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.
Post-crisis, a number of jurisdictions have introduced remuneration regulations in order to reduce bankers’ incentives to take excessive risks. The UK is pioneering the use of bonus clawbacks under which bankers are asked to pay back their bonuses if certain circumstances materialise at a future date. In our latest paper, we show that clawback can encourage better incentives as long as bankers believe that they will be held liable for failures of risk management, and not simply for poor outcomes. Having a transparent mechanism in place to apply clawbacks is therefore critical. If bankers fear that clawback will be wielded too generally upon bad business outcomes, then it could end up making them excessively risk averse.