24-08-2012, 01:06 PM
BANKER’S PAY STRUCTURE AND RISK
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Abstract
This paper studies the contracting problem between banks and their bankers, embedded
in a competitive labour market for banker talent. To motivate eort banks must
use some variable remuneration. Such remuneration introduces a risk-shifting problem by
creating incentives to in
ate early earnings: to manage this some bonus pay is optimally
deferred. As competition between banks for bankers rises it becomes more expensive to
manage the risk-shifting problem than the moral hazard problem. If competition grows
strong enough, contracts which permit some risk-shifting become optimal. Empirically I
demonstrate that balance sheets have changed in a manner which triggers this mechanism.
Keywords: risk-shifting; moral hazard; incentives; bonuses; banks; bankers' pay.
Introduction
Competition between banks and investment houses for bankers and traders is intense. A
compelling narrative of the recent nancial crisis is that the labour market for bankers has
resulted in bankers receiving pay focused too much on short-term revenues. As a result
the most senior policy makers in the US, EU and G20 have, with hindsight, decried the
huge risks which built up in the nancial system. These observations have been met with
pleas for banks to reform their pay practices. Globally, nancial regulators are rushing to
introduce new rules which explicitly intervene in the allowable structure of bankers' pay.1
The hypothesis that those who ran banks did not care about risks and were happy to be
reckless is both too glib and poorly supported by the evidence. All the major banks were
regulated prior to the crisis with a view to managing their overall risk. Analysis of banks'
returns delivers no evidence that those run by CEOs whose interests were better aligned
with shareholders were less reckless or made smaller losses { in fact there is weak evidence
to the contrary (Fahlenbrach and Stulz 2010). It therefore remains crucial to understand
why banks and nancial institutions would, in good faith, enter into the remuneration
contracts whose outcomes have been so damaging. Failure to do so runs the risk that
the regulations on pay being introduced will quickly outlive their usefulness and become
constricting once regulatory monitoring improves.
Related Literature
There is now substantial regulatory and political pressure to critique and dene benecial,
and well justied, interventions in the labour market of bankers. As a result there is a
young literature which explicitly considers the impact of competition between banks on
the risks chosen, their corporate governance eectiveness, and the implications for optimal
nancial regulation. Acharya and Volpin (2010) and Acharya, Gabarro and Volpin
(2010) oer a model in which a principal can save on remuneration of her CEO by implementing
better corporate governance monitoring. However if competition between rms
causes CEO remuneration to be pushed up then there are fewer savings from monitoring,
and so it is argued that principals may save money by providing worse corporate governance.
A similar argument is oered also by Dicks (2010).3 I do not argue that corporate
governance has been deliberately worsened. Rather banks choose their employment contracts
optimally given the competition, and the relative costs and benets of managing
risk-shifting and moral hazard.
Thanassoulis (2010) explores the level of remuneration banks will pay in a competitive
labour market, and its impact on their decision of whether to use a bonus or a xed wage.
The work argues that, as banks face a cost of a default event or a run, they inherit a
concavity in their objective function resulting in them preferring to pay their bankers in
bonuses and not in xed wages. This follows as bonuses shrink when returns are small;
exactly when the risk of a default event is present. The paper then establishes a negative
externality between the banks which forces the level of remuneration up. As remuneration
is in actuality large (Thanassoulis shows evidence that in 10% of cases on the NYSE,
remuneration in banks and shadow banks represented over 80% of their total shareholder
equity) this represents a signicant default risk.
The Competitive Market For Bankers
We consider the market for any one of the services oered by commercial banks, investment
banks, or shadow banks in the nancial intermediation industry. Examples include foreign
exchange, equities investing, securitisation, structured nance products, the provision of
loans and so on. In this sector we suppose there are N dierent active such rms. I refer
to these as banks for short. Bank i has a fund devoted to this sector of size Si: The banks
are ordered so that S1 > S2 > > SN: Banks are risk neutral and look to maximise
the prots generated from their funds. The banks seek an individual banker to run their
fund in this sector.
There are N bankers who the banks are competing to hire. The bankers dier in their
ability. Each banker is of high ability at conducting the specic investment/trade/action
required with probability i 2 (0; 1) : The bankers are ordered so that 1 > 2 > > N:
Each individual banker learns her actual ability in investing this particular asset class in
the current market conditions after contracting, but before making her investment and
eort choices. The bankers are risk neutral and have an outside option normalised to 0.
The assumption of risk neutrality on the part of bankers is not a key assumption. If
the bankers were risk averse then the results would be strengthened. Nevertheless risk
neutrality is a compelling assumption for bankers for at least three reasons (Thanassoulis
2010). Firstly there is evidence that traders show an enhanced bias towards loss aversion,
and are therefore risk loving over losses.
Bankers' Possible Investments
The bankers make their investments at the start of time period t = 1: These trades
generate returns at the end of period t = 1 and again at the end of period t = 2:
Suppose a banker of skill is hired by a bank to manage a fund of size S: If the banker
discovers she is of high ability and exerts eort then in each period the trade generates
a prot, with certainty, of S ( + a) : is the return net of the cost of capital and a is
an additional boost to the return of the trade which arises because the the banker is of
high ability. I normalise the bank's discount rate to 0; and so a high ability banker will
generate prots over the two periods with an npv of 2S ( + a).
If the banker discovers she is not of high ability then she is of lesser ability. In this case
the lesser ability banker, despite exerting eort, does not receive the additional boost (a)
to the prot each period. Hence the npv of prots generated by a lesser ability banker is
2S: However a lesser ability banker could decide to risk-shift and so pump up her t = 1
prots at some risk to the t = 2 returns. If the lesser ability does decide to risk-shift then
at t = 1 she will generate prot of + a per dollar managed with certainty. However at
t = 2 she will only generate the prot + a with probability 1