Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory & buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

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Thursday, 12 September 2013

Banking executives and housing market risks

Chris Joye of the AFR has presented some solid recent articles on Australian housing market risks. Joye has highlighted three risks in particular. Firstly, there is a risk of APRA and the RBA applying stricter lending criteria to loans thus placing a speed limit on credit growth. A second risk is that interest rates revert higher and housing markets stall, with imprudent borrowers mistakenly having believed that ultra-low rates represented a ‘new normal’.

Thirdly, and most compellingly, Joye highlights that households in Australia have not really deleveraged and with dwelling prices now rising very strongly again in some cities, household debt-to-income ratios may soon return to pre-GFC peaks. Notes Joye:

“The major banks are leveraged about 80 times across their $1 trillion home loan books. Put differently, they are only holding about $1.25 of true loss-absorbing capital against every $100 – as opposed to the “risk-weighted” value – of their assets.

While banks do not “mark to market” their mortgage books with current prices because they account for them on a “hold to maturity” basis, with such extreme leverage you only need a small drop in asset values to make the banking system theoretically insolvent (assuming market prices).”

In this recent interview, Joye identifies that one of the key risks to be managed is that bank CEOs are remunerated partly based upon whether they achieve a very high ROE (return on equity).

The media love these kind of statements and repeat them unquestioningly. But is it actually true? Well, let’s take a look by delving into the executive remuneration policies of the ASX’s $119,000 million behemoth, the Commonwealth Bank of Australia (CBA).

CBA – executive remuneration

Commonwealth Bank's Directors Report contains a textbook example of what is perceived to be an appropriate Remuneration Policy for today’s banking executives. It goes to great lengths to stress that performance hurdles are based upon a balanced scorecard approach (rather than purely financial measures) and that excessive risk-taking is discouraged, with remuneration measures weighted accordingly.

“We have made reasonable incentive awards to our people based on performance against appropriate measures that discourage excess risk-taking. We are confident that we have in place robust measures which achieve a direct alignment between the remuneration interests of our employees and the interests of our shareholders.”

A new CEO in 2011

In its 2012 Annual Report, CBA notes that Ian Narev was appointed to replace the retiring Ralph Norris as CEO of the Group in November 2011. As is today’s convention, Narev’s annual remuneration was set at the time of his appointment at fixed pay of $2.5m, a short-term incentives (STI) target of $2.5m and a long-term incentives (LTI) target of $2.5m. In a little more detail:

“The CEO and Group Executives have an STI target that is equal to 100% of their fixed remuneration. Executives are only receive the full amount if they meet all their performance goals. The CEO and Group Executives have a maximum STI potential of 150% of their STI target. No STI awards will be made if the relevant performance goals are not met.

The CEO and each Group Executive has an LTI target that is equal to 100% of their fixed remuneration. The LTI award has a four year performance period and is measured against relative Total Shareholder Return (TSR) and relative Customer Satisfaction performance hurdles. The performance hurdles are aligned to our business strategy of Customer Satisfaction and shareholder interests.”

The balanced scorecard and non-financial measures

Such measures are used to determine the individual STI outcomes of executives, and are managed through what is known by Business Schools and MBAs as a ‘balanced scorecard’ approach, thus including non-financial measures as well as financial targets.

CBA is clear that its financial objectives are accorded a substantial weighting with executives managing business units typically having a 50% weighting on financial outcomes, while executives managing support functions being allocated a typical weighting of 30%.

Adjusting STI remuneration  for risk

Risk is also a key factor in accounting for short term performance. CBA uses a profit after capital charge (PACC) - which is a risk-adjusted metric - as one of its primary measures of financial performance, which takes into account not only the profit achieved, but also considers the risk to capital that was taken to achieve it.

CBA also requires that executives comply with a Risk Appetite Statement. STI awards are adjusted downwards where material risk issues occur. Risk is also managed by Commonwealth Bank through the compulsory 50% deferral of the CEO and executive STI outcomes for a period of 12 months and delivery of one third of their total target remuneration after a four year period.

LTIs - long term performance

CBA's remuneration outcomes also focus on performance and shareholder alignment for the long term by providing executives with LTI awards in the form of Reward Rights with a four year vesting period. Vesting is subject to performance against Total Shareholder Return (TSR) and Customer Satisfaction hurdles.

Linking remuneration to shareholder interests

Joye’s point is that CEO remuneration is too closely tied to short-term financial measures and this is clearly partly true. To some extent, it might be argued that this is unavoidable.

The duty of loyalty requires that a CEO must always act in the shareholders’ best interests and that the CEO places that interest above his own in business decisions. Naturally, shareholders demand that our major banks record strong annual profits, growth and return on capital employed, but a CEO should not pursue an unsustainable ROE if this introduces risks to the longer term better interests of the business.

Realistically, however, there remains a risk that banking executives focus on short-term gain in preference to recognising potential long-term pain, for CEOs tend to have a shelf-life in any individual role.

We see similar outcomes in politics – witness the present UK government policies aimed at inflating the housing market in order to benefit from the associated ‘wealth effect’ of growing equity. If there is a corresponding housing bust down the track, it is likely that it will be someone else’s mess to clear up.

A better solution to managing risk?

The remuneration policies of our major banks represent a reasonable consensus of today’s best practice. They may not be ideal, but they do attempt to limit risk within the limitations of a competitive remuneration structure.

How else can risk be managed in our major banks? The global regulatory standard on bank capital adequacy, stress testing and market liquidity risk known as Basel III introduced three key principles:

1 - Capital requirements – banks to be required to hold a statutory percentage of common equity and capital buffers;

2 – A minimum leverage ratio – calculated by dividing the bank’s ‘Tier 1’ capital (common stock, retained earnings and, where applicable, some types of preferred stock) by its average total consolidated assets, with a statutory minimum ratio to be held; and

3 - Liquidity requirements – a liquidity coverage ratio requiring sufficient liquid assets to cover the bank’s total net cash outflows over a 30 day period and a net stable funding ratio to be maintained.

Future focus

While there may be some tinkering with remuneration policies, these are broadly already based upon what is considered to be best practice of including financial and non-financial measures, short-term and long-term incentives and a due consideration of risk. The areas which appear likely to see more focus for our banks include capital adequacy, stress testing and liquidity ratios, and as Joye has pointed out more than once, increasing scrutiny from APRA focussed upon maintaining appropriately prudent standards of lending.