The cap on banking bonuses in the EU failed to curb excessive risk taking and banks compensated their workers through a permanent and significant increase in their fixed pay.

This is the conclusion of research by Stefano Colonnello, Michael Koetter, Konstantin Wagner, presented at the Royal Economic Society annual conference in April, which looks at EU regulations that were introduced in 2014 to cap the variable pay of bank executives.

They find that bonus capped banks showed lower risk-weighted returns (which measures the return on an investment relative to the amount of risk) after the introduction of the bonus cap. They argue that this could be because managers exerted less effort under the new incentive scheme.

But they also saw higher idiosyncratic risk, which is specific to a small number of stocks such as one firm or an industry and can be solved by diversification. And it was accompanied by hikes in the risk inherent in the overall market, which undermined the goal to enhance the resilience of the banking industry.

The researchers manually collect a novel database of European bank executive compensation before and after the bonus cap regulation and show that compensation regimes changed significantly. On average, the variable earning opportunities of affected directors were reduced by EUR 1.7 million. At the same time, they received EUR 1.1 million more in fixed compensation as compensation.

According to the study, there was an increase in the number of bonus-capped directors moved from their jobs, which was primarily due to poor performance. The researchers argue that this more likely reflects stronger governance, rather than changes in careers.

They also note that the bonus cap also applies to non-executives and that the same compensation schemes may by applied. The researchers say it is likely that the increase in risk are in line with investors anticipating the effects of the reform on bank stability – where market measures of risk have increased due to a fall in the resilience of banks to shows as compensation structures become more inflexible.

After the international financial crisis, compensation practices at financial institutions and high bonus payments were heavily criticised for having contributed to excessive risk-taking. In response the EU introduced the capital requirements directive (CRD) III, which transcribed the Financial Stability Board’s principles for sound compensation practices into European banking regulation. This was to improve the governance of compensation in banks and to closely link compensation to banks’ long-run developments.

The EU then introduced CRD IV, adding a bonus cap rule that limited variable compensation in terms of fixed compensation up to two Euros in variable compensation for each Euro of fixed compensation. This meant that banks had to offer higher fixed competition for each Euro of incentive pay.

Effectiveness and (In)Efficiencies of Compensation Regulation: Evidence from the EU Banker Bonus Cap by Stefano Colonnello, Michael Koetter, Konstantin Wagner