On Hester's bonus

RBS’s award of a £963,000 bonus to Stephen Hester has provoked anger. My chart shows one reason why. In the last 12 months, RBS’s share price has underperformed the market; it has also underperformed two of its three main peers - HSBC and Barclays but not Lloyds. Insofar as Hester’s job is to raise the value of RBS for the tax-payer, he has failed in the last 12 months.

But is the share price the relevant measure of performance?

In one powerful sense, yes. A share price assesses the overall value of the firm. It is (almost) always possible to point to something good that a CEO does; it would be remarkable if a base salary of £1.2m did not buy some competence. The question is: are the things he’s doing sufficient to raise the overall value of the company? The share price is a good gauge of this.

For example, RBS justifies the bonus by saying, among other things, that “all core businesses are now profitable other than Ulster Bank“ and that “RBS's balance sheet has been reduced by more than £600 billion since 2008” (a good thing, apparently).

But it’s possible to return a company to profit and shrink its balance sheet by jeopardizing its future performance - for example, by selling off useful assets or by worsening customer service and so driving business away. The share price is a measure of whether the “improvements” a CEO has made will lead to lasting gains. RBS’s price fall suggests this is in doubt.

Now, there are two objections to this.

One is that, because of investor irrationality, a share price isn’t necessarily a good measure of corporate value. True. But it’s not just investors who a prone to cognitive biases. So are remuneration committees; isn’t it more likely that a handful of like-minded people will be systematically biased than that tens of thousands of share traders will be?

The bias I have in mind here is a halo effect. It’s easy to think: “He’s a nice guy, who seems like he knows what he’s doing and he’s working hard, therefore he must be doing a good job.“ But the “therefore” is a leap of logic.

Why should we believe that RBS’s price is irrationally cheap, rather than that the remuneration committee is biased?

The second objection is that RBS’s price reflects not just Hester’s contribution, but rather the impact of the euro area’s debt crisis.

Of course. But this fact has two implications.

First, it means Hester could be richly rewarded for a factor entirely out of his control. Let’s suppose that the debt crisis is satisfactorily resolved and that RBS’s price - along with that of other banks - thus rises. If it returns to January 2011’s level of 40p, then Hester will make a profit of £477,000 - without him (ex hypothesi) doing anything. Where’s the incentive here?

Secondly, this acknowledges the point I’ve made for years. To a large extent, the value of firms is beyond the control of CEOs. “Management“ functions rather like witchcraft. It’s a set of rituals which are wrongly supposed to have effects on the outside world. When, by happy chance, those effects materialize, the witchdoctor takes credit. And when they don’t he blames external malevolent forces - if not the debt crisis then the “challenging economic environment”, “fragile consumer confidence“ or (more feebly) “operational issues (pdf).”

Now, the key phrase in that last paragraph was  “to a large extent”. Although CEOs might not be able to relaibly affect corporate value on the upside, they can assuredly affect it on the downside through deliberate vandalism and theft.  In this sense, bosses are paid a fortune not so much to motivate them to great performance, but to buy off terrible performance. It’s just an extreme manifestation of the efficiency wage argument.

And this might partly lie behind Hester’s bonus. Robert Peston says the Treasury feared that Hester and the board would have resigned if it had vetoed a bonus. Now, whether this threat was serious or not, and whether the resignations would have been anything worse than a short-term inconvenience, are separate questions. The point is that this shows that bonuses are a reward for power, not performance.

Comments

[Luis Enrique]

"Although CEOs might not be able to relaibly affect corporate value on the upside, they can assuredly affect it on the downside"

I remember somebody telling me (possibly you) that the main thing CEOs have to do is resist investment bankers selling merger ideas.

[Luis Enrique]

I would have thought bargaining power a combination of power and performance. i.e. it's not "a reward for power, not performance" but the combination of the two.

A successful investment banker is in a position to extract nearly all the surplus, but only if they can say "I made you £Xm this year and I want £xm or I'll walk". If they can't say "I made you £Xm" (i.e. if there is no performance) then the power conferred by their position is meaningless.

However, it does appear that CEOs have the power to extract big pay packets without being able to point to performance. I suppose, as you suggest, their performance (contribution) is mainly the avoidance of a negative. They can always say if I leave it will look bad and hit the share price.

[botogol]

this

“Management“ functions rather like witchcraft. It’s a set of rituals which are wrongly supposed to have effects on the outside world. When, by happy chance, those effects materialize, the witchdoctor takes credit. And when they don’t he blames external malevolent forces

is great!

that, on it's own, is worth reading your blog for a month to find:-)

[Luis Enrique]

botogol,

attractive though it is, I'm not sure Chris' conception of management-as-useless is true.

check out this lot:

http://cep.lse.ac.uk/_new/research/productivity/management.asp

and

http://www.stanford.edu/~nbloom/index_files/Page371.htm

[Account Deleted]

Steven Hester has to be paid a huge bonus, because otherwise he would feel really small when dealing with his direct reports.

In other words, the problem isn't the CEO's bonus (fun though it is to personalise the issue), but the fact that he sits on top of an over-paid hierarchy. As the alpha male, his bonus must be of sufficient size to reflect his position.

This doesn't mean it has to be the largest in absolute terms (he'll get additional remuneration via other routes), but it must be large enough to earn respect.

For comparison, football managers normally earn a salary around 75% of their best-paid player, i.e. usually somewhere between the midfield schemer and the top striker.

When top execs flounce off in a hissy fit over pay, it's usually a status issue, not anxiety over meeting the private school fees.

[Chris]

Anyone could do these jobs. Why not just bring in some civil service bureaucrats on civil service wages?

[Tom Voute]

Chief executives' excessive bonuses have nothing to do with performance. These people have personality disorders and have so little self esteem that they need to be paid surreal quantities of money to make them feel better. it is just the same same as the big powerfulcar which compensates for a small penis.

[Niklas Smith]

Chris, a convincing argument in most respects except for high pay being a sort of efficiency wage to "buy off terrible performance".

Surely it is golden parachutes that are the preferred way of buying off terrible performance? They compensate CEOs for their low job security (much lower than that of middle management or the footsoldiers in bank branches) and cushion the pain when they're sacked for doing something monumentally stupid, like buying ABN Amro as financial markets were beginning to collapse. (Step forward, Sir Fred Goodwin.)

I suspect high pay and bonuses for chief executives has much more to do with the "tournament theory" of motivating managers: the pay and perks of the level above are not just (or even not mainly) a reward for the incumbent's productivity, but a carrot to hang in front of the people on the level below competing to get that position - so raising their productivity, in theory.

In practice the problem with this motivational strategy is that it discourages cooperation and information sharing, perhaps one reason why so few people in the top levels of RBS seemed to understand what they were getting themselves into with their rapid expansion of investment banking.

[Calum]

Specifically on RBS's share price, the main driver behind the price is the fact that the markte knows that as soon as it hits a certain price point, 82% of the issue will be hitting the exchanges. That creates an artificial ceiling on the price.

Why the Government doesn't just announce that it will sell 1% of the publicly held portfolio each year, I don't know.

[Pedro]

Hi Skaman125,The Hi Skaman125,The full rieevw can be found at digitaltrendsDOTcom if there are some unanswered questions from the video.Thanks for watching!