Ieva Sakalauskaite and Qun Harris
Following the Global Financial Crisis of 2007–08, some regulators introduced rules on bankers’ bonuses with an aim to mitigate incentives to take excessive risks, and in turn promote financial stability. In a recent paper we use detailed data on remuneration of staff in six large UK banks to look at how two of those rules – the bonus cap and deferral – affected bankers’ pay. We find that the bonus cap did not reduce bankers’ total remuneration but rather shifted it from the variable to the fixed part of the package. And while requirements to defer bonus pay can be expected to affect bankers’ risk-taking incentives, we find some evidence that they increased their total compensation.
There is broad consensus that bankers’ remuneration packages contributed to the Global Financial Crisis because they created a reward structure which encouraged excessive risk-taking: giving bankers a large share in upside rewards, but smaller and more limited exposure to the downside. Following the crisis, regulators introduced remuneration requirements aiming to remedy this. First, they aimed to better align bankers’ incentives with longer-term bank performance through requirements such as deferral, payment in shares, malus or clawback. Furthermore, in some countries (EU and UK) regulators attempted to reduce excessive risk-taking by imposing a bonus cap.
Ten years since their implementation, evidence on the effects of remuneration rules on pay or behaviours in banks is still limited. Some evidence suggests that when they were introduced, some remuneration requirements were associated with a reduction in banks’ risk. But other researchers found that the bonus cap decreased affected banks’ performance at its introduction in 2014 – potentially by reducing bankers’ effort. Furthermore, for top executives most affected, pay shifted from bonuses to salaries.
In this paper we use detailed data on remuneration in UK banks to study two specific regulations. First, the bonus cap, introduced in the UK in 2014, which limits the ratio of bankers’ variable remuneration (comprising mostly of bonuses) to fixed pay (comprising of salaries, role-based allowances and benefits) to a maximum of 100%, or 200% with shareholders’ approval. At the time of its introduction, it was expected that the cap would limit the gains bankers could achieve through excessive risk-taking, in turn reducing such incentives. In our paper, we study whether and how the bonus cap affected bankers’ pay sizes and structures.
Second, we study deferral rules which require that key risk-takers in banks (material risk-takers (MRTs)) receive a proportion (40% or 60% depending on seniority) of their bonuses with a delay. The purpose of this regulation is to increase bankers’ accountability by allowing part of their bonuses to be received only once the longer-term effects of their decisions and banks’ performance have emerged. Deferral periods are set to be sufficiently long to reflect the timescale over which problems come home to roost in banking. Because of discounting effects, deferring bonuses for several years reduces their net present value. Therefore, economic theory predicts that if banks wished to defer a proportion of bankers’ pay, they would need to ‘compensate’ by paying them more. As deferred bonuses are subject to downside risks in the form of a malus and a proportion of them being paid in shares, the risk to bankers, and the need to compensate them, could be even higher. We test this theoretical prediction by looking at whether longer deferral requirements introduced by the Prudential Regulation Authority in 2016 were associated with increases in pay.
To explore the effects of remuneration rules, we use regulatory data on the sizes and structures of MRT remuneration in six major UK banks during 2014–19. MRTs are individuals whom banks identify as having scope to take decisions that can materially affect the risk profile and soundness of their banks due to seniority, ability to create large exposures, and other criteria. Our data covers information on the sizes of their variable and fixed remuneration, the proportion of bonuses deferred as well as deferral periods (in years). Based on data available, we focus on MRTs whose remuneration we can follow for at least three consecutive years; this gives us around 60% coverage across the banks observed.
What does the data tell us about the bonus cap?
To identify the effects of the bonus cap on MRTs’ pay, we look at how individuals’ bonuses, fixed pay, and total pay grow in the year after they reach a bonus-to-fixed pay ratio close to the bonus cap threshold (ie 200%) as compared to colleagues who are further away from it during 2014–19. In particular, we regress individual MRTs’ year-on-year remuneration component growth (in %) on a dummy variable equal to one if in the previous year, that MRT’s bonus to fixed pay ratio was between 175%–200% of fixed pay, ie close to the bonus cap limit.
As individuals with higher bonus ratios are arguably different from their colleagues and experience different year-on-year developments in pay sizes and structures, we account for MRTs’ previous period bonus amounts and the bonus ratio itself. This means that our analysis attempts to capture the additional effect of one’s remuneration being close to the regulatory limit. Furthermore, we factor in shocks that hit each of our sample banks every year.
We find that when an MRT’s bonus ratio got close to 200% (being in the 175%–200% bonus/fixed-pay range), the following year their fixed pay grew much faster than that of other MRTs. We find such effects both when we use data on all MRTs, or only the closer comparison group with ratios already exceeding 100%. We do not find statistically significant evidence that affected MRTs’ total remuneration decreased, consistent with bonuses being replaced by higher fixed pay. These effects are seen on a relatively narrow cohort of employees: on average, only around 4% of MRTs had their bonuses between 175%–200% of fixed pay throughout the sample period.
These effects are illustrated in Chart 1 which plots average remuneration growth figures for MRTs depending on their bonus/fixed pay ratios. It shows that although bankers with higher bonus ratios have overall tended to experience higher fixed-pay growth and lower bonus growth the year after, there is a discontinuity in this trend for individuals closest to the 200% limit.
Chart 1: Average year-on-year (%) growth in MRT remuneration components depending on their previous year bonus/fixed-pay ratios
Notes: This chart plots average year-on-year growth figures for material risk-takers’ fixed pay (salaries, role-based allowances, and other), bonuses (including both bonuses and other components of variable pay), and total pay according to their initial bonus to fixed-pay ratio bucket (from 0% to 200% variable to fixed-pay ratios, at 25% increments). Analysis is based on data in six major UK banks through 2014–19 for material risk-takers which we could track for at least three consecutive years.
What have we learned about deferral requirements?
To measure the effects that bonus deferral has on MRTs’ pay sizes, in particular whether they are compensated for delayed earning, we study the consequences of a change in UK remuneration requirements implemented in 2016. Until then, all largest UK bank MRTs faced the same requirement where at least 40% (or 60%) of bonuses needed to be deferred for at least ‘three to five years’, with banks generally setting it at the minimum of three years for most individuals. In 2016, regulators increased minimum bonus deferral periods to five or seven years for some senior MRTs, and kept the minimum unchanged for the rest. As a result, this policy change affected only some individuals in each sample bank, which allows us to comparing developments in affected and unaffected MRTs’ pay around the time of the rule change.
Specifically we implement difference-in-difference analysis, regressing MRTs’ pay sizes during 2014–17 on (i) a dummy variable equal to one for all MRTs in the years after the rule change (2016–17), and (ii) its interaction with a dummy variable equal to one for MRTs who were affected by the rule change. Whereas the first dummy variable measures how all MRTs’ pay changed in 2016/2017, the interaction term captures how this differed for MRTs affected by longer deferral requirements.
Our results show that the total remuneration of MRTs affected by the rule change indeed increased more than that of the unaffected MRTs around 2016. This is consistent with affected MRTs being compensated for the longer periods over which their bonuses were deferred. These findings are subject to several caveats which do not allow us to definitely conclude the changes were the sole result of the change in deferral regulation – for example, as MRTs affected by the rule change tended to be more senior than those unaffected. Nevertheless, they provide some support for the theoretical point that deferring bankers’ pay could lead to them being compensated via increases in total remuneration. We also find that around 2016, the proportion of affected MRTs’ bonuses deferred voluntarily beyond regulatory minima diminished more than that of unaffected MRTs, consistent with banks trying to reduce the impact of the rule by decreasing the share of bankers’ pay exposed to it.
We have sought to shed some light on how two specific post-crisis rules affected remuneration in UK banks.
We do not find evidence that the bonus cap significantly constrained MRTs’ total pay growth, but rather led to slower bonus and faster fixed pay growth. Our findings also give some support to theoretical predictions that deferring individuals’ pay might mean they need to be compensated for postponed consumption.
But this analysis does not establish whether these costs outweigh the benefits of those rules, which is beyond the scope of our work.
Ieva Sakalauskaite and Qun Harris work in the Bank’s Prudential Policy Division.
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