Pay regulations could make banks too risk averse

• Study finds clawback could make banks too risk averse
• Researchers suggest changes to protect UK banks
• Clawback should penalise bad decisions not banks making losses
• Bonus caps do not curb excessive risk taking

Bankers’ pay clawback should be conditioned on how they manage risk and not on the outcomes of their decisions, so that banks don’t become too risk averse.

That is the finding of a new study looking at the problem of regulation designed to prevent banks from taking excessive risks and causing another financial crisis, while giving them enough leeway to take the risk necessary to ensure that funds are allocated efficiently in the economy.

Since the crash, which saw Lloyds and RBS bailed out by the UK Government, a number of regulations have been put in place to curb bankers’ bonuses, with the European Union imposing a bonus cap and the UK regulating that 40 per cent of any bonus must be deferred for material risk takers, and can be clawed back for a period of seven to 10 years. This, it is hoped, would put a curb on excessive risk-taking.

But in a Bank of England Staff Working Paper, entitled Bankers’ pay and excessive risk, John Thanassoulis, of Warwick Business School, and Misa Tanaka, of the Bank of England, produce a series of models to show that the UK’s pioneering clawback scheme must be implemented carefully, to ensure that bankers are incentivised to make efficient investment decisions.

Professor Thanassoulis said: “Clawback can induce appropriate risk taking incentives if bankers are made to believe that it will be applied proportionately according to the degree of failure in risk management. 

“But it could work imperfectly on bankers’ incentives if they believe it could be triggered when their bank suffers large losses, even if they have conducted appropriate risk management and so making them excessively risk averse. It is therefore important that it is implemented judiciously.”

The researchers used mathematical models to look at a series of measures from bonus caps to clawbacks and malus, which adjusts variable pay when certain circumstances materialise at a future date.

They found that deferral of equity-linked bonus alone cannot correct excessive risk taking as managers’ interests remain aligned to those of shareholders. Shareholders, in their turn, benefit if they can extract value from any too-big-to-fail government guarantee.

They also found that bonus caps do not curb excessive risk taking as the caps shut down the incentive mechanism at key decision points which leave a manager free to implement decisions in shareholders’ interests that are not necessarily aligned with society’s.

Linking pay to equity would also have to factor in the value of any implicit guarantee that boosts the bank’s share price, something that the researchers found hard to reliably measure.

But they found clawback can help induce the right incentives as long as it is applied based on clear evidence of early risk assessment. 

The concern, however, is that it could end up stifling risk-taking too much if bankers fear that clawbacks could be applied according to risk outcome, in the absence of a clear mechanism to determine the materiality in failure of risk management several years later.

Thus, to be fully effective, clawback must only be implemented with clear evidence of deficient prior risk management.

Professor Thanassoulis added: “Banks can still have bad outcomes and make losses despite good risk management. At the moment bank managers have the sense that if the bank makes a loss they will be penalised no matter how good their risk management is.

“Clawback needs to be more nuanced so that it only penalises those bankers who have made bad decisions, otherwise, banks will become risk averse. We need a formalised process where decisions can be recorded and the route to that decision tracked at each stage – then we can have a more nuanced and balanced clawback system.”

John Thanassoulis teaches Corporate Finance on the Executive MBA and on the Executive MBA based at WBS London at The Shard. He also teaches Finance and Business Economics for Senior Executives and the Regulation of Internatinal Finance.