What are the Consequences of Regulating Executive Compensation?

Anya Kleymenova is Assistant Professor of Accounting the University of Chicago. This post is based on a paper authored by Professor Kleymenova and İrem Tuna, Professor of Accounting at London Business School. Related research from the Program on Corporate Governance includes Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here); The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann (discussed on the Forum here); and How to Fix Bankers’ Pay by Lucian Bebchuk (discussed on the Forum here).

The level and structure of executive compensation has been a frequently debated topic among politicians, CEOs, and academics since the financial crisis of 2007-2009. Critiques of compensation practices at financial services companies often attribute the crisis at least in part to incentive pay that purportedly encourages excessive risk taking. Regulators in Europe and the US have proposed, and in some cases even implemented, regulation that monitors or modifies the level and the structure of executive compensation in the financial services industry. In the UK, the Remuneration Code came into effect in 2010 as a response to the allegation that misalignment of shareholders’ and executives’ incentives was at least partly the cause of excessive risk-taking leading up to the financial crisis.

Regulation might be warranted in response to market failure, for instance when there is a mismatch between private benefits and costs and social benefits and costs. In particular, even if compensation contracts overcome the principal-agent problem and are optimally aligned with the interest of shareholders, they might still lead to socially excessive risk-taking because they do not internalize the costs of resolving potential bank failures. At least part of the cost of bank failures is borne by depositors and taxpayers and not executives or shareholders; therefore, there is little incentive on the part of bank executives to take this cost fully into account. In addition, compensation contracts may also be subject to rent-extraction in a typical principal-agent setting, where managers “capture the board,” bid up their compensation above the optimal level, extract surplus from shareholders, and take excessive risk. The introduction of the Remuneration Code in the UK potentially addresses both of these concerns. Introducing regulation is not costless, however. While regulation that addresses a market failure could potentially lead to a socially preferable outcome, it can also have unintended consequences for banks and the economy at large, such as loss of talent and inefficient changes to banks’ asset portfolios.

In our recent paper, Regulation of Compensation, which was recently made publicly available on SSRN, we examine changes in compensation practices of UK financial institutions (BIPRU firms) following changes in regulation. Our objective is to examine the consequences of regulating executive compensation using the evidence from its implementation in the UK and comparing the results to samples of financial institutions in Europe and the United States. While the new regulation specifically targeted bonus-based compensation and bonus deferrals, we review all of the main aspects of compensation to study whether compensation contracts overall changed following regulation.

The Remuneration Code was first proposed in February 2009 and came into effect on January 1, 2010. The restrictions implemented by the Remuneration Code mainly focused on bonus compensation. In particular, at least 50% of bonuses have to be deferred for at least three years and have to have performance vesting conditions attached. These rules apply to executives receiving more than 33% of total remuneration in variable pay, and whose total remuneration exceeds £500,000. In other words, the Remuneration Code affects pay of a wider range of employees and not just the top-tier executives.

In contrast to the Remuneration Code, EU authorities proposed a new rule in February 2013, which capped the ratio of variable and fixed pay at the one-to-one level, with some flexibility to increase the ratio to one-to-two if there was a supermajority shareholder approval (“EU bonus cap”). The cap applies to all EU banks operating in the EU (including their employees based outside of the EU) and to non-EU banks operating in the EU. The EU bonus cap came into force on January 1, 2014 and applied to bonuses related to performance from that point on. All financial institutions subject to the European Capital Directive (CRD4) are covered by the EU bonus cap rules. Furthermore, this cap applies to a wide set of employees identified as being in a position to have “a material impact on the institution’s risk profile.” In reality, all employees with total annual remuneration exceeding EUR 500,000 or in senior positions are affected by these caps. The United Kingdom was the only EU member state that voted against this proposal and appealed the European Parliament’s decision at the European Court of Justice. However, in November 2014 the UK government decided to drop the appeal and bonus caps came into effect in the UK on January 1, 2015.

In order to estimate the effects of regulation, we construct three different sets of comparison groups that were not directly affected by this regulatory change: other large (non-financial) UK firms, and US and EU banks of similar size, profitability and business models. Comparing BIPRU firms with EU and US banks allows us to create a group of control firms that are similar in size and their operations, which experienced the financial crisis but were not exposed to the same regulatory changes. This also allows us to disentangle the effects of the crisis from the effect of the enactment of the Remuneration Code.

We begin our analysis with a series of event studies starting from the announcement of the Remuneration Code and leading up to the introduction of the EU bonus caps, which allows us to investigate the capital market perception of these changes. While we find that the initial reaction to the Remuneration Code was perceived positively (with cumulative abnormal returns of 5.04% in a three-day window surrounded the announcement), the subsequent introduction of bonus caps by the new set of EU rules was perceived negatively by the capital market investors (with negative abnormal returns of 2.25% for UK banks and 0.26% for other EU banks).

We next study the economic consequences of the new regulation. Consistent with the mandate of the UK Remuneration Code, we observe that changes in BIPRU firms’ compensation are concentrated in deferred bonuses as we find that these firms defer more bonuses after the regulation became effective. Furthermore, we find that BIPRU firms become less risky and exhibit higher pay-performance sensitivity, in line with the intended purpose of the regulation.

To evaluate the concerns raised about potential unintended consequences of regulation, we examine whether there is a change in the likelihood of executives leaving their jobs voluntary (“unforced executive turnover”) after the regulation. We find that the likelihood of unforced CEO turnover for BIPRU firms increases following the introduction of the UK Remuneration Code. This also holds true when we compare BIPRU firms to US banks, suggesting that compared to US bank CEOs, BIPRU CEOs in the UK are more likely to switch jobs following the introduction of regulation. Finally, we find that following the introduction of the Remuneration Code, BIPRU CEOs’ compensation contracts become more complex in comparison to compensation contracts of CEOs of other large UK firms.

Given the potential similarities of CEO pay in the UK, EU, and US, and to the extent that the existing institutions and enforcement are similar across the countries currently in the process of proposing regulation of compensation, our findings from the UK as well as our comparative results using US and EU bank should be of international interest to the parties engaged in the compensation debate. In particular, while some of the regulatory changes might have had positive consequences there are also potential endogenous costs to regulating executive pay. As the European Banking Authority recently stated, mutual funds under the scope of the European Capital Requirements Directive will also be subject to the same executive compensation bonus cap and deferral requirements starting in 2017. Therefore, our evidence can be informative about the consequences of regulating pay at a wider set of firms.

The full paper is available for download here.

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