Does the bonus cap work?

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 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 put up examines whether or not the bonus cap mitigates extreme risk-taking and short-termism, each in idea and in apply. 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? Typically, regulation is justified if two circumstances are met: first, a market failure is recognized, and second, the regulation improves available on the market consequence. Within the absence of any market failure, there isn’t a case for regulating pay, as corporations would supply a compensation package deal that incentivises their workers to take acceptable ranges of danger. A excessive bonus itself will not be 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 massive ranges of compensation for essentially the most senior workers might mirror the environment friendly consequence of a aggressive marketplace for expertise towards the backdrop of progress, 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. With a view 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. Among 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 could be withdrawn if adversarial 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 fastened pay, or 200% with shareholders’ approval. Crucially, the prevailing bonus cap rule limits the ratio of variable-to-fixed pay, however it doesn’t restrict the full pay or complete bonus. Thus, the prevailing bonus cap rule could be justified provided that capping the ratio of variable-to-fixed pay can enhance available on the market consequence.

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 powerful incentive to encourage extreme risk-taking by providing a big bonus, as a way 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 likelihood that banks could modify 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 likelihood that banks modify 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 forestall this.

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

Does the bonus cap work – in apply?

There may be solely a handful of empirical research on the affect of the bonus cap rule. Colonnello et al (2018) study 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 lowered 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 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’ skill to retain their greatest executives, and that CEO turnover elevated solely in under-performing banks, probably as a consequence 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 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 will not be 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 quicker whereas their bonus grows extra slowly relative to different MRTs within the subsequent 12 months. Their complete remuneration progress doesn’t differ considerably from that of their colleagues whose bonus will not be constrained by the bonus cap. These findings are in step with banks rising fastened pay to take care of a desired degree 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 may be at present no empirical paper which has clearly recognized how the bonus cap impacts risk-taking of particular person MRTs, as a consequence of information limitations. On this context, Harris et al (2020) carried out a lab experiment by which members have been requested to undertake funding selections on behalf of a hypothetical financial institution, as a way to study how constraints akin to bonus laws, reminiscent of 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 trusted 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 larger dangers and the risk-mitigating results of bonus cap and malus have been considerably weaker.

Conclusions

There may be restricted help from the prevailing literature that the bonus cap rule, as it’s at present 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 modify 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 may very well be ineffective in mitigating risk-taking provided that banks can modify numerous pay parameters, and that it may possibly have an unintended impact of driving up fastened pay, thereby rising banks’ fastened value and their likelihood of failure. The proof based mostly 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 isn’t a clear empirical proof that the bonus cap rule has curbed extreme risk-taking, although information limitations imply that such results are troublesome to determine.

Qun Harris works within the Financial institution’s Technique and Coverage Method 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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