Saturday, December 9, 2023

Does the bonus cap work? – Financial institution Underground

Qun Harris, Ieva Sakalauskaite and Misa Tanaka

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

Does the bonus cap work – in concept?

So what’s the financial case for regulating bankers’ pay? Usually, regulation is justified if two situations are met: first, a market failure is recognized, and second, the regulation improves in the marketplace final result. Within the absence of any market failure, there is no such thing as a case for regulating pay, as companies would supply a compensation package deal that incentivises their staff to take acceptable ranges of danger. A excessive bonus itself is just not 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 government remuneration and the very massive ranges of compensation for essentially the most senior staff might mirror the environment friendly final result of a aggressive marketplace for expertise in opposition to 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 massive to fail’ (TBTF), or when the deposit insurance coverage premium is mispriced. To be able to maximise the implicit subsidy for risk-taking arising from these, banks would incentivise extreme risk-taking by rewarding their staff with a excessive bonus when their dangerous guess succeeds, with out penalising them when it fails.

The purpose of the post-GFC remuneration guidelines was to rectify this asymmetry in bankers’ reward construction. A number of the UK remuneration guidelines purpose 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 cost 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 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 whole 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 final result.

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, with a purpose to exploit the implicit taxpayer subsidy arising from TBTF. Their evaluation, nevertheless, assumes that bankers are rewarded in bonus solely and so a bonus cap additionally places a restrict on whole 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 influence 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 chance of failure. It’s because in a aggressive marketplace for bankers, whole pay will likely 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 influence of the bonus cap rule. Colonnello et al (2018) study the influence 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 diminished 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 cause them to 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 finest executives, and that CEO turnover elevated solely in under-performing banks, probably resulting from 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, fastened pay elevated after 2014 in order to maintain their whole compensation unaffected. These findings have been confirmed by Sakalauskaite and Harris (2022). Utilizing knowledge 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 is just not 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. Nevertheless, 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 yr. Their whole remuneration progress doesn’t differ considerably from that of their colleagues whose bonus is just not constrained by the bonus cap. These findings are per banks growing fastened pay to take care of a desired stage of whole 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 nevertheless low, at round 4% of MRTs receiving bonuses in a given yr.

There’s presently no empirical paper which has clearly recognized how the bonus cap impacts risk-taking of particular person MRTs, resulting from knowledge limitations. On this context, Harris et al (2020) carried out a lab experiment by which members had been requested to undertake funding choices on behalf of a hypothetical financial institution, with a purpose to study how constraints akin to bonus rules, similar to a bonus cap and malus, have an effect on people’ danger selection. 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 had been topic to bonus cap and malus took much less dangers than those that had 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 higher dangers and the risk-mitigating results of bonus cap and malus had been considerably weaker.


There’s restricted help from the prevailing literature that the bonus cap rule, as it’s presently 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 whole reward from risk-taking, and banks don’t modify different pay parameters in response. Nevertheless, 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 could possibly be ineffective in mitigating risk-taking on condition that banks can modify numerous pay parameters, and that it may have an unintended impact of driving up fastened pay, thereby growing banks’ fastened price and their chance of failure. The proof based mostly on UK knowledge means that banks are susceptible to growing fastened 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 knowledge limitations imply that such results are tough to establish.

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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Feedback will solely seem as soon as accredited by a moderator, and are solely revealed the place a full identify is equipped. Financial institution Underground is a weblog for Financial institution of England employees to share views that problem – or help – prevailing coverage orthodoxies. The views expressed listed below are these of the authors, and should not essentially these of the Financial institution of England, or its coverage committees.

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