Do bankers’ bonuses reward risky behavior?

at 02:22 PM ET, 01/08/2012

In the run-up to the 2008 financial crisis, some of the most troubled financial firms also doled out whopping bonuses to their top executives. In response, the United States — along with the UK and the European Union—imposed new regulations on executive pay, with the rationale that executive pay was overly skewed to reward short-term profits and encouraged risky behavior that undermined a sound financial system.

VoxEU’s Ian Tonks took a closer look at whether this was actually the case and concluded that executive pay had little to do with short-term financial performance.
(SOURCE: AP)

In recent research (Gregg et al. 2011), my colleagues and I investigate whether bank executives had been incentivised to take undue risks. To do this, we examine the pay-performance relationship of executives in all UK companies, and in financial services companies in particular. This tiny performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector depended on short-term financial performance. In other words, executives were paid irrespective of performance.

Instead, Tonks, a finance professor at the University of Bath, found that size mattered more than short-term performance, as bankers and other finance executives were rewarded with bigger salaries when their firms became bigger:

We also report that firm size has a larger effect on executive pay than firm return. A 10% increase in firm size measured by total assets, increases CEO pay by 2%, and this translates into a £11,815 increase in CEO pay at the median level...the mechanism for such an impact is not through the relationship between executive pay and stock market performance, but instead through the incentive for executives to ensure that their firm’s assets are as large as possible.

Tonks ultimately concludes that the new regulations curbing executive pay are “jumping the gun.” But, in fact, there’s considerable debate over whether bigger banks pose a greater risk to the financial system. Some firms bent on unabated growth ended up making extremely risky bets that contributed to the meltdown. So if executive pay does, in fact, reward firm size in terms of assets, regulating pay may indirectly curb systemically risky activity by financial firms.

 
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