Regulating Banking Bonuses in the European Union: a Case Study in Unintended Consequences

• Author: Kevin J. Murphy
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12024.x
• Published date: 01 September 2013
• Date: 01 September 2013

Regulating Banking Bonuses in the

European Union: a Case Study in

Unintended Consequences

Kevin J. Murphy

University of Southern California –Marshall School of Business, 3670 Trousdale Parkway, Bridge 308,

Los Angeles, CA, 90089‐0804, USA

E-mail: kjmurphy@usc.edu

Abstract

Beginning in 2014, the European Union (EU) will limit the amount of bankers’

bonuses to the amount of fixed remuneration; the cap could be increased to 2:1 with

the backing of a supermajority of shareholders. I demonstrate that the pending EU

regulations restrictions will: (1) increase rather than decrease incentives for

excessive risk taking; (2) result in significant increase in fixed remuneration; (3)

reduce incentives to create value; (4) reduce the competitiveness of the EU banking

sector; and (5) result in a general degradation in the quality of EU investment

bankers, thereby decreasing access to capital and increasing the cost of capital.

Keywords: executive compensation, CEO pay, banking bonuses, financial crisis,

regulation, European Union

JEL classification: G32, G34, G38, J33, M12, M52, N20

An earlier version of this paper was sponsored by the Global Financial Markets

Association (GFMA) and its affiliated organisations (AFME, ASIFMA, and SIFMA).

However, the views expressed herein are my own, and are based on my extensive

published work in the area (see, especially, Conyon et al. (2013), Murphy

(2009, 2010, 2011, 2012, 2013) and Murphy and Jensen (2011)). I grateful to Devin

Dunn for excellent research assistance and to my co‐authors Martin Conyon, Nuno

Fernandes, Miguel Ferreira, Michael C. Jensen, and Pedro Matos.

1. Introduction and Summary

In the aftermath of the 2008–2009 financial crisis, regulators on both sides of the Atlantic

have considered or implemented rules designed to curb perceived excesses in both the

level of banking bonuses and in the risk‐taking incentives provided by those bonuses. In

the USA, the evolving regulatory proposals have focused on mandated deferrals of

bonuses with explicit clawback provisions; the proposals have stopped short of explicitly

limiting the level of banking bonuses or total remuneration. In Europe, evolving

regulatory proposals have focused on limiting the ratio of variable remuneration to fixed

European Financial Management, Vol. 19, No. 4, 2013, 631–657

doi: 10.1111/j.1468-036X.2013.12024.x

© 2013 John Wiley & Sons Ltd

remuneration (e.g., base salaries). In particular, in February 2013, the European Union

(EU) reached a provisional deal to limit the amount of bankers’bonuses to the amount of

fixed remuneration (i.e., a one‐to‐one ratio); the cap could be increased to 2:1 with the

backing of a supermajority of shareholders. The provisional agreement –added as an

amendment to the fourth Capital Requirements Directive (CRD‐IV) –was formally

approved by the European Parliament in April 2013 and by the European Council of

Ministers in June 2013. The new rules will be effective as of January 2014; the first annual

bonuses restricted under the regulations are those paid in early 2015 for performance in

2014 performance.

The purpose of this paper is to provide an economic analysis of the consequences of

the pending European restrictions on banking bonuses. The articulated objectives of the

proposed cap are to reduce excessive risk taking and to reduce perceived excesses in the

level of banking remuneration. I show that the proposed cap is unlikely to achieve either

objective. In particular, my primary predictions are briefly summarised as follows:

The cap on pay ratios will increase the level of fixed remuneration, making banks much

more vulnerable to business cycles and downturns and thus significantly increasing the

risk of bank failure.

The cap on pay ratios will not decrease ‘excessive’risk taking. In fact, the existing

bonus system –characterised by below‐market salaries and high bonus opportunities –

provides strong incentives to avoid ‘bad’risks and to take ‘good’risks, while the

‘capped’bonus system provides incentives to take bad risks and avoid good risks.

The cap on pay ratios will reduce incentives to create value. By focusing only on

excessive risk taking, the regulators ignore the more important purpose of banking

bonuses: to link pay and performance and to provide incentives for employees to take

actions that increase value for shareholders and, ultimately, society. Without question,

capping variable remuneration at some multiple of fixed remuneration reduces the

sensitivity of pay and performance. Moreover, the ‘variable’portion of pay will

predictably become less variable, further reducing the sensitivity of pay and

performance.

While capping the pay ratio will lead to higher levels of fixed remuneration (continuing

the trend evident since the crisis), it will not lead to lower levels of overall remuneration

after adjusting for ability and the risk of the remuneration package. Ultimately, the

remuneration for top‐performing investment bankers is set in the highly competitive

global marketplace, and not by the European Parliament or other regulators. Top‐

performing investment bankers will predictably have employment opportunities in

non‐EU banks and other non‐bank financial intermediaries not subject to EU

restrictions on pay ratios. EU banks will have to offer competitive market remuneration,

or they will predictably lose their most‐talented and most‐valued employees. Indeed, to

the extent that total remuneration is reduced by the proposed regulations, it will reflect a

less‐talented workforce as the top producers leave for better‐paying opportunities in

financial firms not subject to the pay restrictions.

The cap on pay ratios will reduce the competitiveness of the EU banking sector relative

to non‐EU banks and other non‐bank financial intermediaries and financial‐service

providers not subject to the EU restrictions. The overall effect of the proposed

restrictions will be to reduce bank flexibility, profitability, and shareholder value, while

stifling innovation and creativity in EU capital markets. Among the predictable

casualties are the EU member states as issuers and guarantors of sovereign debt.

© 2013 John Wiley & Sons Ltd

632 Kevin J. Murphy