Qun Harris, Ieva Sakalauskaite and Misa Tanaka
After the 2007–08 Global Financial Crisis (GFC), several jurisdictions introduced remuneration regulations for banks with the aim of discouraging excessive risk-taking and short-termism. One such regulation is the bonus cap rule which was first introduced in the European Union (EU) and the United Kingdom (UK) in 2014. This post examines whether the bonus cap mitigates excessive risk-taking and short-termism, both in theory and in practice. It also discusses unintended consequences highlighted by the literature.
Does the bonus cap work – in theory?
So what is the economic case for regulating bankers’ pay? In general, regulation is justified if two conditions are met: first, a market failure is identified, and second, the regulation improves on the market outcome. In the absence of any market failure, there is no case for regulating pay, as firms would offer a compensation package that incentivises their employees to take appropriate levels of risk. A high bonus itself is not an evidence of a market failure. Indeed, some studies (eg Rosen (1981); Gabaix and Landier (2008); Edmans and Gabaix (2016)) explained how both the rise in the level of executive remuneration and the very large levels of compensation for the most senior employees could reflect the efficient outcome of a competitive market for talent against the backdrop of growth, globalisation and technological advances.
The case for post-GFC remuneration rules was based on the argument that the market-determined pay of bankers incentivised excessive risk-taking and short-termism. This could happen when banks are ‘too big to fail’ (TBTF), or when the deposit insurance premium is mispriced. In order to maximise the implicit subsidy for risk-taking arising from these, banks would incentivise excessive risk-taking by rewarding their employees with a high bonus when their risky bet succeeds, without penalising them when it fails.
The aim of the post-GFC remuneration rules was to rectify this asymmetry in bankers’ reward structure. Some of the UK remuneration rules aim to reduce short-termism and excessive risk-taking in banks by exposing the so-called material risk-takers’ (MRTs’) compensation to losses which may materialise over a longer time horizon. This includes requirements to delay the payment of a part of the bonus (‘deferral’) and pay a proportion of it in bank shares, where deferred bonuses can be withdrawn if adverse circumstances materialise before the deferred bonus is paid out (‘malus’) or even after it is paid out (‘clawback’). By contrast, the bonus 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 restricts the variable pay of MRTs at banks to be no more than 100% of their fixed pay, or 200% with shareholders’ approval. Crucially, the existing bonus cap rule limits the ratio of variable-to-fixed pay, but it does not limit the total pay or total bonus. Thus, the existing bonus cap rule can be justified only if capping the ratio of variable-to-fixed pay can improve on the market outcome.
The theoretical literature on the effectiveness of the bonus cap in preventing excessive risk-taking is mixed. For example, Hakenes and Schnabel (2014) argue that the case for a bonus cap arises when banks have a strong incentive to encourage excessive risk-taking by offering a large bonus, in order to exploit the implicit taxpayer subsidy arising from TBTF. Their analysis, however, assumes that bankers are rewarded in bonus only and so a bonus cap also puts a limit on total reward from risk-taking. It also does not consider the possibility that banks may adjust the pay structure in response to the regulation.
Thanassoulis and Tanaka (2018) also consider the impact of regulating bankers’ pay when banks’ incentives are distorted by TBTF, but they explicitly analyse the possibility that banks adjust the sensitivity of bonus to equity returns in response to regulation. They show that banks can restore excessive risk-taking even in the presence of a clawback rule by offering a bonus which rises more than proportionally with (ie convex in) the equity returns, and that a bonus cap does not prevent this.
Thanassoulis (2012) highlights the unintended consequences of a bonus cap, arguing that it would shift pay from bonuses to fixed salaries, and thereby increase banks’ fixed costs and their probability of failure. This is because in a competitive market for bankers, total pay will be determined by the banker’s ability and the bank’s size.
Does the bonus cap work – in practice?
There is only a handful of empirical studies on the impact of the bonus cap rule. Colonnello et al (2018) examine the impact of the EU bonus cap and find that the risk-adjusted performance of EU banks deteriorated following the introduction of the bonus cap in 2014, possibly because the bonus cap reduced incentive to perform. The paper also looks at how the bonus cap affected bank executives’ turnover, as restrictions on their bonus could lead them to move to non-banks (eg hedge funds) which are not subject to the bonus cap rule. They find that the cap did not impair European banks’ ability to retain their best executives, and that CEO turnover increased only in under-performing banks, possibly due to increased shareholder monitoring.
Colonnello et al (2018) also show that, for those top executives whose variable-to-fixed pay ratio exceeded the bonus cap before its introduction in 2014, fixed pay increased after 2014 so as to keep their total compensation unaffected. These findings have been confirmed by Sakalauskaite and Harris (2022). Using data on a larger number of MRTs in major UK banks between 2014 and 2019, the authors find that the 100% variable-to-fixed pay limit is not binding in practice for most MRTs. Around one third of MRTs in the sample have bonuses exceeding this limit, and there is no clear evidence that getting close to the 100% threshold affects the developments in individuals’ remuneration. However, when an MRT’s bonus ratio gets close to 200%, their fixed pay grows faster while their bonus grows more slowly relative to other MRTs in the subsequent year. Their total remuneration growth does not differ significantly from that of their colleagues whose bonus is not constrained by the bonus cap. These findings are consistent with banks increasing fixed pay to maintain a desired level of total pay for each individual when the bonus cap starts binding. The proportion of MRTs close to the regulatory limits (variable-to-fixed pay ratio of 175%–200%) is however low, at around 4% of MRTs receiving bonuses in a given year.
There is currently no empirical paper which has clearly identified how the bonus cap affects risk-taking of individual MRTs, due to data limitations. In this context, Harris et al (2020) conducted a lab experiment in which participants were asked to undertake investment decisions on behalf of a hypothetical bank, in order to examine how constraints akin to bonus regulations, such as a bonus cap and malus, affect individuals’ risk choice. The bonus cap in this experiment capped the total pay, the total bonus, as well as the bonus-to-fixed pay ratio. When bonus depended on their own investment performance only, participants who were subject to bonus cap and malus took less risks than those who were paid a bonus which was proportional to their investment returns. But when bonus was paid only when their investments outperformed those of their peers, all participants took greater risks and the risk-mitigating effects of bonus cap and malus were significantly weaker.
There is limited support from the existing literature that the bonus cap rule, as it is currently designed, is effective in curbing excessive risk-taking. The theoretical literature suggests that a bonus cap could curb incentives for excessive risk-taking if it caps the total reward from risk-taking, and banks do not adjust other pay parameters in response. However, this is not how the actual bonus cap rule is implemented, as the cap applies to variable pay only.
The theoretical literature also suggests that a bonus cap could be ineffective in mitigating risk-taking given that banks can adjust various pay parameters, and that it can have an unintended effect of driving up fixed pay, thereby increasing banks’ fixed cost and their probability of failure. The evidence based on UK data suggests that banks are prone to increasing fixed pay when the variable pay of an MRT is close to the bonus cap, consistent with the predictions from the theoretical literature. Finally, there is no clear empirical evidence that the bonus cap rule has curbed excessive risk-taking, though data limitations mean that such effects are difficult to identify.
Qun Harris works in the Bank’s Strategy and Policy Approach Division, Ieva Sakalauskaite works in the Bank’s Prudential Framework Division and Misa Tanaka works in the Bank’s Research Hub.
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