Bank Compensation and Risk Taking

The Bank for International Settlements (BIS) has published a new article examining how bank executive compensation and its regulation have evolved since the Global Financial Crisis, highlighting a disconnect between executive pay and prudent risk-taking. 

The paper — authored by the BIS’s Gaston Gelos, Bertrand Rime, and Kevin Tracol — finds little evidence that banks use risk-adjusted performance targets in determining executive compensation, despite post-GFC principles calling for pay to be aligned with long-term, risk-adjusted performance. Return on Equity (ROE), a metric that rewards leverage, remains the performance target with the highest weighting. Meanwhile, the weighting for actual risk metrics, such as the cost of risk or compliance measures, remains “very low,” the paper says.

The authors point to the “banking turmoil” of 2023 as an example of this governance breakdown. At Credit Suisse, the paper notes, a “material and persistent divergence between compensation and performance” was present long before its collapse. The bank adjusted performance metrics to exclude litigation provisions and restructuring costs, allowing significant incentive compensation to be paid despite substantial losses. The paper also notes that the Swiss supervisor FINMA concluded from its own review that the lack of financial consequences for misconduct and the exclusion of certain events from compensation calculations encouraged an “inappropriate risk culture.” A similar dynamic played out at the failed banks in the US, the paper contends.

The authors explain that the failed banks were not outliers in the formal structure of their pay plans. Instead, they argue, the banks’ governance failed to ensure the schemes reflected the risks executives were taking and recognized deteriorating performance in a timely manner. The paper also offers insights for supervisors, finding that empirical evidence supports longer deferrals of compensation as a tool for reducing bank risk. However, the results regarding the effectiveness of bonus caps are “inconclusive.”

“The turmoil highlights the role of governing boards and supervisors in overseeing the operation of compensation frameworks,” the authors conclude.