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  Issue 24 | Archive August 2015

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

A paper by Esa Jokivuolle (Bank of Finland), Jussi Keppo (National University of Singapore), and Xuchuan Yuan (National University of Singapore)

RMI¡¯s Affiliated Researcher A/P Jussi Keppo and Research Fellow Xuchuan Yuan, in collaboration with their co-author, wrote a paper titled ¡°Bonus Caps, Deferrals, and Bankers' Risk-Taking¡± that considers regulation of banker's bonuses. It is known that in the aftermath of the global financial crisis that started in 2007, bankers' compensation has become a major issue for banks' corporate governance and regulation. Therefore, 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, and rules regarding their payment deferrals. The US Dodd-Frank Act includes an option for bonus clawbacks which may be paralleled with bonus deferrals. Recently, the UK has announced plans on extending the potential bonus clawback period until seven to ten years.

Which of the two types of bonus restrictions, caps or deferrals, is more effective in containing risk-taking in banks? The authors 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 times just before the financial crisis started. As expected, they verify that bonuses spur risk-taking since they are a series of call options on future profits. Like regular options, the higher the volatility of the underlying ¡°asset¡± (i.e., the bank¡¯s profits) is, the more valuable the bonuses are. They show that the risk-taking effect is stronger the less bonuses are deferred. A cap on bonus clearly reduces the risk-taking incentive by limiting the upside potential of the bonus.

Then they ask the question, how much US bank CEOs would have reduced their risk-taking, had bonus restrictions been implemented prior to the global financial crisis. They 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 the risk-taking. For an average bank, the risk-reduction effect would translate into reducing the bank¡¯s leverage from 25 to 20 if they assume that the original leverage was 25 and that the entire risk adjustment was done by reducing leverage. Incorporating other forms of variable compensation, such as stock and option grants, although important in size, would not change their results qualitatively.

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

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

On balance, their results suggest that the European Union'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.

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Published quarterly by Risk Management Institute, NUS
Editor: Shivani Nakhare (rminsr@nus.edu.sg)