Capping bankers’ bonuses

What is at stake: The question of remuneration in the financial services’ industry has become central and featured to a large extent on the agenda of finance ministers from the G20 group of leading industrialised and emerging economies as they met in London last Friday and Saturday, setting the stage for a full-blown G20 summit in Pittsburgh on September 24-25. European Union finance ministers agreed ahead of the meeting to jointly press for clearly defined restrictions on bonus pay for bankers but splits emerged over how to do it. Several options are still discussed: Mandatory deferrals of bonuses, holding periods for stock options and clawbacks in the case of negative outcomes to link pay to risk and long-term performance; limits on banker pay through taxation; and legal caps or rules linking total bonuses to a bank’s profits.

Howard Davies says that the options explored by politicians and regulators are unlikely to solve the problem if shareholders do not take more of an interest in pay policy. Davies argues that in fragile speculative industries it is hard for investors to monitor those who manage their money. Because of that, managers can demand higher and higher returns in the upturn. But eventually these high returns reduce the payouts to investors and slow the growth of the sector. Managers then take more risks in search of higher returns to justify their pay, which at some point will lead to risk mispricing, and a crisis. If this explanation of pay policy in the financial industry is broadly correct (and therefore that excessive pay is not mostly due to deregulation as argued by Thomas Philippon and Ariell Reshefis), then it is unclear whether the options explored by policymakers and regulators could do anything to solve the problem.

Lucian Bebchuk says that improvements in governance would not obviate the need for regulating pay structures. Regulation of pay in financial institutions is justified by the very same moral hazard concerns that provide the basis for existing regulation of the sector. Because the failure of such companies imposes costs on taxpayers that shareholders do not internalise, shareholders’ interests are served by more risk-taking than is socially desirable. Shareholders’ interest in more risk-taking implies that they could benefit from providing executives with excessive incentives in this direction. Because of this, regulating compensation structures should become a critical instrument in financial regulators’ toolkits as it would help prevent in the future the excessive risk-taking that contributed to the current crisis.

Lucian Bebchuk says that even though tying bonus plans to long-term results is desirable, it isn't sufficient to avoid excessive incentives to take risks. Bonus plans based on short-term results can produce excessive risk-taking and, as such, these plans should be structured to account for the time horizon of risks. But bonus plans tied to long-term results can still produce perverse incentives if they reward executives for the upside produced by their choices but insulate them from a significant part of the downside. In his testimony before the Committee on Financial Services of US House of Representatives Bebchuk discusses several options to deal with that problem.

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