1. Incentive Pay and Bank Risk Taking: Evidence from Austrian, German and Swiss Banks 1 Matthias Efing University of Geneva and SFI Patrick Kampkötter University of Cologne Harald Hau University of Geneva and SFI Johannes Steinbrecher Ifo Institute Dresden

2. 2 “When times are good in financial markets, bankers get colossal bonuses. When things go badly? Bankers still live well off the fat. Many can cash in and check out, leaving taxpayers to pay for the mess … an incentive system that rewarded greed and excessive risk.” (http://www.bloomberg.com/quicktake/banker-bonuses/) Do large cash bonuses create incentives for excessive risk-taking? Research Question

3. 3 Regulatory pressure: EU legislative proposals on limiting bonuses at 100% of fixed salary Bank of England focuses on deferred compensation, claw backs Say on Pay rule (Dodd-Frank Act) Focus on trading activity: Largest bonuses Regulatory focus on trading: Liikanen Report to European Commission Financial markets offer a menu of risk-return profiles: Derivatives, European sovereign debt, sub-prime, … Rogue traders (Jérôme Kerviel expected a bonus of € 300t for 2007). Research Question

4. 4 Detailed payroll data Trading profits and incentive pay Positive relationship between pay incentives, trading profits and volatility IV approach to explore causality Optimality of pay incentives Examine marginal effect of incentives on Sharpe ratio of trading profits Bonus moderation during the crisis seems to have reduced excessive incentive pay Highlights

5. 5 Payroll data on bank employees from a pay consultant 1,27 million employee-year obs. 123 Austrian, German and Swiss banks over period 2004-2011 Investm. Banking (12,343 obs.) and Treasury/Capital Mkts (34,977 obs.) Base Salary, (Cash) Bonus, Age, Tenure, Hierarchy Level, Bank Segment Define:Bonus Share = Bonus / Total Salary Correlation ( Equally Weighted BS in Trading ; BS of CEO ) = 0.37 Bank risk taking: Trading income for 67 banks and 401 bank-years Define:Relative Trading Inc. = Trading Inc. / Gross Interest Inc. Data

6. 6 Employee-Level Pay Incentives Bonus can reach up to 10 times Base Salary Bonus Share (almost) linear in log Base Salary Bonus Share dropped ~40% in 2008-11 relative to 2004-7 (Bonus ↓ & Base Salary ↑ )

7. 7 Bank-Level Pay Incentives Aggregated at bank level by period: Large variation across banks (different “incentive cultures”) Drop of Bonus Share during crisis period

8. 8 Trading Income Unlike the bonus share, trading income did not systematically decrease in the crisis period. Is drop in Bonus Share largely induced by public pressure?

9. 9 Correlation (Trading Income, Bonus Share) > 0 Pay incentives incentivize higher effort levels Pay incentives incentivize higher risk-taking (convexity of remuneration), which is rewarded by higher expected profitability Hypothesis 1

10. 10 Hypothesis 1 - Results Bonus Share correlates significantly with Trading Income: 1 SD in BS (=0.146) → Increase in Log Relative Trading Income by 75% of a SD Decreasing returns to scale Results similar for Hierarchy Weighted Bonus Share

11. 11 Correlation (Std. Dev. of Trading Income, Bonus Share) > 0 Pay incentives incentivize higher risk-taking (convexity of remuneration) Hypothesis 2

12. 12 Hypothesis 2 - Results Bonus Share correlates significantly with Volatility of Trading Income: 1 SD in BS (=0.146) → Increase in Log SD of Rel. Trading Inc. by one SD Results are similar for Hierarchy Weighted Bonus Share

13. 13 Reverse Causality Instruments: “Bonus culture”: Bonus Share in retail / corporate / private banking Monitoring deficiency for “invisible” trading divisions: Employment in non- capital markets segments

14. 14 Hypothesis 1 - IV IV coefficients are large and significant

15. 15 Hypothesis 1 - IV

16. 16 Hypothesis 2 - IV IV coefficients are large and significant

17. 17 Hypothesis 2 - IV

18. 18 Maximization of Bank Value Value Maximization = Maximization of Sharpe Ratio of Trading for self-financing trading strategies FOC: E For a concave unimodal function: If marginal effect of Bonus Share on Sharpe Ratio is negative, pay incentives incentivize excessive risk taking from a the perspective of asset value max. Hypothesis 3

19. 19 Hypothesis 3 Pre-crisis: Instrumented Bonus Share correlates negatively with Sharpe Ratio. Crisis: Instrumented Bonus Share correlates positively with Sharpe Ratio. Bonus moderation during the crisis removes excessive incentive pay. (but low statistical significance in (1) to (3), weak instrument in (4) and (5))

20. 20 Hypothesis 3 - IV

21. 21 Conclusion Substantial decrease in Bonus Share in 2008-11 in trading, but no corresponding decrease in Relative Trading Income Relative Trading Income and its volatility strongly correlated with Bonus Share (equally- & hierarchy-weighted) IV Regressions using the “bonus culture” proxied by the Bonus share in Other Segments and “governance quality” proxied by the Employment Share in Other Segments suggest that incentive pay increases both trading income and its volatility The marginal effect of incentive pay on the Sharpe Ratio of Trading Income appears to have been negative in the pre-crisis period, but slightly positive during the crisis. Bonus moderation seems to have reduced excessive incentive pay.

22. 22 Appendix CEO and executive board compensation has low correlation with overall bank incentive structure (in Austria, Germany and Switzerland) Research focus on board compensation may mismeasure actual organizational incentive structures Correlation between EW Bonus Share and HW Bonus Share is high at approximately 0.98. Correlation CEO Bonus Share Executive Board Av. Bonus Share Equally Weighted Bonus Share 0.370.47 Hierarchy Weighted Bonus Share 0.430.50

23. 23 Appendix

24. 24 Appendix