Qun Harris, Ieva Sakalauskaite and Misa Tanaka

After the 2007–08 World Monetary Disaster (GFC), a number of jurisdictions launched remuneration laws 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? Basically, regulation is justified if two circumstances are met: first, a market failure is recognized, and second, the regulation improves in the marketplace end result. Within the absence of any market failure, there is no such thing as a case for regulating pay, as corporations would provide a compensation bundle that incentivises their workers to take applicable ranges of threat. A excessive bonus itself 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 government remuneration and the very giant ranges of compensation for probably the most senior workers may replicate the environment friendly end result of a aggressive marketplace for expertise in opposition to the backdrop of development, 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 large to fail’ (TBTF), or when the deposit insurance coverage premium is mispriced. To be able to maximise the implicit subsidy for risk-taking arising from these, banks would incentivise extreme risk-taking by rewarding their workers 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 few of the UK remuneration guidelines intention to scale 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 cost of part of the bonus (‘deferral’) and pay a proportion of it in financial institution shares, the place deferred bonuses might be withdrawn if hostile circumstances materialise earlier than the deferred bonus is paid out (‘malus’) and even after it’s paid out (‘clawback’). In contrast, 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 overall pay or whole bonus. Thus, the present bonus cap rule might be justified provided that capping the ratio of variable-to-fixed pay can enhance in the marketplace end 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 robust incentive to encourage extreme risk-taking by providing a big bonus, with a purpose 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 contemplate the likelihood that banks might regulate the pay construction in response to the regulation.

Thanassoulis and Tanaka (2018) additionally contemplate the impression of regulating bankers’ pay when banks’ incentives are distorted by TBTF, however they explicitly analyse the likelihood that banks regulate 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 stop this.

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

Does the bonus cap work – in apply?

There’s solely a handful of empirical research on the impression of the bonus cap rule. Colonnello et al (2018) study the impression 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, presumably as a result of the bonus cap decreased incentive to carry out. The paper additionally seems to be 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’ potential to retain their greatest executives, and that CEO turnover elevated solely in under-performing banks, presumably as a result of elevated shareholder monitoring.

Colonnello et al (2018) additionally present that, for these prime 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 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. Nonetheless, 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 yr. Their whole remuneration development doesn’t differ considerably from that of their colleagues whose bonus isn’t constrained by the bonus cap. These findings are in step with banks rising fastened pay to take care of 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 yr.

There’s presently no empirical paper which has clearly recognized how the bonus cap impacts risk-taking of particular person MRTs, as a result of information limitations. On this context, Harris et al (2020) carried out a lab experiment during which individuals had been requested to undertake funding selections on behalf of a hypothetical financial institution, with a purpose to study how constraints akin to bonus laws, equivalent to a bonus cap and malus, have an effect on people’ threat selection. The bonus cap on this experiment capped the overall pay, the overall bonus, in addition to the bonus-to-fixed pay ratio. When bonus relied on 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 better dangers and the risk-mitigating results of bonus cap and malus had been considerably weaker.

Conclusions

There’s restricted assist from the present literature that the bonus cap rule, as it’s presently 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 regulate different pay parameters in response. Nonetheless, this isn’t how the precise bonus cap rule is carried out, because the cap applies to variable pay solely.

The theoretical literature additionally suggests {that a} bonus cap might be ineffective in mitigating risk-taking provided that banks can regulate varied pay parameters, and that it may have an unintended impact of driving up fastened pay, thereby rising banks’ fastened value and their likelihood of failure. The proof primarily based on UK information means that banks are liable to rising fastened pay when the variable pay of an MRT is near the bonus cap, in step with 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 Strategy 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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