Does Limiting Bankers’ Pay Work?
- July 09, 2016
- CBR - Accounting
When it comes to assigning blame for the 2007–10 financial crisis and ensuing global downturn, plenty of people have pointed to bankers—and to pay packages that encouraged them to take big risks. Regulators in Europe have tried to reign in this risk-taking by changing how bankers are paid, which has led to safer, healthier banking—but not without some cost, suggests research by Chicago Booth’s Anya Kleymenova and London Business School’s A. İrem Tuna.
Bankers’ incentives caused them to behave badly, many have argued. For example, when a bank employee’s bonus is tied to the one-year performance of his company or team, the banker has an incentive to take short-term risks to maximize his bonus.
The United Kingdom, United States, and European Union have all attempted to counter this, to varying degrees. The variation in the details and degree of compensation control allowed Kleymenova and Tuna to compare the effects of the rule changes. They collected compensation, market, and accounting data on 2,470 executives from 532 companies in the UK for the period covering 2006–12. They supplemented their analysis with data for CEOs working for other EU and US banks of comparable size.
The UK became the first to act when its Financial Services Authority in 2010 introduced its original Remuneration Code, which focused primarily on bonus compensation. To fight short-termism, the Remuneration Code deferred at least half of bonuses for at least three years, and tied bonus funds to performance conditions.
The EU adopted bonus compensation caps in 2014, typically capping a bonus paid to a bank employee in the EU at the same amount as his salary. In the US, formal bonus regulation remains much more lax, and US regulators are still fighting for more control over pay packages.
Kleymenova and Tuna find that the compensation regulations imposed in the UK and EU did generally reduce risky investing by financial institutions—as measured by a company’s volatility and leverage.
“At least part of the cost of bank failures is borne by depositors and tax payers and not executives or shareholders; therefore, there is little incentive on the part of bank executives to take this cost fully into account,” the researchers write.
However, the changes had several unintended consequences—among them, higher CEO turnover at UK banks, compared to that at other UK companies and at US banks. Because finance requires a high degree of specialization, high turnover indicates a loss of talent, the researchers write. In addition, UK compensation contracts became more complex.
Shareholder reaction to pay limits was mixed. Share prices for UK financial institutions affected by the Remuneration Code rose when the stricter rules came in—affected stocks rose 5 percent in the three-day window around the announcement date. But when EU bonus-cap regulations were put in place, shares at affected companies fell 2 percent, “suggesting that equity market investors perceive at least some costs from regulating executive compensation.”
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