Incentive Pay and Bank Risk Taking:
Evidence from Austrian, German and Swiss Banks
Matthias Efing
University of Geneva and SFI
Harald Hau
University of Geneva and SFI
Patrick Kampkötter
University of Cologne
Johannes Steinbrecher
Ifo Institute Dresden
1
Research Question
“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?
2
Research Question
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Regulatory pressure:
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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:
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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).
3
Highlights
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Detailed payroll data
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Trading profits and incentive pay
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Positive relationship between pay incentives, trading profits and volatility
IV approach to explore causality
Optimality of pay incentives
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Examine marginal effect of incentives on Sharpe ratio of trading profits
Bonus moderation during the crisis seems to have reduced excessive
incentive pay
4
Data
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Payroll data on bank employees from a pay consultant
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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:
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Trading income for 67 banks and 401 bank-years
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Define:
Relative Trading Inc. = Trading Inc. / Gross Interest Inc.
5
Employee-Level Pay Incentives
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Bonus can reach up to 10
times Base Salary
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Bonus Share (almost) linear in
log Base Salary

Bonus Share dropped ~40%
in 2008-11 relative to 2004-7
(Bonus ↓ & Base Salary ↑)
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Bank-Level Pay Incentives
Aggregated at bank level by period:
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Large variation across banks
(different “incentive cultures”)
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Drop of Bonus Share during
crisis period
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Trading Income
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Unlike the bonus share, trading
income did not systematically
decrease in the crisis period.
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Is drop in Bonus Share largely
induced by public pressure?
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Hypothesis 1
Correlation (Trading Income, Bonus Share) > 0
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Pay incentives incentivize higher effort levels
Pay incentives incentivize higher risk-taking (convexity of remuneration),
which is rewarded by higher expected profitability
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Hypothesis 1 - Results
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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
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Hypothesis 2
Correlation (Std. Dev. of Trading Income, Bonus Share) > 0
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Pay incentives incentivize higher risk-taking (convexity of remuneration)
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Hypothesis 2 - Results
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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
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Reverse Causality
Instruments:
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“Bonus culture”:
Bonus Share in retail
/ corporate / private
banking
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Monitoring deficiency
for “invisible” trading
divisions:
Employment in noncapital markets
segments
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Hypothesis 1 - IV
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IV coefficients are large and significant
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Hypothesis 1 - IV
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Hypothesis 2 - IV
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IV coefficients are large and significant
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Hypothesis 2 - IV
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Hypothesis 3
Maximization of Bank Value
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Value Maximization = Maximization of Sharpe Ratio of Trading
for self-financing trading strategies
 d ( SharpeRatio)

E  d ( BonusShare ) | X   0


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FOC:
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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.
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Hypothesis 3
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Pre-crisis: Instrumented Bonus Share correlates negatively with Sharpe Ratio.
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Crisis: Instrumented Bonus Share correlates positively with Sharpe Ratio.
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Bonus moderation during the crisis removes excessive incentive pay.
(but low statistical significance in (1) to (3), weak instrument in (4) and (5))
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Hypothesis 3 - IV
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Conclusion
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Substantial decrease in Bonus Share in 2008-11 in trading,
but no corresponding decrease in Relative Trading Income
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Relative Trading Income and its volatility strongly correlated with Bonus
Share (equally- & hierarchy-weighted)
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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.
21
Appendix
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Correlation
CEO
Bonus Share
Executive Board
Av. Bonus Share
Equally Weighted
Bonus Share
0.37
0.47
Hierarchy Weighted
Bonus Share
0.43
0.50
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.
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Appendix
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Appendix
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