Bankers’ bonuses claw-back clauses are critical

How big is bonuses and increases in size to bankers: Evidence from the united kingdom

The sheer scale of the income gains that the best-paid workers, and particularly financial sector workers, experienced during the period of the last decade is nearly unprecedented. Figure 1 shows the full total gains (as a share of the aggregate wage bill) likely to the very best groups within the wage distribution in the united kingdom between 1998 and 2008.

Workers in the very best 10% gained a supplementary three percentage points of the wage bill over this era. Nearly all these gains visited the most notable 1% of workers, and finance workers accounted for nearly three quarters of the gains. As opposed to previous decades, this expansion of inequality towards the top of the distribution had not been matched by rising inequality at lower levels.

The increased share that bankers were taking amounted to a supplementary £12 billion each year by 2008, and virtually all the gains accrued because of bonuses instead of increases in basic pay. 1 Even these figures underestimate increases in size since we’ve no reliable data on bonuses paid in restricted stock and commodity. Accounting for these would definitely make the gains at the very top a lot more extreme.

Figure 1 . The change in share of most income going to the most notable 1%, 2-5% and 6-10%

Source: Bell and Van Reenen (2010). Notes: Figures are computed from the Annual Survey of Hours and Earnings, ONS

Why should bonuses have contributed to the financial meltdown?

Bonuses are usually considered to improve incentives for workers since, theoretically, they try to link pay more closely with performance. In a classic piece-rate scheme such as for example those applied to production lines, there is accurate monitoring of individual or group output and bonuses are payed for past output. Workers in these environments cannot in virtually any sense produce negative output in the years ahead.

Bonuses for traders in financial markets encourage risk-taking since such risk-taking is instrumental in producing high returns. Risk-taking is desirable in the financial sector; indeed, this is a key reason to encourage performance-related pay. The downside, however, is that traders who are paid bonuses based on the annual profits of their publication have an incentive to find short-term profits also to maximise the risk they are able to take at the trouble of the long-term interests of the firm.

These effects become magnified throughout a period where the low policy interest levels of the major central banks encourage risk-taking and leverage. That is particularly so for traders who make profit aggregate only by luck and also have no capability to outperform the market over time. The worst that may eventually such traders is that they lose their jobs but keep carefully the bonuses that they had previously received.

All this shows that to mitigate the surplus risk-taking that bonuses can induce, bonuses in the sector have to be predicated on risk-adjusted performance and either to be predicated on long-run performance or even to be at the mercy of “clawback” if future performance declines.

Altering the mixture of bonus compensation

The mixture of cash and equity in bonus compensation has been highlighted as a significant area for reform and regulation. It must be recognised, however, that lots of investment banks have historically paid bonuses in a combined mix of cash and restricted equity.

A reasonably typical example may be a trader finding a £500,000 bonus made up of perhaps £250,000 cash and £250,000 in equity. The equity would have to be held over a three-year period, with a third permitted to be sold by the end of every subsequent year. The proportion paid in cash versus equity tended to fall as how big is the bonus rose.

The motivation for such a bonus structure was to tie top performing workers in to the firm by raising the expenses to the worker of changing firms. Workers who had such a bonus payment and made a decision to leave the firm prior to the full three-year ‘vesting’ period would lose any remaining unvested equity.

The renewed concentrate on equity-based compensation targets the potential to align workers’ incentives more closely with the long-run interests of the firm instead of their lock-in properties. Economists have long argued that incentives for CEOs are more consistent with those of shareholders if a considerable proportion of their remuneration is by means of restricted stock and commodity.

The essential intuition is easy. The CEO takes actions that affect the worthiness of the firm but shareholders usually do not clearly observe these actions. To make certain the CEO takes the actions that maximise shareholder value, it’s important for shareholders to link CEO remuneration right to the worthiness of the firm. But imperative to this argument is that the CEO’s actions have at least some influence on the share price – if not, shareholders must have no interest in sharing the worthiness of the firm with the CEO.

But this is simply not obviously true for other employees, whose activities probably result in for the most part only a little change in underneath line because of their employer. So that it is unclear why an employee would alter their risk-taking behaviour only due to receiving more remuneration in equity than cash. While workers are at the mercy of the same kind of “principal-agent” issues that afflict top management, simply copying the remuneration strategies in one to the other is unlikely to work.

Clawback agreements in bonuses

Clawback agreements enable bonus payments to be recovered from the employee if future performance falls below pre-specified standards. They are apt to be particular useful in the financial sector as the existence and size of “alpha” (that’s, investment returns because of the worker’s true ability) is surely only observable over time (Rajan 2008). As Rajan highlights, “compensation structures that reward managers annually for profits, but usually do not claw these rewards when losses materialise, encourage the creation of fake alpha”.

Such clawback arrangements are envisaged in the remuneration code recently implemented by the Financial Services Authority (2009), although teeth of such regulations are an open question. The code proposes a significant proportion of any bonus ought to be deferred for at least 3 years and a substantial proportion of the deferred bonus ought to be “from the future performance of the firm” and “the business enterprise undertaken by the employee”.

A good example of such a bonus system may be the one now operated by UBS (see Logutenkova 2010 on Bloomberg.com). Senior bankers were allocated a bonus pool of 900 million Swiss francs, which would spend in equal parts this year 2010, 2011 and 2012 provided explicit profit targets were met. Carrying out a loss for this year’s 2009 fiscal year, UBS clawed back 300 million from the pool.

For clawback contracts to fit the bill, they must be predicated on explicit formulae of readily observable and verifiable measures of performance since more arbitrary clawback will be prone to challenge in the courts. It remains unclear whether such contracts could be successfully written for traders predicated on individual risk-adjusted performance instead of simply the efficiency of the firm.

Taxing increases in size from guarantees and subsidies

One argument towards a tax directed explicitly at bankers is to recuperate the gains that primarily occur due to both explicit guarantees (such as for example deposit insurance) and implicit guarantees (for instance, “too large to fail”) that the sector enjoys from the taxpayer and the implicit subsidy supplied by central bank liquidity policy.

Ideally, we wish to estimate the advantage of these guarantees and subsidies to individual institutions and charge them appropriately – presumably at some rate in the years ahead as capital is replenished 2 . This can be unrealistic, in which particular case a strong argument could be made to utilize the tax system to recuperate these gains.

It really is, however, unclear why it seems sensible to tax bonuses instead of impose a windfall tax or subsidy charge on the sector. This second item is actually what the National government has proposed with the FINANCIAL MELTDOWN Responsibility Fee, imposing a levy predicated on the size of the total amount sheet of large financial firms.

Increasing taxes on high earners?

Furthermore to regulating the mix, deferral, and clawback of bonuses, there’s also been a far more general focus on the problem of raising marginal tax rates on higher earners – either generally or directly centered on bonuses. Such a focus is hardly surprising given both fiscal outlook and the dramatic gains which have accrued recently to those towards the top of the wage distribution.

THE UNITED KINGDOM government has shifted both general front and on bonuses specifically. This year’s 2009 Budget introduced a fresh 50% marginal tax rate on those earning over £150,000 (roughly the very best 1% of wage earners) and tapering the tax relief on pension contributions for these workers to the essential tax rate. In the November 2009 UK Pre-Budget Report, the federal government imposed a 50% tax rate on employers for just about any bonus paid to a worker more than £25,000 for the existing tax year only. The Conservatives usually do not propose to reverse the first tax increase and the next will already be completed prior to the election.

There are two common arguments against raising marginal tax rates on bankers (or indeed more generally on high-skilled high-earners). First, it’s advocated that the behavioural responses of labour supply and effort, changes in the proper execution where compensation is taken and reduced compliance can lead to the tax yield being significantly less than expected. Evidence shows that such responses are larger for highly paid workers facing higher marginal tax rates. 3

Second, such workers are purported to be highly mobile and would rapidly relocate to lessen tax jurisdictions 4 . There’s been much anecdotal reporting of London-based hedge funds scouring Switzerland for suitable premises.

There is, however, hardly any robust empirical evidence on international mobility and tax differentials. One notable recent analysis (Kleven et al. 2009) shows that the location selection of football superstars in Europe responded strongly to marginal tax rates – though this is a matter of some debate concerning how workers in London investment banks and hedge funds truly match footballers. More generally, policymakers must decide whether such potential flows out of London certainly are a price worth paying.

Conclusions

The financial meltdown raised knowing of the sheer size of bankers’ bonuses during the last decade. This band of workers have been the largest gainers in the labour market, plus they have significantly increased their presence near the top of the income distribution.

The structure of bonuses has can be found in for sustained criticism since it allegedly increased risk-taking in the financial sector to dangerous levels and contributed to the unravelling in 2007/8. The data shows that simply changing the cash/equity split of such payments won’t solve these problems nor will deferral if not connected with clawbacks.

The sharp rebound in bonuses during 2009/10 will probably raise the popularity of higher marginal tax rates – or special bonus taxes – regardless of the potential unwanted effects from international mobility of workers and firms.

References

Bell, BD and J Van Reenen (2010), “Bankers’ Pay and Extreme Wage Inequality in the united kingdom”, CEP Special Report.
Logutenkova, Elena (2010), “UBS Claws Back $282 Million of Bonuses After Posting 2009 Loss”, Bloomerg.com, 10 February.
Financial Services Authority (2009), Reforming Remuneration Practices in Financial Services, FSA Policy Statement 09/15.
Gruber, J and E Saez (2002), “The Elasticity of Taxable Income: Evidence and Implications”, Journal of Public Economics, 84:1-32.
Kleven, HJ, C Landais and E Saez (2009), “Taxation and International Mobility of Superstars: Evidence from the European Football Market”.
Rajan, R (2008), “Bankers’ Pay is Deeply Flawed”, Financial Times, 8 January.

1 See Bell and Van Reenen (2010) for a complete accounting and discussion of the role of financial bonuses in the wage distribution during the last decade.
2 We usually do not here consider the choice approach of coping with the ‘too big to fail’ problem – namely regulating to ensure they are not too large to begin with.
3 Gruber and Saez (2002) claim that the entire elasticity of taxable income regarding marginal tax rates lies between 0.4 and 0.6, with higher elasticities for the best earners.
4 Separately, it really is argued that tighter financial regulation will encourage firms to relocate to countries with looser regulation.

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