Credit Suisse (CS) has announced it will pay a portion of its bankers’ bonuses with a structured note instead of cash. The note pays a fixed coupon of around 6% per year, and is backed by a package of derivative contracts currently in the balance sheet of CS. Since the value of the portfolio is risky, the payout is not guaranteed.
In a memo to staff, CS CEO Brady Dougan touts the structured note as a way to address the criticism made against the financial industry’s bonus structures. But is that true?
The central criticism is that the relationship between risk and return is out of whack. The principal behind past bonus structures has been “heads I win, tails you lose”. Performance has been rewarded without regard to risk. Losses have been put to shareholders or to taxpayers. A related criticism is that the process for setting bonuses is opaque and managed by insiders, at the expense of shareholders and taxpayers. This makes it unlikely that insiders ever fail to succeed against the benchmarks that are set, and ensures that the system is skewed against shareholders and taxpayers.
Does the new CS structured note address these criticisms?
No it doesn’t.
It was designed with an entirely different purpose in mind, which is strengthening the bank’s capital position in light of new banking rules. The derivatives portfolio backing the structured note comes from CS’s balance sheet, and CS hopes the move will decrease the measured risk of its balance sheet and improve its capital ratio under the new Basel III agreement. CEO Dougan is straightforward about this strategic objective. But he also wants to advertise the move as addressing shareholder and public concerns on bonus rules.
The structured note fails to address either of the two key criticisms.
Most importantly, it is terribly opaque. Many details haven’t yet been released, but in his memo to staff, CEO Dougan acknowledged that “Instruments such as PAF2 are inherently hard to value. It’s obviously not something that is traded in regular markets so has to be modeled.” Only an investment banker still locked in a pre-2008 mindset would structure a note like this as a step forward to transparency and accountability?
It is also hard to see how the structured note provides a sensible risk-reward relationship for the bank’s senior staff. No one starting from a blank piece of paper would design a compensation scheme based this way on the portfolio of derivatives now on the bank’s balance sheet. Indeed, CS has designed the arrangement with an escape hatch should the capital regulations surrounding its real strategic objective change:
PAF2 represents an effective and real sharing of risk but, nonetheless, we still need to reserve the right to amend this structure in the event of changing requirements. The most likely change would be to amend PAF2 to an instrument that instead of referring to our specific portfolio would reference a public index of credits. In our view this would be just as good for our employee investors. We also need to include a call at market value in case these requirements change so materially that the instrument is no longer effective.
If the note were also a real solution to the bonus problem, it would survive changes in the regulatory capital rules that are its real objective.
If CS’s management were serious about addressing the compensation problem, they would design a durable scheme, not a one-off gimmick. The scheme would include a clear downside for managers and a clear tie to the long-term fortunes of the bank. Simon Nixon at the Wall Street Journal’s Heard on the Street column mentions UBS’s plan to pay bonuses as contingent convertibles as one example in this direction. Another alternative would be the explicit clawback provisions being pushed by New York City Comptroller John Liu. The key is that managers should not be able to walk away from the future fortunes of the bank, and the scheme should encourage cross monitoring of risks among managers within the bank. And these incentives should be clear to all, inside and out. The CS proposal is not a step forward on this front.