naked capitalism

The UK’s Times reports that Swiss bank UBS intends to change its bonus program so that current year bonuses can be largely reversed if performance in subsequent year falls or generates losses. Even more striking, the bank is considering trying recoup bonuses already paid to certain executives.

The UBS move is a worthwhile effort towards establishing greater accountability and linking pay to longer-term performance measures. However, the idea of giving a bonus that can later be almost completely reversed is such an odd construct that it suggests that the idea of basing pay on current year performance may need rethinking.

Note that the sort of ills that plague Wall Street now were almost unheard of when firms were private partnerships. There was no incentive to produce financial statements that gave an unduly rosy picture of business results; indeed, the very last thing that owner-managers would want to do is pay out compensation in excess of “true” earnings, since that would deplete their hard-earned capital. So the annual bonus worked despite the potential for abuse because the leadership was vigilant.

But now that the products and the risks have become vastly more complex, it is possible for top executives to have sufficient knowledge to make informed decisions on an annual basis? There are other ways to approach this conundrum. When Warren Buffett started his insurance operations, the executives got 15% of the profits……five years later. The risks in insurance are long-tailed (it can and does take years to know the total payout and expenses on policies written in the current year), so that structure fits the timeframe required to measure results accurately.

If UBS has to resort to boomerang bonuses, it says that it has serious doubts about its ability to determine the earnings of its units on a current basis (as refreshing as that is, I would not find that very comforting were I a shareholder). So why not attack the problem more directly with a longer-term payout structure? That is what this amount to. In fact, UBS uses a surprisingly Buffett-like five year time frame and “ring-fences” the amount that UBS reserves the right to withdraw.

And when better to implement a change like this, when jobs are scarce and former Masters of the Universe have little bargaining power?

From the Times Online:

Senior executives and traders at UBS will forfeit previously earned bonuses if they underperform, under a radical new pay system devised by the stricken Swiss bank.

Just as bonuses (Latin for “good”) are paid out for good performance, maluses (“bad”) will be meted out if the bank subsequently makes losses or if the employee misses performance targets, UBS said. The maluses could wipe out all previously agreed share bonuses and two thirds of all cash bonuses under stringent new rules designed to align the interests of executives and traders with those of shareholders.

The Swiss bank announced plans for a complete overhaul of its pay system and disclosed that it was taking legal advice to see whether it could claw back previously paid bonuses from tarnished executives. That raises the prospect of UBS demanding and, if necessary, suing Marcel Ospel, its former executive chairman, for the return of millions of dollars of bonuses that he received before UBS collapsed into losses.

Maluses will be awarded for financial losses at group or divisional level, for asset writedowns, for personal misconduct, for breaches of risk rules and for missing performance targets. A worker receiving a malus will forfeit previously awarded cash and/or share bonuses held in ringfenced accounts. Both cash and share bonuses will be held in ringfenced accounts for up to five years. Executives underperforming repeatedly could be given so many malusus that they could end up with a negative balance, UBS said….

UBS is reforming bonuses under pressure from the Swiss Federal Banking Commission. Last month the bank was rescued with a $60 billion (£40 billion) bailout package by the Swiss Government. All 2008 bonuses will be down from 2007 levels, UBS said