[No. 192] Executive Comp at SNS Reaal - Back to Square One?

In an influential article published in the Harvard Business Review in the early nineties, Michael Jensen and Kevin Murphy famously wrote that

The relentless focus on how much CEOs are paid diverts public attention from the real problem—how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance. On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets?

Jensen and Murphy's study revealed that a $1,000 change in corporate market value corresponded to a change in CEO compensation of just $2.59. To ensure appropriate incentives, Jensen and Murphy argued that CEOs should own substantial amounts of company stock and that cash compensation should be structured to provide big rewards for outstanding performance and meaningful penalties for poor performance.

The rest is, of course, history. Executive compensation became significantly more dependent on stock price performance, up to a point where, as many believe the financial crisis has revealed, incentives became distorted in the sense that executives overly focused on the short term.

The notion that focus on stock price performance leads to focus on the short term carries with it the implicit notion that apparently share prices fail to adequately reflect the value of the firm (expressed as the sum of discounted future cash flows) - indeed, the efficient market hypothesis is another major victim of the financial crisis. Perhaps that is why Dutch bank SNS Reaal, according to an article published in today's FD has decided to do away entirely with executive compensation based on share price performance.

Back to square one? Not quite. Instead, bonuses at SNS will be dependent on quantitative measures such gross profit and efficiency ratio, and qualitative measures such as customer and employee satisfaction. So perhaps we are witnessing the emergence of a new generation of executive compensation instead. Whether this new generation will indeed be more sophisticated will undoubtedly be the subject of interesting research, such as by my friend Emmanuel Lokin over at Erasmus University.