Misa Tanaka and John Thanassoulis
In the 2007-8 global financial crisis, a number of banks were bailed out by taxpayers while their most senior employees were paid extraordinary bonuses up to that point (E.g. here, here and here). The resulting public outcry led to new regulations allowing clawback of bonuses earned on the back of decisions that subsequently damage their banks and the wider economy. But will these rules work? Our theoretical research shows that sophisticated banks can game clawback regulations by altering pay contracts so as to incentivise bankers to take risks that benefit shareholders but that are excessive for society. The entire pay package matters, and so, understanding how it shapes risk-taking incentives is as important as monitoring compliance with clawback rules.
Malus and clawback are both mechanisms for exposing variable pay to the risk of future forfeiture if certain circumstances materialise. Banks can use malus to withhold unvested pay, for example stocks that have been awarded to the employee but not yet transferred to his or her ownership. By contrast, banks can use clawback provisions to request a return of vested pay, i.e. money that has already been paid out to the employee. Under what circumstances is it desirable to mandate malus and clawback through regulation? If the only problem with bankers’ pay is that it is excessive and not fully aligned with shareholders’ interests, then it would be enough to increase shareholders’ say over pay. A case for regulating pay by mandating a greater level of clawback than shareholders would themselves choose could arise when there is a clear divergence between the interests of the banks’ shareholders and those of society. Implicit expectations that a bank is too-big-to-fail and mis-priced depositor guarantees create such a divergence: as they keep the interest rates on bank debt low, they create an incentive for shareholders to encourage bank management to select excessively risky projects. This incentive would be stronger at highly leveraged banks, but a bank with any debt funding (which includes insured deposits) can gain in this way.
Regulatory intervention has increased the prevalence of the contractual use of malus and clawback, although clawback has rarely been invoked thus far. The Financial Stability Board reports that, as of 2014, 80% of its reporting jurisdictions required malus mechanisms, and some also mandated the adoption of clawback provisions. In the UK alone, £290 million was confiscated through malus in 2014, and JP Morgan Chase recovered more than $100 million from individuals linked to the 2012 London Whale incident.
Clawback regulation is aimed at raising the bar for an executive in choosing a risky project over safer alternatives, and not at stopping all risky investments. The regulator would want the clawback rule to incentivise the executive to choose the risky project only when the extra market value it generates reflects some genuine economic surplus being created, rather than being simply an outcome of pushing the cost of risk-taking on to the taxpayer.
Our research demonstrates that shareholders, and the Board that represents them, can in theory learn to ‘optimise’ the pay contracts to meet the clawback regulations while still incentivising risk takers to maximise shareholder value by adjusting the shape of the executives’ incentive contracts. For example, not offering any rewards for mediocre results, while lavishing sufficiently high rewards for strong results can be sufficient to encourage bankers to choose risky projects even when their rewards are at risk of clawback.
To see this, consider the following scenario. Suppose that the CEO of a bank, which is considered to be “too big to fail”, is evaluating two alternative investment strategies. One of these could be called `safe’: it will with a high probability keep the bank’s market value close to flat for this year, while also ensuring that its risk of failure remains minimal for the coming years. By contrast, the `risky’ strategy will boost the bank’s market value quite a bit this year, but at the expense of substantially increasing its risk of failure in the subsequent years. Creditors and depositors don’t fully price the risk taken by the bank: insured depositors would be indifferent to the bank’s strategy, while other creditors factor in some probability of being bailed out by taxpayers in the event of a bank failure. Consequently, the bank’s shareholders do not bear the full cost of the CEO’s risk-taking.
Let us suppose then that the bank’s shareholders expect their returns from the risky strategy to be large enough that they would prefer the CEO to go for this strategy. It is easy to design a contract to incentivise the CEO to choose the strategy which maximises the shareholders’ returns: the shareholders simply offer the CEO a contract which pays a bonus that is proportional to the bank’s market value. But if the risky strategy generates its superior performance for shareholders only because of the implicit government guarantees, then the regulator would not be happy with this outcome, as the losses arising from the bank’s failure could be ultimately imposed on the deposit insurance fund, and possibly also the taxpayers.
Clawback is designed to deal with this problem. By forcing the bank to have a clawback provision that requires the CEO to return some or all of the bonuses received if the chosen strategy fails, the CEO is forced to view the risky strategy as less desirable. If designed appropriately, the clawback will deter the CEO from choosing the risky strategy unless it generates sufficient real economic value that it compensates, at least in principle, for any costs to the taxpayer or society.
But will this be the outcome of the pay regulation? Not necessarily, as the bank’s shareholders can respond to the regulation. Our work shows that it is always possible to design a pay contract that incentivises the CEO to select the risky project preferred by shareholders even in the presence of a clawback rule by ensuring that the CEO’s expected pay rises more rapidly in shareholder value generated than the potential clawback amount. This can be done by increasing the curvature of the pay contract – that is, the rate at which the bonus increases with the bank’s market value – whilst at the same time keeping the CEO’s expected pay unchanged. The first effect ensures that pay grows fast enough in bank value to outpace clawback, whereas the second effect keeps a lid on the total amount paid to the CEO in expectation. It is possible to incentivise excessive risk-taking even in the presence of a bonus cap, for example by simply setting a high return target at which the maximum bonus can be paid out.
Such circumventions of clawback regulation can be done without costing bank shareholders any more on average than a standard equity pay scheme. It is not difficult to do: stock options are just one way of delivering high rewards for high returns. We thus conclude that compliance with clawback rule alone may not be sufficient in preventing excessive risk-taking. Our work shows that other provisions, such as pay deferral or linking pay to the cost of debt don’t particularly help, either. Pay deferral still maintains the link between the CEO’s choice and the shareholders’ preference; and too-big-to-fail distorts the cost of debt in any case.
A solution to this weakness in pay regulation, at least in principle, is that the regulator introduces additional restrictions on pay structure to limit how much shareholders can incentivise management to choose risky projects over safer ones. What is required is a pay rule which limits how curved compensation can be as a function of the bank’s value: this can solve the problem of excessive risk-taking, and induce a profit-maximising bank to adjust pay contracts so as to incentivise management to maximise society’s overall welfare. We fear, however, that implementing this in a fool-proof way may not be easy in practice. Restricting the use of equity options could help. But there may be other ways of incentivising risk-taking, for example by linking promotion to achieving extraordinary earnings, or being ready to sack executives who fail to meet demanding return-on-equity targets.
Regulators therefore need to be alert to the possibility that banks may use the tools at their disposal to undo the intended effect of clawback rules, rather than simply monitoring compliance with these rules. At the moment, UK banks can strongly incentivise CEOs to seek high returns, for example by increasing the percentage of long-term incentive plans paid out when the CEO hits a high earnings target. Banks also have significant discretion over who gets promoted, and who is shown the door, although the Prudential Regulation Authority could use its powers to block senior appointments if deemed inappropriate.
Charles Goodhart argued that regulation should be focused on reforming incentives. We agree that incentives are important, but we caution that such regulations can themselves be gamed when bank shareholders’ interests are not aligned with those of society. As such, regulators need to monitor how bank executives’ entire pay packages are structured and how they shape risk-taking incentives.
Misa Tanaka works as a Senior Research Manager in the Bank’s Research Hub Division.
John Thanassoulis is from the Warwick Business School.
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