”

BOX: “Losses (as well as profits) are not necessarily the measure of success”

The following is an extract from JP Morgan’s management task force report into the trading losses at its chief investment office (CIO), run by Ina Drew:

“CIO does not have its own incentive compensation system; instead, it participates in the firm-wide annual incentive plan that is reviewed and overseen by the compensation and management development committee of JP Morgan’s board of directors. Awards under the plan are discretionary and non-formulaic, and compensation is dependent on multiple factors that can be adjusted and modified depending on the particular circumstances. These factors include financial performance – for the firm, for the business unit and for the individual in question – but they also consider “how” profits are generated, and compensation decisions are made with input from risk management and other control functions (as was the case for CIO).

“The task force has found little in the form of direct evidence to reveal what Ms Drew and the other synthetic credit portfolio managers and traders were thinking about their own specific compensation as they made decisions with respect to the synthetic credit portfolio.

“Throughout the relevant period, however, at least two of the traders clearly maintained a strong focus on daily, monthly and quarterly profit-and-loss numbers, and were acutely concerned about mounting losses in the synthetic credit portfolio...

“The task force believes that the CIO management, including Ms Drew, should have emphasised to the employees in question that, consistent with the firm’s compensation framework, they would be properly compensated for achieving the RWA and neutralisation priorities – even if, as expected, the firm were to lose money doing so. There is no evidence that such a discussion took place. In the future, when the firm is engaged in an exercise that will predictably have a negative impact (either in absolute terms or relative to past performance) on a front office employee’s or business unit’s contribution to the firm’s profits and losses, the firm should ensure those personnel are reminded that the firm’s compensation framework recognises that losses (as well as profits) are not necessarily the measure of success. This approach is fully consistent with the current incentive compensation structure, but should be reinforced through clear communication.”

BOX 2: The cutters

• Credit Suisse. The bank closed a handful of its fixed-income businesses but decided to re-engineer the rest by making swingeing cuts to risk-weighted assets (RWAs) and setting up a new unit – fixed-income department portfolio management (Fid PM) – to oversee the project. Using its budget of €1 billion to absorb the costs involved in exiting trades, Fid PM took an axe to the bank’s excess RWAs last year. By the third quarter of 2012, fixed-income RWA consumption under Basel III sat at Sfr130 billion ($138 billion), compared with Sfr230 billion a year earlier. Half of that reduction was achieved by Fid PM, which dramatically exceeded expectations.

• Deutsche Bank. In September last year, Deutsche Bank hived off €135 billion of non-core RWAs into a separate business unit, dubbed a ‘bad bank’ by some of its competitors. By the end of the first quarter of this year, it aims to have sold off around €100 billion of this total in an effort to boost its core Tier I capital ratio from 8% to 8.5%.

• UBS. On October 30 last year, UBS stunned the industry by stepping away from its fixed-income business altogether, leaving itself with the tricky task of managing existing RWAs down over time. The unwanted assets generated a total of Sfr139 billion in RWAs, with Sfr49 billion coming from legacy credit and real-estate assets, and Sfr44 billion from derivatives trades. The bank aims to reduce the combined portfolio to Sfr25 billion by the end of 2017.