How capping bonuses could reduce bank leverage

It’s true. Capping bankers’ pay really does reduce the risks they take.

Even if regulators don’t believe it.

Stopping bankers from paying themselves huge bonuses on top of their salary reduces the level of reckless risk-taking by up to a fifth, according to study from the National University of Singapore and the Bank of Finland.

“A cap on bonuses can substantially reduce risk-taking,” the academics said. “For an average bank, the risk-reduction effect would translate into reducing the bank’s leverage from 25 to 20.”

Leverage is the amount of debt banks use to ramp up trading profits, compared to how much shareholder equity it has. It’s a good measure of risk-taking because the more the bank borrows, the less able it is to take losses and stay in business.

Lehman Brothers had about a 30 to 1 leverage ratio and paid CEO Dick Fuld a $22 million bonus the year before it collapsed.

The UK and US regulators hate bonus caps and prefer bonus clawbacks and deferrals. They believe bankers will be more careful if their future earnings are on the line in the event of failure, rather than just paying them a flat sum.

Andrew Bailey, the UK’s chief bank regulator, said last year: “Let me be blunt, the bonus cap is the wrong policy, the debate around it is misguided, and the best thing I can say about allowances is that they are a response to a bad policy. They are not a good solution.”

The study used mathematical models to predict firms’ behaviour based on how their executives are paid.

There’s a lot of complicated maths: 

Bonus Caps, Deferrals and Bankers’ Risk-Taking

But the results are clear:

“Bonus deferrals reduce the large and rare risks, but not the regular volatility of profits,” according to the study. “Nonetheless, bonus deferrals are clearly still not as effective in reducing risk-taking incentives as bonus caps are.”

The caps work because bankers get paid the same, no matter how much profit they make their bank, so there’s less incentive to go gambling on the markets with other people’s money.

This is good news for the taxpayers that ultimately backstop the banks.

An EU policy bans bonuses of more than 200% of salary, which the UK is forced to implement as an EU member country. The rules were put in place by the European Parliament, which blamed excessive risk taking for causing the 2008 financial crisis.

The Bank of England prefers clawback and deferral which allows bankers to pay themselves what they want, as long as they wait at least three years to receive it and pay it back to the bank if the firm takes massive losses or is fined for poor conduct.

This article is published in collaboration with Business Insider. Publication does not imply endorsement of views by the World Economic Forum.

 To keep up with the Agenda subscribe to our weekly newsletter.

Author: Ben Moshinsky is a writer for Business Insider.

 Image: A pedestrians walks under an arch opposite the Bank of England in London March 5, 2015. REUTERS/Suzanne Plunkett.