Since the financial crisis of 2007-2009, economists and policy makers around the world have gone to great lengths to quantify the degree to which bank failure creates negative externalities that can impact economic growth and lead to huge social costs. Many national regulators have also tried to formulate strategies to limit risk-taking by banks – including regulating executives’ incentive pay.
The 2007-2009 crisis is often attributed in part to incentive pay at financial services firms that allegedly encouraged excessive risk-taking. Indeed, even if the risk-taking at the financial institution was optimal and was aligned with the incentives of its shareholders, the social costs of bank failure – costs borne by taxpayers and depositors – were not fully internalised by the firm taking the risk. Therefore, regulating incentive pay, alongside prudential oversight, has the potential to make the financial sector and the economy safer in the future. While prudential regulation focused on banks’ capital adequacy, it did not directly oversee individual decision makers’ potential to influence the risk of the financial system. Regulating individuals’ incentive pay could help address this.
Although other countries were also proposing to regulate compensation around the same time, the UK was the first country to implement remuneration regulation following recommendations of two reviews.
One, headed by Lord Adair Turner, then chair of the Financial Services Authority (FSA), the financial regulator at the time, investigated the causes of the financial crisis. The other, led by Sir David Walker, former chairman of Barclays and Morgan Stanley International, reviewed banks’ corporate governance. Despite working separately on different topics, both reviews concluded that compensation practices needed to be changed. The FSA proposed a Remuneration Code in February 2009, which became effective on 1 January 2010, requiring that remuneration policies be consistent with effective risk management.
The Remuneration Code requires banks’ remuneration committees and risk functions to work together and regularly report to the financial sector regulator on the structure and level of executive remuneration. The Code applies to executives and other employees in the position of potential material risk influence, requiring deferral of at least half of their bonuses and tying this bonus payout to future performance. The Code was initially applicable to the largest banks; later its scope was extended to include all financial institutions.
The Code was aimed at addressing the concerns with existing remuneration policies; in particular the negative externalities created by decisions made by the bank employees (ie, the costs borne by shareholders and the wider society rather than by the institutions or decision makers responsible). These externalities can take years to come to light, by which time there may be no recourse and the taxpayer is left to deal with the consequences of financial instability and increased systemic risk – and ends up footing the bill for bank rescues.
Before the Code was implemented, the FSA found that none of the banks had arrangements in place to defer substantial bonus payments and their vesting was not conditional on achieving future performance targets. The Code changed that with two new mandatory conditions to be applied to bonuses. The first was that at least 50% of bonuses had to be deferred for a minimum of three years. The second was that there had to be performance targets attached to the vesting of the deferred bonus, thereby increasing the horizon of the incentives. Bank employees would potentially have money earmarked for them being taken away, should they fail to meet performance targets in future years. No more would risk-taking be a case of ‘heads I win/tails you (the bank, the shareholders and the public) lose’.
The Code applies to managers and employees in roles that affect the risk exposure of the business whose compensation exceeds £500,000 and who receive more than 33% of their total remuneration in variable pay. The scope of the Code is thus a much broader range of personnel than simply top-tier executives.
“In comparison with other UK firms, UK banks exhibit incrementally lower risk-taking and lower contribution and sensitivity to systemic risk”
We focus on the largest banks in the UK and compare them to other large UK firms, EU banks and US banks during 2006-2012. Our findings indicate that the Remuneration Code seems to have succeeded: in comparison with other UK firms, UK banks exhibit incrementally lower risk-taking and lower contribution and sensitivity to systemic risk.
We also examined the outcomes for UK banks relative to those in the US and the EU, neither of which have been subject to the Code.
Taking the US first, after the introduction of the Remuneration Code, both UK and US banks contribute more to their respective systemic risks. However, the increase in UK banks’ contribution to UK systemic risk is significantly lower. We also observe an increase in the sensitivity to systemic risk for US banks after 2010, but we do not observe the same for UK banks.
When we compare UK banks to EU banks prior to the introduction of the Remuneration Code, we observe that UK banks contribute more but are less sensitive to UK systemic risk than EU banks’ contribution and sensitivity to EU systemic risk. This does not change significantly after the introduction of the Remuneration Code.
No regulation is cost-free. In terms of unintended consequences, we examined the possibility that constraints on remuneration have led to a higher turnover in banking chief executives. The potential loss of talent was a major concern during the consultation stage for the Remuneration Code; not least because of the international nature of banking and the ability of senior industry figures to seek employment abroad, either by transferring within multinational banking groups to jurisdictions unaffected by the Code, or by finding new employment at an unaffiliated company.
If the Remuneration Code constrained the ability of firms to achieve the optimal level or structure of pay, we would expect to see a higher likelihood of unforced turnover in the post-2010 period; our data suggests that unforced turnover increased. For this analysis, we focused on voluntary departures of UK bank CEOs and found that, unlike CEOs in the US and EU, UK bank CEOs are more likely to retire, start their own businesses, or secure jobs in the then unregulated part of the financial services sector after the introduction of the Code.
To sum up, the UK’s Remuneration Code has shown some success in curbing risk-taking and reducing UK banks’ incremental contribution and sensitivity to systemic risk, but not without some costs.
Anya Kleymenova is Senior Economist, US Federal Reserve Board and an alumna of London Business School’s PhD and Masters in Finance programmes. Irem Tuna is Professor of Accounting at London Business School. Read the full paper here.
The views expressed in this study are those of the authors and do not necessarily reflect the views of the Federal Reserve Board or Federal Reserve System.
Anya Kleymenova is Senior Economist at the Board of Governors of the US Federal Reserve System. She holds a PhD in Accounting, an MSc in Accounting and Finance and an MSc in Finance from London Business School.
Irem Tuna is Professor of Accounting and Deputy Dean (Faculty) at London Business School.