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

Before the 2007-2009 crisis, many financial institutions paid traders annual bonuses based on same-year profits, with no deferral or clawback. Which governance lesson about compensation is most consistent with this experience?

The lesson is that pay should reflect risk-adjusted performance over a multi-year horizon, using deferral and clawback. Same-year profit bonuses rewarded taking risks whose losses appeared later, so aligning payout timing with the risk horizon reduces incentives for excessive risk-taking.

  1. APay should be tied to revenue so that traders are rewarded quickly for generating profit
  2. BCompensation structures should reflect risk-adjusted performance over a multi-year horizon, with deferral and clawback featuresCorrect
  3. CCompensation should be fixed entirely in cash to remove any link to performance
  4. DCompensation design is an HR matter and should be kept outside board oversight

Explanation

Short-term, unadjusted bonuses rewarded risk-taking whose losses emerged later, shifting the costs to shareholders and others. Reform emphasizes risk-adjusted measures, deferral and clawback, and board oversight. Pure revenue links reinforce the problem.

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