HSBC’s Remuneration Strategy

HSBC judge performances on the basis of what employees have achieved, how they have achieved it and how much time they took to achieve the task, as they believe that these efforts contribute to the long-term sustainability of the business. Therefore, their remuneration framework focusses more on total compensation (fixed pay and variable pay) with annual and long-term incentives.

HSBC’s remuneration strategy is based on their reward package, which is based on five elements:

• Fixed Pay

• Benefits

• Annual Incentives

• Long Term incentive award

• Shareholding requirement

HSBC believe that these remuneration practices support the business objectives, strategies, values and long-term interests of the firm. This reduces conflicts of interest – all the employees are remunerated based on their performance, and a remuneration strategy with functional objectives also promotes effective risk management.

HSBC Holdings Performance Bonus depends on the employees’ standards of performance and market conditions, their yearly performance and achievements. Employees get a bonus by the end of the year – the company pays the prizes, which are incentives are for their smart work, in cash.

The HSBC value assessment process operates through performance management that is open to different ideas and cultures. They believe in treating people fairly, valuing their perspectives, listening to them and communicating with them openly and honestly. They are also systematically connected with their customers as they believe in building connections and care about the individuals and their own connections with people.

Question

Executive compensation contracts should provide efficient incentives for CEOs to maximise shareholder value. Examine contrasting claims in the managerial power approach and optimal contracting theory that pay-for-performance relations are broken. The notion of pay-for-performance continues to underpin arguments on how best to reform executive compensation arrangements. Critically evaluate the debate on the reform of executive compensation in banking and explain how the introduction of concepts, such as, malus and clawback, a greater use of debt and deferred compensation, and long-term incentives might be a step in the right direction.

Abstract

Compensation of CEO’s has received a lot of attention in current years because CEO compensation is essential to meet the shareholder’s goals and the company’s objective. Firm’s performance, mechanisms governing corporate’s (include ownership structure and board composition), and exterior monitoring performance are examined before determining the CEO’s compensation. These compensations can cause bankruptcy in the companies if not well revised because of how the CEOs perform in the organization. Compensation arrangements can be arrived at using both managerial power and an optimal contract approach. We seek to differentiate the optimal contracting approach of executive compensation with an alternative point of view that we termed the “rent extraction view”. The rent extraction view centres on the ability of executives to impact the compensation process for their own gain at the expense of the investors. Managerial approach and rent extraction play a vital role in executive compensation. Theoretically, an analysis of the compensation-setting process shows that its results really affect manager’s attention in staking out rents and in the managerial power.

CEOs have always played a key role in corporate strategy, and even though the dispersion of talent amongst CEOs is quite small, these little differences in talent levels can have large impacts on the firm performance. CEOs are not simply paid a fixed, lump sum salary each year. Instead, they are paid in a wide array of forms that include base salaries, end of year bonuses, signing bonuses, stock options, restricted stock grants, performance shares, retirement benefits, long-term incentives, severance payouts and perquisites (Kuehn, 2013).

Stockholders depend on CEOs to approach policies that amplify the value of their shares. Like other people, however, CEOs get opportunities to involve in activities that improve their own perspective. One of the most important participation of the board of directors is to make incentives that influence the CEO’s best attention to do what’s in the stockholder(s) best interests. Conceptually, this is an easy task. Combination of three essential policies will ensure the correct money-related incentives for chiefs to boost the estimate of their companies:

Boards can necessitate that chiefs become considerable owners of company stock. Salaries, rewards and stock options can be organised in order to give enormous rewards for superior performance and huge penalties for low-level performance. The insecurity of dismissal for bad performance can be made effective (Hermalin and Weisbach, 1991).

Compensation arrangements can be arrived at using both managerial power and an optimal contract approach. From the optimal contracting point of view, executive pay arrangements are placed by a directorate that is supposed to enlarge shareholder value by planning an optimal principal-agent arrangement. Executive pay practices in massive, traded-on open market companies are supposed to limit the agency costs that exist between the shareholders and the senior executives. The board of directors is viewed as seeking to maximise shareholder value and the compensation scheme is designed to serve this objective. Financial economists have mainly worked in trying to explain the different features viewed in executive pay programs as well as the cross-sectional changes in pay practices among corporations (Edmans and Gabaix, 2009). The Standard and Poors’ Execucomp collected data on compensations to executives of various companies by retrieving the information from the annual proxy (DEF14A SEC form).

The managerial power approach inferred that the compensation practices cannot be properly explained by optimal contracting alone. Both approaches adopt different compensation practices; however, the managerial approach significantly deviates from the optimal approach. Under the managerial power approach, the practices employed only keep managers under-thinking. Managerial approach and rent extraction play a vital role in executive compensation. Theoretically, an analysis of the compensation-setting process shows that its results really affect manager’s attention in staking out rents and in the managerial power. Broad experimental proof on executive pay is reliable with the predictions of the managerial power approach. In reality, this approach can clarify certain significant highlights of the executive pay scene better.

We seek to differentiate the optimal contracting approach of executive compensation with an alternative point of view that we termed the ”rent extraction view”. The rent extraction view centres on the ability of executives to impact the compensation process for their own gain at the expense of the investors. Under this perspective, the boards don’t receive an optimal pay contract because the board of directors is captured by the management as they are essentially inexperienced for supervising payment. Therefore, executives get paid in surplus of the level that would be optimal for investors, and this surplus pay constitutes rent. Despite the fact that this rent extraction perspective lies at the heart of many of the people’s outcry over pay levels and practices, it has gotten little consideration and improvement in the academic literature.

The view that executives can extract rents does not imply that there are no constrictions on their ability to do so. One important force in this particular is what we call the ”outrage constraint.” Executives would be disinclined to approve, and managers too timid to propose, pay plans that would seem despicable to observers. Such plans would, therefore humiliate the executives and managers or reduce the inclination of shareholders to poll with the management in future control challenges. The nature of the constrictions on the process implies that executives would pay attention to obscuring the presence of rent extraction and disguising its magnitude. It would be apt, thus, for executives to favour compensation configurations and processes that enable them to do so. In the rent extraction vision, this craving to camouflage rent extraction has an imperative influence on the design of reimbursement practices and is a strategic concept for understanding standing practices.

Although the rent extraction view is abstractly pretty diverse from the optimal contracting view, the two are not communally exclusive, and related executive compensation practices might replicate a mix of rent extraction and incentive generation. The rent withdrawal view does not propose that any chunk of the compensation scheme serves stakeholders’ interests. It only debates that rent extraction plays a significant part in compensation provisions and that, as an outcome, managers are waged more than is ideal and paid in means that are not inevitably ideal for stakeholders (Bebchuk et al., 2001)

After inspecting the problems with the optimal contracting view, I am going on to provide an interpretation of the alternate rent extraction view of managerial compensation. The precise cause for inspecting the optimal contracting approach also proposes that the managers will have a considerable impact on their distinctive pay and, thus, considerable power to extract rents. These motives also propose that the greater the manager’s power, the greater their aptitude to extract rents.

According to the rent extraction view, two major building obstructs are ”camouflage” and ”outrage constraint”. Although all directors would adopt the management rent extraction approach to a certain extent, they would adhere to the boundary in case of outrageous practices that may cause embarrassment to their reputation, and both the management and the directors might want to refrain from decisions that would improve the probability of an ouster. Since outrage from an outsider’s identification of the existence of rent extraction places vital limitations on compensation under this approach, decisions intended to complicate and legitimise – or, more generally, camouflage – play a significant part in the design of pay arrangements. This impression of camouflage will be quite helpful in clarifying a large number of the patterns given by the executive pay landscape (Murphy, 2002)

The unavailability of any sifting of the general-market or industry impacts is not confusing from the rent extraction point of view. According to this view, pay schemes are often planned to focus on increasing executive pay while remaining within the scope of legitimacy and adequacy. Given that the utilisation of standard options is established and generally thought a legitimate type of pay, and that indexing may serve shareholders’ interests yet reduce managers’ profit, the absence of any development towards some kind of indexing is compatible from the rent extraction point of view.

An optimally planned scheme would give risk-avoiding managers the most effective and cost-related motivations to apply effort and settle on value-amplifying decisions. Under such a plan, the optimal exercise costs should rely on different factors that may vary from company to company, executive to executive, and now to then, including the level of managerial risk avoidance (which may be influenced by the manager’s age and riches), the project decisions accessible to the firm, the unpredictability of the company’s stock, the expected rate of enhancement; and the length of the agreement. There is thus no cause to expect that the similar exercise cost formula would be ideal for all executives at all firms in all companies at all times. Thus, the way in which choices are almost consistently issued at-the-money is rather hard to clarify based using an optimal contracting approach (Kogut and Harnal, 2010)

However, the consistent use of the at-the-money option is not baffling according to the rent extraction approach. From this point of view, provided that executives derive advantage from lower exercise costs, there will be a wish to put practice costs to the least level possible without an intersection with the outrage constraint. Designers of plans derive no gain from trying to raise the practice prices above the market cost at the time the choices are issued, given that some avocation is provided for at-the-money option. The only practice to avoid is providing the in-the-money option that may be viewed as a fortune and whose grant may compromise the financial avocation for ignoring indexed pay schemes.

One more surprise for optimal contracting is the manager’s widespread opportunity to loosen up their incentives. An ideal principal-agent contract can be relied upon to put some limitation on the manager’s capacity to offer stock or shield the stock choices given, so as to more readily adjust their interests with those of the shareholders. However, aside from vesting essentials, such limitations are never imposed. Therefore, executives mostly offer existing shares when allowed options or limited stock, practices options well before failure, immediately offer the shares they get upon practices of choices; and try to support their exposure when disposal is impossible.

The need for such limitation, while hard to clarify from an optimal contracting approach, is in accordance with rent extraction. Under this point of view, the pay structure is outlined in the light of the manager’s welfare. The rent extraction view accordingly predicts that the architects of pay designs would abstain from including unwinding limitations, which may well serve investors but would diminish the manager’s benefits (Bebchuk et al., 2002).

The conclusion that rent extraction assumes a noteworthy part in executive compensation has critical limitations on the examination, control, and routine with regards to corporate administration. Let’s assume to fully investigate these implications in an ensuing work. However, we focus on a prior and vital step – to advance a systematic framework for the investigation of rent extraction in executive compensation, which plays a major role in executive compensation.

At last, it is significant to highlight that, on account of the outrage constraint and the camouflage intention, there might be a major overlap between incentive generation and rent extraction. Payments that are in accordance with incentive generation may be comparatively easy to prove and protect. The purpose of the rent extraction approach, however, is that the executive pay outcome would stray from that which would be in the shareholder’s interest. When rent extraction is at work, executives will get more pay than they would have gotten under an optimal principal-agent contract. Pay structures that give sub-optimal incentives yet serve to build executive wealth may then be received.

Rent extraction, at that point, can produce a variation from optimality in both the size and structure of executive pay. The degree of that deviation, obviously, is the important issue. The supporters of the optimal contracting perspective would not be bothered to find that rent extraction leads to some minor deviation from the optimal contract.

Indeed, even with liberal stock option designs, executives catch only a restricted fraction of any increase in strength. In an important article, Jensen and Murphy reported finding a statistically significant relationship between the chief’s pay and the firm’s performance, but they argued that the fraction of increase in the company value retained by chief was too small to be consistent with optimal contracting. The authors recommend that political requirements may account for the gap. Different observers have argued that the affectability of pay-for-performance found by Jensen and Murphy can be accommodated with optimal contracting. In any occasion, more recent data indicate that the fraction of value retained by executives has increased dramatically over the last two decades. We inferred that the compensation-for-performance sensitivity information does not conflict with either model of executive compensation (Jensen and Murphy, 1990)

The compensation for execution information, however, also appears to be consistent with the rent extraction view. It is not possible to measure the optimal pay-for-performance affectability; thus, we can neither decide whether the options given today are generally adequate nor ignore the possibility that diminished grants may upgrade the shareholder value. Some incentives might be important to induce executive exertion, and the form, when compared to the amount of incentives provided, might be more important for urging optimal attempt and decision-making. We require one more essential regardless of whether executive compensation is too insensitive to performance, to conclude that overall compensation is too low and should be expanded to increase the pay-performance affectability. It may be the case that the overall level of executive pay could be reduced with either no impact or a positive impact on sensitivity by rebuilding the form of pay (Bebchuk and Fried, 2002)

Once the connection between rent and power is identified, there is reason to trust that rent extraction may occur to some degree in all organisations without a controlling or predominant shareholder. Certainly, managers can be expected to have relatively less power and, thus, able to extricate less rent in conditions where a huge external shareholder is present or more shares are in the hands of companies. However, even in such circumstances, managers still have impressive power and can, thus, be expected to extract rent. Indeed, the evidence that I have described in the preceding sections, which also applies to the organization or large shareholder-impacted companies, shows that rent extraction may well take place, regardless of whether or not to a reduced extent, in such organisations.

The second query that arises with this approach to pay policy is about how it would fit into a broader regulatory framework – the existing compensation policy and the more extensive monetary and financial stability policy. Setting up a direct link between compensation and risk adjusted execution could supplement and strengthen the present policy of deferring the pay subject to clawback and malus. There are two causes for that – an objective and certain character of the measuring and the possibility of implanting pay policy in the countercyclical macro-prudential regulation. The principle advantage of deferred compensation with clawback and malus is in reducing some of its short-termism (Vaneylen, 2016).

The possibility of restoring a part of the compensation by relying on longer-term execution and risk results naturally elongate the employee’s time-horizons. By keeping the employee’s skin in the game, this measure also recreates some of the features of unlimited liability and, as a result, lowers risk-taking. There is, however, an important limitation for this policy. The less risk-averse and the more overconfident employees are, the less they expect negative future outcomes, and hence, the less likely they are to lower risk-taking even when confronted with the possibility of an ex-post pay adjustment.

Reforms in executive Compensation

Creating new policies in the organization will produce some proper monetary incentives for CEOs to the optimal value of the company. Systems such as; board require that CEOs become substantial owners of company stock, and that bonuses, salaries and stock are restructured such that the provision of penalties for reduced performance and better reward for good return is implemented. Additionally, Organisation can make real the threat of dismissal for poor performance which will improve CEOs performance

Pay for Performance

The employees in pay for performance are presented with a financial incentive for achieving quantifiable or predetermined goals(Elliott, Quinn, & Vink, 2014). Some circumstances break the compensation for performance relations such as; not every employee is motivated by money, some inspiration is by recognition, praise or a chance for a better assignment. Some goals are not possible to achieve because they are not SMART, and attempting to hold employees to targets that are not attainable is unfair(Jensen & Murphy, 2012).

A Step in the right Direction

Banks using clawback compensation is in the right direction because of the contract which specifies that the employee has to deliver with how the agreement states to receive a certain amount of payment. Clawbacks involve monetary penalties which ensures that CEOs delivers on their promises(Corporate Finance Institute, 2015). Malus-bonus for executive compensation where annual bonuses are not immediately given to the CEOs such that in case of losses in the future it can be reduced (clawed back)(Elliott, Quinn, & Vink, 2014). This initiative encourages employees to perform better in banking. Differed and dept compensation of CEOs ensures that they invest in projects that are profitable and reduce risks in the banks. Additionally, long-term incentives where payment is in the form of matching shares of the company, these will ensure that the bank’s CEOs perform better to improve the value of the banks(Jensen & Murphy, 2012).

The less risk-taking and the more excessively confident employees are, the more they trust that short-term additions will surpass potential long-haul losses and react to this by taking high risks. Subjective state to risk issues and clawback and malus would have a different effect on employees with various risk inclinations. In cases of low risk seeking – both are common in finance – the possibility of an ex-post pay adjustment is not an effective tool for an ex-ante reduction in risk-taking. Linking compensation to the yearly risk-adjusted execution could address this issue by eliminating both the uncertain and the subjective elements from the connection between the employee’s compensation and incentives.

Compensation connected to the present risk-adjusted execution would have a similar effect on more risk-averse representatives as on less risk-averse. While the deferred pay subject to malus and clawback tends to the issue of short-termism, connecting pay to risk-adjusted execution handles the issues around subjective risk inclinations and uncertainty. In this way, the two policy measures support each other.

The main advantage of deferred pay with malus and clawback is in diminishing short-termism to some extent. The possibility of restoring a part of the compensation relying upon longer-term execution and risk results normally prolongs the employee’s time-horizons. By keeping employees’ skin in the game, this measure also reproduces some of the highlights of unlimited liability and, accordingly, reduces risk-taking (Thanassoulis and Tanaka, 2018). Subjective attitude to risk matters, and malus and clawback would have a different effect on employees with various risk preferences.

Recommendation

Hiring consultants could be a good decision made by the HSBC as the use of compensation consultants is one way for CEOs to extract rent in a stealthy manner. Payments settings can be arranged by using both the managerial power and the optimal contract approach, but for HSBC, the managerial approach will be more suitable, as discussed above. HSBC should hire more risk-taking employees and focus on pay per performance. Malus and clawback may be used to remove short-term employees from HSBC.

Conclusion

Adjusting the Compensation of executives which affects the Bank monetary value by initiating new policies, which ensures that the CEOs invest in profitable risks with the fear of lost because it will change their annual bonus and compensation. Systems like deferred and dept compensation which is the initial contract ensure that CEOs are compensated with the marginal profit they have made. Their initiatives for banks is for an overall better performance in the banks as a result of CEOs working smart.

References

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BEBCHUK, L. A., FRIED, J. M. & WALKER, D. I. 2002. Managerial power and rent extraction in the design of executive compensation. National bureau of economic research.

CORPORATE FINANCE INSTITUTE. (2015). Corporate Finance Institute. Retrieved 9. 14., 2018, from https://corporatefinanceinstitute.com/resources/knowledge/finance/clawback

EDMANS, A. & GABAIX, X. 2009. Is CEO pay really inefficient? A survey of new optimal contracting theories. European Financial Management, 15, 486-496.

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Master of Science in Business Economics., Ghent University.

APPENDIX I

The Standard and Poors’ Execucomp collected data on compensations to executives of various companies by retrieving the information from the annual proxy (DEF14A SEC form). Extensive information on bonuses, stock awards, salaries, pensions, non-equity incentive plans, and other compensation items are collected and stored in an extensive database. The executives have an id that can be used to locate their records in the database. The EXECID and CO_PER_ROL are permanent identity markers for the executives. The figure data demonstrates the executives of the IBM Company and their compensation over the years 2000-2003.