Bonus Caps, Deferrals and Bankers Risk-Taking Esa Jokivuolle (Bank - PowerPoint PPT Presentation

Background & Literature Model & Optimal Risk Level Model Calibration & Policy Simulation Conclusion Bonus Caps, Deferrals and Bankers’ Risk-Taking Esa Jokivuolle (Bank of Finland and Aalto University) Jussi Keppo (National University of Singapore) Xuchuan Yuan (Harbin Institute of Technology) May 20, 2016 Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Background Bankers’ compensation becomes a major issue for banks’ corporate governance and regulation after the recent financial crisis The question is whether large short-term bonuses spurred too much risk-taking that partly caused the crisis Cash bonuses are short-term compensation schemes Both regulators and banks themselves have started to take restrictive measures on compensation The EU has limited the bonus per salary ratio to one, subject to flexibility, and is imposing guidelines for bonus deferrals. The Dodd-Frank Act imposes clawback policies on bonuses. Many leading banks have introduced or are considering clawback policies voluntarily. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Research Question Given the compensation contracts, are the compensation restrictions effective to contain bankers’ risk-taking? bonus cap bonus deferral The objective is to study the effect of compensation restrictions on bankers’ risk-taking both theoretically and empirically Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Contributions Theoretical model Using a standard continuous-time asset pricing framework, a theoretical model for the value of future bonuses with/without bonus caps and for bonus-induced risk-taking incentives is developed The series of bonuses is worth more, the shorter the bonus payment interval If there are no costs of risk-taking, the shorter the bonus payment interval, the higher is the banker’s risk-taking incentive short-term bonus contracts spur risk-taking imposing a bonus deferral can help contain risk-taking Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Contributions, Cont’d Policy simulation Using data on 85 US banks the theoretical model with cost of risk-taking is first calibrated to each bank and then the effect of bonus caps and deferrals on the banks’ risk-taking is simulated Bank specific risk-taking cost parameters are estimated The effect of bonus deferral on the bankers’ risk-taking is immaterial for all the banks A cap on bonuses can substantially reduce the risk-taking on average bonus caps reduce the banks’ earnings volatility by up to 22%, but the bank-specific effect varies (0%–100%) some evidence that bonus caps are effective on bigger banks Results remain qualitatively the same with option grants, risk preferences, internal bonus caps, etc. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Related studies: Compensation based risk-taking Coles et al. (2006), Low (2009): the aggressiveness of compensation does increase risk-taking in corporations managers are inherently risk averse (Beatty and Zajec (1994)) depend on the amount and composition of personal wealth (Korkeamaki et al. (2013)) Houston and James (1995): bankers’ compensation does not promote more risk-taking than in other industries in banks risk-taking incentives can be more hidden Cain and McKeon (2014): risk-taking is driven by CEO’s personal risk preferences & compensation-based risk-taking incentives Hagendor et al. (2015): management style also affects risk-taking in banks Leaven and Levine (2009) and Pathan (2009) show that banks’ risk-taking may be determined at the level of a board Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Background, Research Question, Contribution Model Calibration & Policy Simulation Related Studies Conclusion Related studies: Short-term compensation contracts Gopalan et al. (2010) provides most direct evidence that shorter-term compensation contracts increase risk-taking Makarov and Plantin (2015): long-term contracts can discourage fund managers to hide their risk-taking Thanassoulis (2012) limit on the maximum bonuses can reduce banks’ default risk Acharya et al. (2014) show in a theoretical model that the impact of pay duration is minor for bankers’ risk-taking Thanassoulis (2014): bonus caps can be a better regulatory device to reduce bank risk than a higher capital requirement Fahlenbrach and Stulz (2011): “(b)anks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis” Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Model Setup Assumptions A risk-neutral banker receives bonuses during tenure [ 0 , T ] . Bonuses are from profit which depend on the change of the bank’s asset values. A risk-free asset (source of leverage, the debt ) and a risky asset (the main business, the loan portfolio after operational costs ). The dynamics of bank debt: B ( t ) = exp ( rt ) Under the risk-neutral probability measure, the risky asset follows dS ( t ) = S ( t ) rdt + S ( t ) σ dW ( t ) Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Model Setup Assumption The banker keeps the fractions invested in the risk-free and risky assets constant. At time 0 the banker selects the fractions and the asset quality, i.e., the parameter σ . The equity value evolves according to dA ( t ) = A ( t ) rdt + A ( t ) σ θ dW ( t ) , where A ( t ) is the equity value and A ( 0 ) > 0, earnings volatility σ θ = ( 1 + θ ) σ , and θ is the bank debt relative to the equity value. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Model Setup, Cont’d Tenure [ 0 , T ] is divided into n equal length intervals Bonus frequency n is bounded. Bonus payment interval ∆ = T / n . At the end of i ’th interval, the bonus payoff is Π( A ( i ∆) , A (( i − 1 )∆)) = k max [ A ( i ∆) − A (( i − 1 )∆) , 0 ] where k ∈ ( 0 , 1 ) is the fraction of profits as compensation. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Compensation Value Without bonus cap By the risk-neutral pricing, the present value of the compensation package is a sequence of call option contracts , given by n ∑ π n = E [ exp ( − ri ∆)Π( A ( i ∆) , A (( i − 1 )∆))] i = 1 n ∑ = E ( exp ( − ri ∆) k max [ A ( i ∆) − A (( i − 1 )∆) , 0 ]) . i = 1 Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Compensation Value, Cont’d Without bonus cap The value of the compensation without bonus cap equals nkA ( 0 ) many call options with maturity ∆ = T / n , strike price K = 1, and initial underlying asset value of one. Proposition The value of the compensation package with n payout periods on [ 0 , T ] is given by π n = nkA ( 0 ) C ( T / n , 1 ) , where C ( T / n , 1 ) is the call option price, k is the fraction of profits paid out as compensation, and A ( 0 ) is the initial equity value. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking

Background & Literature Model & Optimal Risk Level Model Setup Model Calibration & Policy Simulation Optimal Risk Level Conclusion Compensation Value, Cont’d Without bonus cap Corollary � � � Let 0 < r < σ 2 5 1 0 , T � � 1 + 4 + for all y ∈ . Then π n rises θ σ 2 n θ y in n , i.e., π n + 1 ≥ π n . Figure: Two bonus frequency examples. Solid line depicts cumulative earnings. The left panel is under a high bonus frequency. The right panel is the corresponding case with only one bonus accrual period. Jokivuolle, Keppo, Yuan Bonus Caps, Deferrals, and Bankers’ Risk-Taking