There has been a global push, driven by the Financial Stability Board, to improve bank risk management since the systemic financial crisis in 2008. In Australia, CPS 511 and FAR proposed requirements (see HERE and HERE for the latest updates) were also reinforced by the Hayne Royal Commission (see HERE).

An FSB global requirement is to defer at-risk remuneration for bank executives and “material risk-taker” employees.

A forthcoming Journal of Finance article assessed the economics of deferral and clawback requirements within the banking sector. The study focused on the effects of regulatory intervention (particularly deferral and clawback requirements) on risk-taking.

Interestingly, the study found that deferral regulation had a mixed effect in curbing risk-taking. Their model revealed that the effectiveness of deferral regulation was dependent on the stringency of the mandatory deferral period, labour demand and the “information environment”.

The analysis revealed less stringent deferral regulation alongside lucrative outside options (high labour demand) decreases risk-taking. However, risk-taking does not decrease when deferral periods are excessive. When there are limited outside options (low labour demand), the “information environment”, which is the ease with which risk-taking action is observable in performance, implies that higher observability decreases risk-taking.

The study concludes that deferral regulations do not have a robust effect of risk mitigation in the financial sector. More broadly, the authors conclude that regulations targeting remuneration packages are not the most effective method to curb risk-taking.

The authors argue:

• Remuneration packages are endogenously determined. Shareholders require remuneration to meet their risk adjusted return requirements;
• Hence, regulatory constraints on remuneration allows shareholders to restructure remuneration packages (i.e. engage in regulatory arbitrage). Examples include adjusting the pay mix to increase fixed pay and decrease at-risk pay;
• Improvement in risk management is better influenced via capital regulation. The requirement to contribute additional equity will cause shareholders to be concerned with downside risk from excessive risk-taking, and subsequently require remuneration packages to better manage these risks; and
• The regulatory tools “pecking order” based on their study suggests that capital regulation is most effective risk management tool. Remuneration regulation should only be considered if capital regulation is restricted; and
• A “one-size-fits-all” remuneration regulation for a heterogeneous group of risk takers cannot be a robust tool to curb risk-taking.

You can find the research paper (HERE).

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