FINANCIAL SERVICES
Paying bank bonuses in shares will not curb excessive risk-taking
A report by the Centre for Economic Performance warns that altering the mix of bonus compensation for bankers by paying more in shares is “unlikely to be effective” in changing risk behaviour.
The research paper suggests that while linking the remuneration of chief executives directly to shareholder value may act as an incentive, simply changing the cash/equity split of an individual trader, who may only have a small effect on a firm’s share price, is unlikely to “alter any perverse risk incentives”.
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Clawback agreements in bonuses
Brian Bell, the author of the report, reckons that proposals to “claw back” bonuses if performance is sub-standard in the future makes more sense. “Unlike simply deferring bonuses, this in principle could improve incentives,” he says.
Bell adds: “For clawback contracts to be practical, they must be based on explicit formulae of readily observable and verifiable measures of performance since more arbitrary clawback would be liable to challenge in the courts. It remains unclear whether such contracts can be successfully written for traders based on individual risk-adjusted performance rather than simply the overall performance of the firm.”
Size of bonuses
According to the CEP report, the sheer scale of the income gains that the top earners, and particularly financial sector workers, experienced during the last decade is “almost unprecedented”. What’s more, the vast majority of those gains at the top of the income distribution have come from an “explosion” in bankers’ bonuses.
The reports says: “Over the decade from 1998, the top 10% of workers in the UK saw their share of total annual wages rise from 27% to 30%. The majority of this went to the top 1% and can be mainly accounted for by bonuses to financial sector workers. By 2008, the increased share that bankers were taking amounted to an extra £12 billion per year in wages alone.”
A final word
“To mitigate the excess risk-taking that bonuses can induce, bonuses in the sector need to be based on risk-adjusted performance and either to be based on long-run performance or to be subject to ‘clawback’ if future performance declines.” - “Bankers’ bonuses”, by Brian Bell, Centre for Economic Performance.
Want to know more?
Title: “Bankers’ bonuses”, by Brian Bell, Centre for Economic Performance, CEPEA010, April 2010.
Availability: You can download the seven-page PDF report on the CEP web site at http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEPEA.
--> See also 34-page report, Bankers’ pay and extreme wage inequality in the UK, by Brian Bell and John Van Reenen, Centre for Economic Performance, Special Paper 21, April 2010.
The Centre for Economic Performance (CEP) is an interdisciplinary research centre at the London School of Economics Research Laboratory. It was established by the Economic and Social Research Council (ESRC) in 1990 and is now one of the leading economic research groups in Europe. More details are available at http://cep.lse.ac.uk/.