Abstract
In this paper we argue that the program of compensation reform at financial institutions – despite recent wide-ranging changes – remains incomplete. The issue of compensation of senior bankers at financial institutions has gained huge attention since the Global Financial Crisis of 2007-2010. A considerable body of theoretical and empirical research has been developed which, for the most part, suggests that compensation incentives embedded in compensation contracts at banks encouraged risk-taking behaviour. On the basis of these findings extensive reforms to compensation rules at financial institutions have been implemented, including inter alia increased use of deferral, mandatory capping of bonuses and the introduction of clawback powers. However, this paper contends that these reforms do not go far enough. In the first instance, we argue that current reforms do not take into account the vagaries of the financial cycle in influencing executive pay at banks, which may continue to expose banks to long-term risks. Secondly, and more specifically in the context of this paper, in light of the causes of the failure of the Icelandic banks in 2008, deeper reform to compensation incentives is necessary if future excessive risk-taking is to be avoided. The Icelandic experience revealed entrenched and systematic examples of earnings and accounting manipulation and bank capital and liquidity management, much of which was driven by managerial compensation incentives. These findings were based on the empirical work of the Special Investigation Commission, appointed by the Icelandic parliament. In response, Icelandic regulators have implemented strict rules on bankers’ pay. This paper argues that some elements of the Icelandic reform program ought to be transposed to the EU and US jurisdictions, and to this end, we make some tentative recommendations for future regulation of banker compensation. Arguably, these recommendations will help improve the resilience of the banking system and contribute to greater financial stability.
Highlights
In spite of the extensive structural and regulatory reforms on financial oversight in Europe, this article argues that the program of reform to executive compensation at banks in the EU remains incomplete
One of the key themes to emerge from the Global Financial Crisis (GFC) was that excessive risk-taking by bankers and traders at financial institutions had been encouraged by incentives embedded in their compensation packages
The basic principles are as follows: (i) Limits to compensation as a proportion of capital - total variable remuneration should not limit the capacity of the financial institution concerned to strengthen its capital base; (ii) Cap on variable compensation - There is a default position that variable compensation must be capped to the same level as fixed compensation (1:1), with shareholder approval, a ratio of 1:2 will be permitted; (iii) Bonus structure - Up to 25 per cent of the bonus may be paid in long term instruments valued on a discounted basis
Summary
In spite of the extensive structural and regulatory reforms on financial oversight in Europe, this article argues that the program of reform to executive compensation at banks in the EU remains incomplete. On the basis of studies purporting to demonstrate a link between excessive risk and private incentives – and perhaps with a nod to political sensibilities concerning the role of banks in causing the post-2008 global recession – there has been large-scale reform to the structure and composition of bankers’ compensation incentives, with the general aim of reducing the capacity for bankers to profit individually from excessive risk-taking These reforms are at various stages of implementation in developed Western financial centers, with some jurisdictions implementing much deeper reforms than others. It is impossible to accord proportionate weighting to the many drivers of the crisis, which included macroeconomic imbalances, a well-documented savings glut, inappropriate monetary policies, a lack of financial oversight or cross-border surveillance, and misplaced faith in modern risk-management techniques, as well as poor micro- and macro– incentives Whilst recognizing this plurality, we concentrate our analysis solely on incentive pay structures as a contributing factor to the banking collapses, and leave it to other scholars to account for alternative causes.
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