Rethinking Remuneration Laws for the Financial Sector

Abstract

Excessive risk-taking in the banking industry has led to the default of firms and to increased systemic risks as demonstrated during the previous financial crisis. The causes of this excessive risk taking are numerous and complex. However, it is now consensus that inappropriate remuneration structures can contribute to excessive risk taking. Substantial parts of the financial sector CEOs' variable compensations has a short-term focus and are not risk adjusted as empirical surveys have shown. Such remuneration structures persist in the aftermath of the crisis as part of the finance industry's remuneration culture. This, however, is inefficient from a risk perspective and thus triggers the need for a remuneration regulation. With the entrenchment of the Directives for the European Union in December 2010 and the implementation into national laws, e.g. Germany, UK and France, the remuneration focus substantially shifted to a more long-term perspective. Our analysis shows the reform efforts to aim in the right direction. However, the methodology for and the measurement of „success" should be revised. Due to different regulations in different European countries there is danger of regulatory arbitrage. Additionally, the new remuneration laws are given in the form of general principles leaving room for interpretation. Efficient regulation should ensure remuneration policies and structures to be aligned with an effective risk management. The financial authorities should therefore closely observe the market development in this perspective and take countermeasures if necessary. Furthermore, an elimination of existing regulatory flaws in national laws is needed. (K33, G30, G38, J33)