Qun Harris, Ieva Sakalauskaite and Misa Tanaka

After the 2007–08 International Monetary Disaster (GFC), a number of jurisdictions launched remuneration rules for banks with the intention of discouraging extreme risk-taking and short-termism. One such regulation is the bonus cap rule which was first launched within the European Union (EU) and the UK (UK) in 2014. This publish examines whether or not the bonus cap mitigates extreme risk-taking and short-termism, each in concept and in apply. It additionally discusses unintended penalties highlighted by the literature.

Does the bonus cap work – in concept?

So what’s the financial case for regulating bankers’ pay? Typically, regulation is justified if two circumstances are met: first, a market failure is recognized, and second, the regulation improves in the marketplace final result. Within the absence of any market failure, there is no such thing as a case for regulating pay, as corporations would supply a compensation package deal that incentivises their staff to take acceptable ranges of danger. A excessive bonus itself just isn’t an proof of a market failure. Certainly, some research (eg Rosen (1981); Gabaix and Landier (2008); Edmans and Gabaix (2016)) defined how each the rise within the degree of govt remuneration and the very massive ranges of compensation for essentially the most senior staff may replicate the environment friendly final result of a aggressive marketplace for expertise towards the backdrop of progress, globalisation and technological advances. 

The case for post-GFC remuneration guidelines was primarily based on the argument that the market-determined pay of bankers incentivised extreme risk-taking and short-termism. This might occur when banks are ‘too massive to fail’ (TBTF), or when the deposit insurance coverage premium is mispriced. With a purpose to maximise the implicit subsidy for risk-taking arising from these, banks would incentivise extreme risk-taking by rewarding their staff with a excessive bonus when their dangerous wager succeeds, with out penalising them when it fails.

The intention of the post-GFC remuneration guidelines was to rectify this asymmetry in bankers’ reward construction. A number of the UK remuneration guidelines intention to cut back short-termism and extreme risk-taking in banks by exposing the so-called materials risk-takers’ (MRTs’) compensation to losses which can materialise over an extended time horizon. This consists of necessities to delay the fee of part of the bonus (‘deferral’) and pay a proportion of it in financial institution shares, the place deferred bonuses could be withdrawn if adversarial circumstances materialise earlier than the deferred bonus is paid out (‘malus’) and even after it’s paid out (‘clawback’). Against this, the bonus cap is meant to mitigate extreme risk-taking by limiting the reward from dangerous bets. The bonus cap rule within the EU and the UK restricts the variable pay of MRTs at banks to be not more than 100% of their fastened pay, or 200% with shareholders’ approval. Crucially, the present bonus cap rule limits the ratio of variable-to-fixed pay, but it surely doesn’t restrict the whole pay or whole bonus. Thus, the present bonus cap rule could be justified provided that capping the ratio of variable-to-fixed pay can enhance in the marketplace final result.

The theoretical literature on the effectiveness of the bonus cap in stopping extreme risk-taking is combined. For instance, Hakenes and Schnabel (2014) argue that the case for a bonus cap arises when banks have a powerful incentive to encourage extreme risk-taking by providing a big bonus, in an effort to exploit the implicit taxpayer subsidy arising from TBTF. Their evaluation, nonetheless, assumes that bankers are rewarded in bonus solely and so a bonus cap additionally places a restrict on whole reward from risk-taking. It additionally doesn’t think about the likelihood that banks might modify the pay construction in response to the regulation.

Thanassoulis and Tanaka (2018) additionally think about the affect of regulating bankers’ pay when banks’ incentives are distorted by TBTF, however they explicitly analyse the likelihood that banks modify the sensitivity of bonus to fairness returns in response to regulation. They present that banks can restore extreme risk-taking even within the presence of a clawback rule by providing a bonus which rises greater than proportionally with (ie convex in) the fairness returns, and {that a} bonus cap doesn’t forestall this.

Thanassoulis (2012) highlights the unintended penalties of a bonus cap, arguing that it might shift pay from bonuses to fastened salaries, and thereby improve banks’ fastened prices and their likelihood of failure. It’s because in a aggressive marketplace for bankers, whole pay might be decided by the banker’s means and the financial institution’s dimension.

Does the bonus cap work – in apply?

There may be solely a handful of empirical research on the affect of the bonus cap rule. Colonnello et al (2018) study the affect of the EU bonus cap and discover that the risk-adjusted efficiency of EU banks deteriorated following the introduction of the bonus cap in 2014, probably as a result of the bonus cap lowered incentive to carry out. The paper additionally seems at how the bonus cap affected financial institution executives’ turnover, as restrictions on their bonus may cause them to transfer to non-banks (eg hedge funds) which aren’t topic to the bonus cap rule. They discover that the cap didn’t impair European banks’ means to retain their greatest executives, and that CEO turnover elevated solely in under-performing banks, probably as a consequence of elevated shareholder monitoring.

Colonnello et al (2018) additionally present that, for these high executives whose variable-to-fixed pay ratio exceeded the bonus cap earlier than its introduction in 2014, fastened pay elevated after 2014 in order to maintain their whole compensation unaffected. These findings have been confirmed by Sakalauskaite and Harris (2022). Utilizing information on a bigger variety of MRTs in main UK banks between 2014 and 2019, the authors discover that the 100% variable-to-fixed pay restrict just isn’t binding in apply for many MRTs. Round one third of MRTs within the pattern have bonuses exceeding this restrict, and there’s no clear proof that getting near the 100% threshold impacts the developments in people’ remuneration. Nevertheless, when an MRT’s bonus ratio will get near 200%, their fastened pay grows sooner whereas their bonus grows extra slowly relative to different MRTs within the subsequent 12 months. Their whole remuneration progress doesn’t differ considerably from that of their colleagues whose bonus just isn’t constrained by the bonus cap. These findings are according to banks growing fastened pay to keep up a desired degree of whole pay for every particular person when the bonus cap begins binding. The proportion of MRTs near the regulatory limits (variable-to-fixed pay ratio of 175%–200%) is nonetheless low, at round 4% of MRTs receiving bonuses in a given 12 months.

There may be at the moment no empirical paper which has clearly recognized how the bonus cap impacts risk-taking of particular person MRTs, as a consequence of information limitations. On this context, Harris et al (2020) performed a lab experiment through which individuals had been requested to undertake funding selections on behalf of a hypothetical financial institution, in an effort to study how constraints akin to bonus rules, equivalent to a bonus cap and malus, have an effect on people’ danger selection. The bonus cap on this experiment capped the whole pay, the whole bonus, in addition to the bonus-to-fixed pay ratio. When bonus trusted their very own funding efficiency solely, individuals who had been topic to bonus cap and malus took much less dangers than those that had been paid a bonus which was proportional to their funding returns. However when bonus was paid solely when their investments outperformed these of their friends, all individuals took higher dangers and the risk-mitigating results of bonus cap and malus had been considerably weaker.

Conclusions

There may be restricted help from the present literature that the bonus cap rule, as it’s at the moment designed, is efficient in curbing extreme risk-taking. The theoretical literature suggests {that a} bonus cap may curb incentives for extreme risk-taking if it caps the whole reward from risk-taking, and banks don’t modify different pay parameters in response. Nevertheless, this isn’t how the precise bonus cap rule is applied, because the cap applies to variable pay solely.

The theoretical literature additionally suggests {that a} bonus cap could possibly be ineffective in mitigating risk-taking on condition that banks can modify varied pay parameters, and that it could have an unintended impact of driving up fastened pay, thereby growing banks’ fastened price and their likelihood of failure. The proof primarily based on UK information means that banks are vulnerable to growing fastened pay when the variable pay of an MRT is near the bonus cap, according to the predictions from the theoretical literature. Lastly, there is no such thing as a clear empirical proof that the bonus cap rule has curbed extreme risk-taking, although information limitations imply that such results are tough to determine.

Qun Harris works within the Financial institution’s Technique and Coverage Method Division, Ieva Sakalauskaite works within the Financial institution’s Prudential Framework Division and Misa Tanaka works within the Financial institution’s Analysis Hub.

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