Does the bonus cap work?

Qun Harris, Ieva Sakalauskaite and Misa Tanaka

After the 2007–08 International Monetary Disaster (GFC), a number of jurisdictions launched remuneration laws for banks with the goal 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 submit examines whether or not the bonus cap mitigates extreme risk-taking and short-termism, each in idea and in observe. It additionally discusses unintended penalties highlighted by the literature.

Does the bonus cap work – in idea?

So what’s the financial case for regulating bankers’ pay? On the whole, regulation is justified if two situations are met: first, a market failure is recognized, and second, the regulation improves in the marketplace consequence. Within the absence of any market failure, there is no such thing as a case for regulating pay, as companies would provide a compensation bundle that incentivises their workers to take applicable ranges of danger. 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 stage of govt remuneration and the very giant ranges of compensation for essentially the most senior workers might replicate the environment friendly consequence 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 based mostly 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. In an effort 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 goal of the post-GFC remuneration guidelines was to rectify this asymmetry in bankers’ reward construction. A number of the UK remuneration guidelines goal 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 may be withdrawn if antagonistic 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 mounted pay, or 200% with shareholders’ approval. Crucially, the prevailing bonus cap rule limits the ratio of variable-to-fixed pay, but it surely doesn’t restrict the full pay or complete bonus. Thus, the prevailing bonus cap rule may be justified provided that capping the ratio of variable-to-fixed pay can enhance in the marketplace consequence.

The theoretical literature on the effectiveness of the bonus cap in stopping extreme risk-taking is blended. 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, to be able 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 complete reward from risk-taking. It additionally doesn’t contemplate the chance that banks might alter the pay construction in response to the regulation.

Thanassoulis and Tanaka (2018) additionally contemplate the affect of regulating bankers’ pay when banks’ incentives are distorted by TBTF, however they explicitly analyse the chance that banks alter 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 mounted salaries, and thereby enhance banks’ mounted prices and their chance of failure. It is because in a aggressive marketplace for bankers, complete pay shall be decided by the banker’s capacity and the financial institution’s dimension.

Does the bonus cap work – in observe?

There’s solely a handful of empirical research on the affect of the bonus cap rule. Colonnello et al (2018) look at 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 decreased incentive to carry out. The paper additionally seems at how the bonus cap affected financial institution executives’ turnover, as restrictions on their bonus might make them 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’ capacity to retain their greatest executives, and that CEO turnover elevated solely in under-performing banks, probably attributable to 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, mounted pay elevated after 2014 in order to maintain their complete 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 observe 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 mounted pay grows sooner whereas their bonus grows extra slowly relative to different MRTs within the subsequent 12 months. Their complete remuneration development doesn’t differ considerably from that of their colleagues whose bonus isn’t constrained by the bonus cap. These findings are per banks growing mounted pay to keep up a desired stage of complete 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’s at the moment no empirical paper which has clearly recognized how the bonus cap impacts risk-taking of particular person MRTs, attributable to information limitations. On this context, Harris et al (2020) performed a lab experiment during which members have been requested to undertake funding selections on behalf of a hypothetical financial institution, to be able to look at how constraints akin to bonus laws, corresponding to a bonus cap and malus, have an effect on people’ danger alternative. The bonus cap on this experiment capped the full pay, the full bonus, in addition to the bonus-to-fixed pay ratio. When bonus relied on their very own funding efficiency solely, members who have been topic to bonus cap and malus took much less dangers than those that have 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 members took better dangers and the risk-mitigating results of bonus cap and malus have been considerably weaker.

Conclusions

There’s restricted help from the prevailing 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 might curb incentives for extreme risk-taking if it caps the full reward from risk-taking, and banks don’t alter different pay parameters in response. Nonetheless, 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 may very well be ineffective in mitigating risk-taking on condition that banks can alter numerous pay parameters, and that it may well have an unintended impact of driving up mounted pay, thereby growing banks’ mounted price and their chance of failure. The proof based mostly on UK information means that banks are vulnerable to growing mounted pay when the variable pay of an MRT is near the bonus cap, per 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 troublesome to establish.

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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