Compensation and management incentives
The compensation of managers can be structured to bring the interests of managers more into harmony with those of shareholders. Corporations usually tie the compensation of managers to the market success of the business. The salary increases and bonuses of most high-level managers are directly related to the firm’s profitability and the price of its shares. How important are these incentives? In recent years, salaries have constituted only about 10 percent of the compensation of chief executive officers (CEOs). The other 90 percent has been in the form of bonuses, often stock awards and stock options (the right to buy shares at a certain price). Both forms of payment have a “vesting period,” which means they will be granted only if the CEO stays with the firm for a certain amount of time and meets specific goals. Policies like these encourage corporate managers to maximize the the firm’s profits – and, not coincidentally, the value – of its shares both strongly in the interest of shareholders. Managers who develop a good track record of adding value to the firm gain not only more pay and greater job security, but also better job offers should they later decide to switch firms.
Incentive pay brings with it another unwanted incentive for managers, though: the incentive to gain personally by manipulating the firm’s accounting records to make its financial performance look better than it really is. However, stockholders and portfolio managers, and especially investors who specialize in selling stocks short when they think the firm is overvalued, will be scrutinizing the records to detect phony accounting designed to mislead investors.
Capital Management
Banks and capital markets both act as conduits for savings to be channeled to the most productive sectors of an economy. Here, productive means those sectors in which businesses can generate the highest economic returns. Bank management plays a similar role internally. Capital is a scarce commodity and management need to ensure that it is utilized effectively. External conditions are in a constant state of change and management must continually monitor the risk-adjusted returns from, and prospects for, specific businesses.
Bank management are responsible for the allocation of capital to those businesses with the highest returns and for taking capital out of businesses generating inferior returns, by restructuring such businesses to generate acceptable returns or through disposals.
The adoption of BIS standards as defined in the Basel Accord to specify minimum bank capital-adequacy levels has had a marked impact on bank approaches to capital management. Developments in finance theory have also helped managers understand the functions of capital and issues involved in its allocation better. Advances in technology have made it possible to apply at least some of these theoretical developments in a practical world. Despite this progress no-one who has studied this subject would deny that significant flaws, both theoretical and practical, remain.
Shareholder value advocacy, embodied in Anglo-Saxon capitalism, has gained considerable support in countries such as Germany, France and Italy where it has not been given the highest priority in the past. As a result capital management has gained a much higher profile in recent years. Recent is a relative term but in this context means approximately 25 years.
Capital management is complex not least because it has to find ways to accommodate the above flaws and come up with practical, effective ways to determine capital allocation. The old adage that a fool can ask more questions than a wise man can answer springs to mind. It is easy for capital managers to get bogged down in the morass of the underlying theoretical and implementation issues. The key questions for them to answer today, however, boil down to how much capital their bank needs, how it should be allocated between different businesses and what constitutes an acceptable return on this capital.