Risk culture and incentives

Barings' draft accounts for 1994 showed a profit of £102 million before tax, after setting aside about the same again for bonuses. Hidden in a Singapore error account were losses of over £200 million. The bank was paying bonuses on profits that did not exist.

You met the collapse of Barings in L1.7.12: Derivatives disasters and their lessons: one trader in Singapore, Nick Leeson, hid losses that reached £827 million by February 1995, more than the bank's capital. The usual telling is a story about one rogue. The Bank of England's report (July 1995) told a different one: about managers who did not ask, structures in which nobody was responsible, and rewards that made questions unwelcome. That is risk cultureRisk culture: the norms, attitudes and behaviours in a firm related to risk awareness, risk-taking and risk management (FSB, 2014)..

Culture is what people do when no rule covers the case and nobody is watching. Every firm has one, good or bad. In 2014 the Financial Stability Board gave supervisors four indicators to look for:

Why pay matters so much. A traditional bank bonus had a built-in asymmetryA pay structure in which the employee shares in gains but not in losses, which rewards taking more risk.. A trader who takes a big risk and wins earns a large bonus this year. If the same risk blows up two years later, the bonus has been paid and spent; the firm, its shareholders and sometimes taxpayers carry the loss. Heads I win, tails you lose. Multiply that by thousands of staff and you get a firm that takes on more risk than its owners would choose.

After 2008, the FSB set out Principles for Sound Compensation Practices (April 2009) and implementation standards (September 2009). Their core tools:

Malus is the easy tool: the firm simply does not hand over money it still holds. Clawback means asking for money back from someone who may have spent it, left the firm or moved abroad, and can end in court. That is why deferral matters: it keeps enough pay within reach of malus.

A bank awards a €1,000k bonus. Start at the FSB minimum (40% up front, the rest over three years) and move the year in which a problem is found. Then shorten the deferral, or pay everything up front, and see what malus loses.

A London trader is awarded a bonus of £800k for 2024: 40% at once, the rest in equal slices over 3 years. Eighteen months later, the bank finds that part of the desk's profit came from positions marked at prices the market would not pay.

• Global: FSB Principles for Sound Compensation Practices and implementation standards (2009); FSB risk culture guidance (2014); FSB toolkit on misconduct risk (2018).
• EU: the Capital Requirements Directive caps a banker's variable pay at 100% of fixed pay, or 200% with shareholder approval, and requires multi-year deferral with malus and clawback.
• UK: the PRA and FCA removed the bonus cap from 31 October 2023 but kept deferral, malus and clawback. The Senior Managers and Certification Regime adds personal accountability.
• US: SEC Rule 10D-1 (2022) requires listed companies to claw back incentive pay awarded on financial results that are later restated, under exchange rules effective from October 2023.
• Asia-Pacific: APRA's CPS 511 (in force for large Australian banks from 2023) requires long deferral for senior executives and lets boards cut variable pay for risk and conduct failures; the Hong Kong Monetary Authority and the Monetary Authority of Singapore have guidelines on sound remuneration.

• Risk culture is what people do about risk when no rule covers the case. The FSB looks at tone from the top, accountability, communication and challenge, and incentives.
• Barings failed through culture as much as fraud: no segregation, unclear responsibility, no challenge to impossible profits, and bonuses paid on them.
• Bonuses paid at once on revenue reward risk-taking without the downside. Deferral, shares and risk adjustment fix the asymmetry.
• Malus cancels deferred pay before it vests; clawback recovers pay already received and is much harder.
• Rules differ: an EU bonus cap, no cap in the UK since October 2023, US mandatory clawback after restatements, long deferral under Australia's CPS 511.

Risk culture

Risk culture: the norms, attitudes and behaviours in a firm related to risk awareness, risk-taking and risk management (FSB, 2014).

Variable pay

Variable pay: pay that depends on performance, such as a bonus, on top of fixed salary.

Deferral

Holding back part of a bonus and paying it in slices over later years.

Vesting

The point at which deferred pay becomes the employee's to keep.

Malus

Reducing or cancelling deferred pay before it vests, because of misconduct, error or a failure of risk management.

Clawback

Recovering pay that has already been paid or has vested.

Pay asymmetry

A pay structure in which the employee shares in gains but not in losses, which rewards taking more risk.