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Incentive Pay and Bank Risk Taking:Evidence from Austrian, German and Swiss Banks

Matthias EfingUniversity of Geneva and SFI

Patrick KampkötterUniversity of Cologne

Harald HauUniversity of Geneva and SFI

Johannes SteinbrecherIfo Institute Dresden

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“When times are good in financial markets, bankers get colossal bonuses. When things go badly? Bankers still live well off the fat. Many can cash in and check out, leaving taxpayers to pay for the mess … an incentive system that rewarded greed and excessive risk.” (http://www.bloomberg.com/quicktake/banker-bonuses/)

Do large cash bonuses create

incentives for excessive risk-taking?

Research Question

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Regulatory pressure: EU legislative proposals on limiting bonuses at 100% of fixed salary Bank of England focuses on deferred compensation, claw backs Say on Pay rule (Dodd-Frank Act)

Focus on trading activity: Largest bonuses Regulatory focus on trading: Liikanen Report to European Commission Financial markets offer a menu of risk-return profiles:

Derivatives, European sovereign debt, sub-prime, … Rogue traders (Jérôme Kerviel expected a bonus of € 300t for 2007).

Research Question

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Detailed payroll data

Trading profits and incentive pay Positive relationship between pay incentives, trading profits and volatility IV approach to explore causality

Optimality of pay incentives Examine marginal effect of incentives on Sharpe ratio of trading profits Bonus moderation during the crisis seems to have reduced excessive

incentive pay

Highlights

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Payroll data on bank employees from a pay consultant 1,27 million employee-year obs. 123 Austrian, German and Swiss banks over period 2004-2011 Investm. Banking (12,343 obs.) and Treasury/Capital Mkts (34,977 obs.) Base Salary, (Cash) Bonus, Age, Tenure, Hierarchy Level, Bank Segment

Define: Bonus Share = Bonus / Total Salary Correlation ( Equally Weighted BS in Trading ; BS of CEO ) = 0.37

Bank risk taking: Trading income for 67 banks and 401 bank-years

Define: Relative Trading Inc. = Trading Inc. / Gross Interest Inc.

Data

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Employee-Level Pay Incentives

Bonus can reach up to 10 times Base Salary

Bonus Share (almost) linear in log Base Salary

Bonus Share dropped ~40% in 2008-11 relative to 2004-7

(Bonus ↓ & Base Salary ↑)

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Bank-Level Pay Incentives

Aggregated at bank level by period:

Large variation across banks (different “incentive cultures”)

Drop of Bonus Share during crisis period

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Trading Income

Unlike the bonus share, trading income did not systematically decrease in the crisis period.

Is drop in Bonus Share largely induced by public pressure?

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Correlation (Trading Income, Bonus Share) > 0

Pay incentives incentivize higher effort levels Pay incentives incentivize higher risk-taking (convexity of remuneration),

which is rewarded by higher expected profitability

Hypothesis 1

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Hypothesis 1 - Results

Bonus Share correlates significantly with Trading Income: 1 SD in BS (=0.146) → Increase in Log Relative Trading Income by 75% of a SD

Decreasing returns to scale Results similar for Hierarchy Weighted Bonus Share

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Correlation (Std. Dev. of Trading Income, Bonus Share) > 0

Pay incentives incentivize higher risk-taking (convexity of remuneration)

Hypothesis 2

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Hypothesis 2 - Results

Bonus Share correlates significantly with Volatility of Trading Income: 1 SD in BS (=0.146) → Increase in Log SD of Rel. Trading Inc. by one SD

Results are similar for Hierarchy Weighted Bonus Share

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Reverse Causality

Instruments:

“Bonus culture”:

Bonus Share in retail / corporate / private banking

Monitoring deficiency for “invisible” trading divisions:

Employment in non-capital markets segments

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Hypothesis 1 - IV

IV coefficients are large and significant

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Hypothesis 1 - IV

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Hypothesis 2 - IV

IV coefficients are large and significant

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Hypothesis 2 - IV

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Maximization of Bank Value

Value Maximization = Maximization of Sharpe Ratio of Trading for self-financing trading strategies

FOC: E

For a concave unimodal function:If marginal effect of Bonus Share on Sharpe Ratio is negative, pay incentives incentivize excessive risk taking from a the perspective of asset value max.

Hypothesis 3

0|)(

)(

X

BonusShared

oSharpeRatid

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Hypothesis 3

Pre-crisis: Instrumented Bonus Share correlates negatively with Sharpe Ratio.

Crisis: Instrumented Bonus Share correlates positively with Sharpe Ratio.

Bonus moderation during the crisis removes excessive incentive pay.(but low statistical significance in (1) to (3), weak instrument in (4) and (5))

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Hypothesis 3 - IV

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Conclusion

Substantial decrease in Bonus Share in 2008-11 in trading, but no corresponding decrease in Relative Trading Income

Relative Trading Income and its volatility strongly correlated with Bonus Share (equally- & hierarchy-weighted)

IV Regressions using the “bonus culture” proxied by the Bonus share in Other Segments and “governance quality” proxied by the Employment Share in Other Segments suggest that incentive pay increases both trading income and its volatility

The marginal effect of incentive pay on the Sharpe Ratio of Trading Income appears to have been negative in the pre-crisis period, but slightly positive during the crisis. Bonus moderation seems to have reduced excessive incentive pay.

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Appendix

CEO and executive board compensation has low correlation with overall bank incentive structure (in Austria, Germany and Switzerland)

Research focus on board compensation may mismeasure actual organizational incentive structures

Correlation between EW Bonus Share and HW Bonus Share is high at approximately 0.98.

CorrelationCEO

Bonus Share Executive Board Av. Bonus Share

Equally WeightedBonus Share

0.37 0.47

Hierarchy Weighted Bonus Share

0.43 0.50

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Appendix

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Appendix