Kon Harris, Eva Sakaloskite, and Misa Tanaka
After the 2007-2008 global financial crisis (GFC), many jurisdictions introduced bonus regulations for banks with the aim of discouraging excessive risk-taking and short-term. One such regulation is the reward cap rule that was first introduced in the European Union (EU) and the United Kingdom (UK) in 2014. This publication examines whether a reward cap mitigate excessive and short-term risk-taking, both in theory and in practice. . It also discusses unintended consequences highlighted in the literature.
Does the bonus cap work – in theory?
So what is a file economic condition To regulate bankers’ wages? In general, regulation is justified if two conditions are met: first, market failure has been identified, and second, regulation improves market outcomes. In the absence of any market failure, there is no case for wage regulation, as firms will offer a compensation package that incentivizes their employees to take appropriate levels of risk. High reward by itself is not a sign of market failure. Indeed, some studies (eg, Rosen (1981); Gabaix and Landier (2008); Edmans and Gabaix (2016)) have shown how higher levels of executive pay and very large levels of compensation for senior employees can reflect the effective outcome of a competitive market. talents against the background of growth, globalization and technological advancement.
The issue of bonus rules after the GFC was based on the argument that bankers’ market-determined salaries motivate excessive risk-taking and short-termism. This can happen when banks are “too big to fail” (TBTF), or when the deposit insurance premium is wrong. In order to maximize the implicit support for the risk arising from these risks, banks can incentivize excessive risk-taking by rewarding their employees with a high reward when their risky bet succeeds, without penalizing them when it fails.
The aim of the bonus rules after the GFC was to correct this asymmetry in the bonus structure of bankers. Some bonus rules in the UK aim to reduce short-term and excessive risk-taking in banks by exposing so-called physical risk compensations (MRTs) to losses that may materialize over a longer time horizon. This includes requirements for delaying payment of a portion of the bonus (“deferral”) and paying a portion of it into Bank shares, as deferred bonuses can be withdrawn if adverse circumstances materialize before or even after the deferred bonus is paid (“clawback”). By contrast, a reward cap is supposed to mitigate excessive risk-taking by limiting the reward from risky bets. The bonus cap rule in the EU and the UK limits the variable pay of MRTs at banks to no more than 100% of their fixed pay, or 200% with shareholder approval. Crucially, the current bonus cap rule limits rate From variable to fixed pay, but it does not limit the total salary or the total bonus. Thus, the current bonus cap rule can only be justified if fixing the ratio of variable to fixed pay can improve market outcomes.
The theoretical literature on the effectiveness of a reward cap in preventing excessive risk-taking is mixed. For example, Hakenes and Schnabel (2014) argue that the reward cap issue arises when banks have a strong incentive to encourage excessive risk-taking by offering a large reward, in order to exploit the implicit taxpayer support arising from the TBTF. However, their analysis assumes that bankers reward as a matter of reward only, so the reward cap also places a cap on the total reward generated by risk. It also does not take into account the possibility of banks adjusting the wage structure in response to regulation.
Thanasoulis and Tanaka (2018) also consider the effect of regulating bankers’ wages when banks’ incentives are distorted by the TBTF, but explicitly analyze the possibility that banks may adjust bonus sensitivity to equity returns in response to regulation. They show that banks can recover excessive risk even under a recovery rule by offering a reward that rises more than proportionate to (ie convex in) equity returns, and that the reward cap does not prevent this.
Thanasolis (2012) highlights the unintended consequences of a bonus cap, arguing that it would shift pay from bonuses to fixed salaries, and thus increase banks’ fixed costs and probability of failure. This is because in the competitive market for bankers, the total salary will be determined by the capacity of the banker and the size of the bank.
Does the bonus cap work – in practice?
There are only a few empirical studies on the effect of the reward cap rule. Colonello et al. (2018) examined the effect of the EU reward cap and found that the risk-adjusted performance of EU banks deteriorated After the introduction of the bonus cap in 2014, perhaps because the bonus cap reduced performance incentive. The paper also looks at how the bonus cap affects the turnover of bank executives, as constraints on their bonuses can migrate to non-banks (such as hedge funds) that are not subject to the bonus cap rule. They found that the cap did not impair European banks’ ability to retain their best CEOs, and that CEO turnover only increased in underperforming banks, possibly due to increased shareholder control.
Colonello et al. (2018) also showed that for senior executives whose ratio of variable to fixed pay exceeded the bonus cap before it was introduced in 2014, fixed pay increased after 2014 so as to keep their total compensation unaffected. These results are confirmed by Sakalauskaite and Harris (2022). Using data on more MRTs in major UK banks between 2014 and 2019, the authors found that a variable to fixed 100% payment limit is not binding in practice for most MRTs. About a third of the MRTs in the sample had rewards above this threshold, and there is no clear evidence that approaching the 100% threshold affects developments in individuals’ pay. However, when the MRT’s bonus percentage approaches 200%, his fixed salary grows faster while his bonus grows slower relative to the other MRTs in the following year. Their total salary growth is not significantly different from that of colleagues for whom the bonus cap does not limit their remuneration. These results are consistent with banks increasing fixed wages to maintain the required level of gross salary per capita when the bonus ceiling begins to be adhered. However, the proportion of MRTs close to organizational boundaries (the ratio of variable to fixed wages from 175% to 200%) is low, with about 4% of MRTs receiving bonuses in a given year.
There is currently no empirical paper that has clearly identified how the reward cap affects risk in individual MRTs, due to data limitations. In this context, Harris et al (2020) conducted a laboratory experiment in which participants were asked to make investment decisions on behalf of a hypothetical bank, in order to examine the effect of restrictions similar to bonus regulations, such as bonus caps and malus. Individual risk selection. The bonus ceiling in this experiment determined the total pay, the total bonus, as well as the ratio of bonus to fixed pay. When the reward is based solely on their investment performance, the participants who were subject to bonus and money caps took less risk than those who received a reward commensurate with the returns on their investment. But when the reward was paid only when their investments outperformed those of their peers, all participants took greater risks and the risk-mitigating effects of the reward and money caps were significantly weaker.
There is limited support from the current literature that the reward cap rule, as it is currently designed, is effective in curbing excessive risk-taking. Theoretical literature suggests that a cap on reward can reduce incentives to take excessive risks if it is a cap Total bonus Of risk, banks do not adjust other payment standards in response. However, this is not how the actual bonus cap rule is implemented, as the cap applies to variable wages only.
Theoretical literature also suggests that the reward cap may be ineffective in mitigating risk given that banks can adjust different payment criteria, and that it can have the unintended effect of increasing fixed wages, thus increasing the fixed cost to banks and the probability of their occurrence. to fail. Evidence based on UK data suggests that banks tend to increase fixed wages when the MRT’s variable salary is close to the bonus ceiling, consistent with expectations from the theoretical literature. Finally, there is no clear empirical evidence that the reward cap rule curbed excessive risk-taking, although data limitations mean that such effects are difficult to quantify.
Con Harris He works at the bank Department of Strategy and Policy Approaches, Ieva Sakalauskaite He works at the bank Precautionary Frame Division and Misa Tanaka He works at the bank Research center.
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