Reducing Risk-Taking by Regulating Bonuses: EU vs US Dodd-Frank

Yves here. Bankers whinge about how much tougher their lives are in the post-crisis world. That is no small degree to central banks’ efforts to prop them up having caught up with their bottom lines. ZIRP and QE eliminate cheap, low-risk sources of profit, like interest income on float and simply yield curve arbitrage (borrow short, lend long pays off less well in a time of a flattish yield curve). And QE also dampens volatility, another source of fun and profit for banks.

But even allowing for that, members of the financial services industry are still too highly paid. As Simon Johnson stressed in his landmark article, The Quiet Coup, in the early 1980s, members of the banking industry broadly defined were paid the pretty much same on average as people outside finance. The pay gap exploded to a yawning 81% premium by 2007. And remember, that’s an average. We’re not focusing on the tail end of power law pay curve, where CEOs of real economy companies are in the 1% while the partners in medium to large hedge funds and private equity funds are in the 0.1%.

So there’s a long way to go in correcting the pay disparity, particularly as more and more economic studies confirm that an outsized financial services industry is bad for growth, and one of the main mechanisms is that it drains resources (human and otherwise) from more productive Main Street activities.
Thus studies like this one are important in identifying ways to chip away at this problem.

By Esa Jokivuolle, Senior Adviser in the Research Unit, Bank of Finland, Jussi Keppo, Associate Professor, NUS Business School, and Xuchuan Yuan, Research Fellow at the Risk Management Institute, National University of Singapore. Originally published at VoxEU

Bankers’ compensation has been indicted as a contributing factor to the Global Crisis. The EU and the US have responded in different ways – the former legislated bonus caps, while the latter implemented bonus deferrals. This column examines the effectiveness of these measures, using US data from just before the Crisis. Caps are found to be more effective in reducing the risk-taking by bank CEOs.

In the aftermath of the Global Crisis that started in 2007, bankers’ compensation has become a major issue for banks’ corporate governance and regulation. The main question is whether large short-term bonuses spurred too much risk-taking that partly caused the Crisis.

For instance, Rajan (2005), who foresaw some of the key developments that eventually led to the Crisis, emphasised the role of short-term compensation. Post-crisis empirical research on the question is somewhat mixed. Fahlenbrach and Stulz (2011) do not find a link between cash bonuses and US banks’ stock price performance in the Crisis of 2007-8. However, DeYoung et al. (2013), for example, find that a US bank CEO’s contractual risk-taking incentives in a given year explain the bank’s risk-taking in the following year, measured from the bank’s daily stock returns. The effect was strongest and most persistent in the largest banks.1

In response to the compensation concerns, the EU has legislated a cap on bankers’ variable pay (henceforth simply ‘bonus’) of 100% relative to fixed salary, or at most 200%, subject to shareholder approval, along with rules regarding their payment deferrals.2 The US Dodd-Frank Act includes an option for bonus clawbacks which may be paralleled with bonus deferrals.3 Recently, the UK has announced plans to extend the potential bonus clawback period for 7-10 years.

Caps or Deferrals?

Which of the two types of bonus restrictions – caps or deferrals – is more effective in containing risk-taking in banks?

We have addressed this question by developing a theoretical model which has been calibrated to data on CEO pay of the 78 largest US banks during 2004-2006, reflecting the time just before the financial crisis started (Jokivuolle et al 2015).4

We first modelled the present value of a banker’s future cash bonuses and, based on that, her bonus-induced risk-taking incentives. Both depend on the size of the bonuses and the bonus payment frequency. In the model, the bonus size and the bonus frequency can be constrained by a regulatory bonus cap and deferral.

As expected, we verify that bonuses spur risk-taking since they are a series of call options on future profits. Like regular options, bonuses are more valuable, the higher the volatility of the underlying ‘asset’ is (i.e., the bank’s profits). We show that the risk-taking effect is stronger the less bonuses are deferred. A cap on bonuses clearly reduces the risk-taking incentive by limiting the upside potential of the bonus.

To calibrate the model, we took into account the cost of risk-taking, which can stem from various sources. One obvious source is that by taking too much risk the banker runs the risk of poor performance and hence losing her job. Other examples are costs that stem from corporate culture and regulation.

In the calibration we have made a simple assumption that the costs and benefits of risk-taking in any given sample bank have been in balance, optimised by the banker. Introducing bonus restrictions would change this balance by changing the risk-taking incentives but, by assumption, not the costs of risk-taking. Hence, the optimal amount of risk-taking from the banker’s point of view would have to change. We simulate this effect by considering both bonus deferrals and bonus caps.

Pre-Crisis Bonus Restrictions

More specifically, we ask the question: “How much would US bank CEOs have reduced their risk-taking, had bonus restrictions been implemented prior to the Global Crisis?”

We find that the effect of bonus deferral on the bankers’ risk-taking is immaterial unless bonuses are originally paid more frequently than once a year. That might be the case in hedge funds and private equity companies, but not in banks. In contrast, a cap on bonuses can substantially reduce risk-taking. For an average bank, the risk-reduction effect would translate into reducing the bank’s leverage from 25 to 20 if we assume that the original leverage were 25 and that the entire risk adjustment were done by reducing leverage. Incorporating other forms of variable compensation, such as stock and option grants, although important in size, would not change our results qualitatively.

Intuition suggests that bonus deferrals might be more effective if banks follow a ‘collecting nickels in front of a steamroller’ style of investment strategy; i.e. enjoying relatively steady spread returns which are, however, subject to a rare risk of a catastrophic loss. Investments in the securitised credits prior to the crisis were examples of this type of negative tail risks. We find that when re-doing our analysis by assuming that banks’ risk profiles have followed such ‘jump processes’, bonus deferrals indeed start to bite. Thus, according to our analysis, bonus deferrals reduce the large and rare risks, but not the regular volatility of profits. Nonetheless, bonus deferrals are clearly still not as effective in reducing risk-taking incentives as bonus caps are.

Concluding Remarks

The bank-specific effect of the bonus cap varies widely and we find some evidence that it is larger in bigger banks. It is important to note that our analysis is mute on how much risk-taking is desirable and what should be considered excessive. Our aim has been simply to assess the effectiveness of the various bonus restrictions in limiting risk-taking.

On balance, our results suggest that the EU’s bonus cap is effective in reining in risk-taking whereas bonus clawbacks included in the US Dodd-Frank Act, or as planned by UK regulators, is less effective.

See original post for references

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