UBS recently announced a new compensation structure for its executive board and 'risk takers', which included what hedge fund managers have long used - a high water mark - as well as clawbacks or so called 'maluses' on as yet unpaid, but awarded, compensation.
These are certainly big changes for senior executive managers, and their implementation at UBS raises two questions. Firstly, what will happen to everyone else's bonus at UBS? And secondly, what will other banks do?
To answer the second question first, there is little doubt that other banks will come up with something not too far from what UBS has implemented. Such is the political furore over this crisis that something is going to have to give in executive pay. And while this topic re-emerges every time there is a crash, this time it is different.
Taxpayers are now shareholders and this provides the political teeth to make the changes that have been hovering in the wings for years.
The first question is more interesting. For now at least, the UBS changes are said only to apply to the executive board and certain senior managers. This scheme however may well also need to be applied to all proprietary traders.
Who are the risk takers?
However, risk is also implicit in other roles. In M&A, for example, winning a mandate may be conditional on balance sheet lending, and the M&A banker may exert pressure on the loan officer to grant the loan. In ECM, the risk associated with soft underwritten deals risk is not that great. But for block trades, there is a risk that banks get left with a rump of stock that loses value in the market.
How about the institutional salesforce? Most banks differentiate between commission and spread business. Within spread business they then differentiate between at-risk and mark-up and between inventory and agency. Mark-up and agency businesses are usually the low-risk value generators, but sales are still incentivised to try and bring in long-term illiquid and price sensitive (ie, risky) trades.
And how about flow traders? In theory, they keep the risk on their books low and simply capture bid-ask spreads or commission. This is a great strategy in the current market where spreads are wide and there's a lot of simple money to be made. But there's also an incentive to boost P&L by holding extra inventory, and therefore taking on additional risk.
Malus system will enforce good management
In practice, however, it may not be necessary to apply the malus system wherever risk is present. It is hard to see how any senior manager exposed to potential maluses will tolerate significant risk taking within their business area. The malus system is a recipe for management discipline in investment banking. It is something that has been historically lacking. Thanks to UBS, that may now change.