The window-shopping trip to the sports car showroom, as bonus season approaches, has become a keenly anticipated part of the annual financial calendar. And a rite of passage for many young financial wizards has been the early morning test-drive race across London/Sydney Harbour Bridge in a bright red European sports model (accompanied, if lucky, by a dumb blond European sporty model).
When the great semi-religious festival of the 'Day of the Bonus Handout' finally arrives, hordes of suddenly richer bankers gather to celebrate at celebrity-chef restaurants on buckets of Cristal champagne and a few extra laps with a lap dancer. Silly spending is de rigueur. Then, a few days later, off to the Porsche or BMW dealer to buy the new sports car, only to be disappointed, as there is a waiting list; others, more sure of their bonuses, had already shelled out a deposit. But that just increases the anticipation.
Finally the new machine arrives and the eager owner can take it for a 'burn'. Unfortunately, this can only be done at night (when regrettably few can actually see the new toy) as the super-car can only move at the average 15 mph of the average traffic jam on the drive to the office. After a few weeks of being late for work, the banker takes to the train again, only bringing out the 'beast', as it has become known, for a weekly burn-up, often to pick up breakfast at the local coffee shop, where the car park looks like Monte Carlo before a race, as every other local bonus recipient is doing exactly the same.
Conspicuous consumption of 'luxury' has become an integral part of the culture of Finance. Even a staid newspaper, such as the Australian Financial Review, publishes, amongst the reams of stock and option prices, a 'lifestyle' pullout that contains glossy adverts for absolute necessities, such as designer pens, watches, crocodile-skin covered PC laptops. It also shows blond European models (male and female) wearing long pointy-toed shoes that would bring howls of laughter at a circus but elicit admiring glances in the City's streets.
But this edifice of extravagance is about to tumble, yet another victim of the Global Financial Crisis.
Fast and first out of the starting gates, the UK FSA and Australian APRA have just published proposed changes to remuneration in regulated institutions. Among many contentious points, the new regulations require that firms include 'good' risk management in assessing bonuses for individuals. In a massive change to current practices, the FSA notes that: "Poor performance in non-financial metrics such as poor risk management or other behaviours contrary to firm values can pose significant risks for a firm and should, as appropriate, override metrics of financial performance." APRA obviously agrees, noting: "It is important for institutions to recognise and adjust remuneration for non-financial measures, such as compliance with risk management and internal audit frameworks, management of staff, adherence to corporate values and displaying good corporate citizenship." Good corporate citizenship! What's that?
But regulators have missed an important point.
It is not the value of remuneration, per se, that moderates risk-taking but, as the new discipline of 'neuroeconomics' is demonstrating, it is the 'anticipation' of rewards that drives risky behaviour.
In order to encourage good risk practices then managers must concentrate on managing the anticipation of bonuses as much as the bonuses themselves. And in order to achieve this, there must be some measures or metrics for adherence to risk management rules.
Finance is well known for its ARs. There is VAR (Value At Risk), EAR (Earnings At Risk), CFAR (Cash Flow At Risk) and a number of similar measures of risks. It would make sense then to develop a similar "At Risk" that relates to the anticipation of remuneration.
This is where the concept of PAR or 'Porsche At Risk' comes in.
It would work as follows.
On the first day of the new financial/bonus year, when a risk taker signs on to their system, he/she will be faced with a picture of an empty parking spot. As each day passes, bits of a Porsche or Lamborghini would appear; first a wheel, then a door, then another wheel and so on. Over time the desired object would emerge slowly, provided that good risk management is observed. But if, for example, a credit or market risk limit were to be exceeded then there would be a loud crashing noise and a window wiper or hubcap would be ripped off. An adverse audit report could, for example, result in a busted windscreen and a fraud would total the vehicle completely.
Desire is a drug; it makes, even in the midst of winter, traders catch the 4:58 a.m. train from Westchester or Essex to battle another day in the financial trenches. Of course, not everyone desires a new sports car (or already has one or two) so other measures may be needed, such as HHAR (Holiday Home At Risk) or EVAR (Expensive Vacation At Risk). But the principle is the same; the picture of the desired item would emerge gradually over time but would be chipped away if rules were broken.
As the bonus year draws to a close then, the risk taker will become fixated on ensuring that they follow good risk management practices otherwise they will lose their 'obscure(d) object of desire'. Rather than a boring warning message appearing when something untoward is about to happen, maybe a picture of a completed sports car should be shown, the potential loss should encourage second thoughts about the implications of the proposed action.
Behavioural Finance has shown that, contrary to 'rational expectations', people value things they already own over potentially greater gains. This 'endowment effect' or 'loss aversion' means that risk takers will take special care if they stand to lose something they already perceive as 'theirs'. Risk Management will become an obsession.
By the end of the year, the risk taker, if they have observed the rules, will be awarded a bonus sufficient to purchase his/her desire, although the usefulness of a three-wheeled BMW Boxster is somewhat debatable. Never mind, next year a Ferrari?
Of course a whole new terminology will arise; traders will be above or below PAR, risk takers will be on a bogey (above PAR) or on a birdie (that dumb blond European model again).
While implementation of risk-based remuneration may differ somewhat from the concept of Porsche At Risk, this is a serious issue. If regulators demand that employees are measured not merely against obedience with, but belief in, the firm's risk management culture, there must be a way of ensuring that risk takers know where they stand at any point in time. Otherwise, in the proposed regime, Risk Management will morph into the Inquisition, brought in to deliver bad news and think up reasons for unpopular remuneration decisions.
As with all other aspects of risk management, people have got to buy-in and not merely 'tick boxes'.
As the wise Confucius said: "By nature, men are nearly alike; by practice, they get to be wide apart".
