The Bonus Risk

CHICAGO – In its July session, the European parliament approved some of the strictest rules in the world on the bonuses paid to bankers. The aim is to curb risk-taking by financial institutions.

The new rules require that no more than 30% of bankers’ bonuses be paid in cash, that between 40% and 60% be deferred for at least three years, and that at least 50% be invested in “contingent capital,” a new form of debt that converts to equity when a financial company is in distress. The most innovative aspect of these new rules is that the limits do not apply only to financial institutions’ chief executive officers, but to all the top managers (though the definition of top managers is delegated to national parliaments).

The alleged justification for this major interference in private contracting is the systemic effect that these bonuses can have. High pay in the banking sector, so the argument goes, rewards success but does not penalize failure. Managers can easily move from firm to firm when things go badly, avoiding any punishment. This system rewards managers for taking risks, even when the risk is excessive. This distortion is perceived to be one of the main causes of the 2008 financial crisis.

The problem with this argument is that there is no evidence supporting the first crucial link in its logic. Much research has tried to establish a connection between bankers’ compensation schemes and risk-taking, but has failed to find one. At most, such research has found that more highly paid executives took greater risks, but it is unclear whether this is a cause or an effect. Executives in highly leveraged institutions should be paid more, because they bear more risk.