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FRM Part I · FRM Exam Part I · The Governance of Risk Management

A bank's trading desk bonus plan pays out entirely in cash each year based on that year's reported trading revenue, with no clawback. Which reform would best address the governance weakness this illustrates?

The plan rewards short-term revenue regardless of risk. Deferring part of pay, paying in equity, applying clawbacks and using risk-adjusted performance measures aligns trader incentives with long-term firm performance. Higher cash share or volume-based pay would increase risk-taking incentives rather than reduce them.

  1. ARaise the cash bonus percentage so traders are more motivated to hit revenue targets
  2. BBase bonuses on notional trading volume rather than revenue
  3. CDefer a significant portion of pay, pay part in equity, and apply clawback and risk-adjusted performance measuresCorrect
  4. DMove trading revenue reporting from quarterly to annual

Explanation

The plan rewards short-term revenue without regard to risk or later losses. Deferral, equity-based pay, clawback and risk-adjusted metrics align horizons with long-term firm health. Using notional volume would encourage even more risk-taking, and raising cash share worsens the misalignment.

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