Regulation of Compensation and Systemic Risk: Evidence from the UK

• Published date: 01 June 2021
• Author: ANYA KLEYMENOVA,İREM TUNA
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/1475-679X.12355

DOI: 10.1111/1475-679X.12355

Journal of Accounting Research

Vol. 59 No. 3 June 2021

Printed in U.S.A.

Regulation of Compensation and

Systemic Risk: Evidence from the

UK

ANYA KLEYMENOVA∗AND ˙

IREM TUNA†

Received 25 March 2016; accepted 2 February 2021

ABSTRACT

This paper studies the consequences of regulating executive compensation at

financial institutions by examining the introduction of the UK

∗Board of Governors of the Federal Reserve System; †London Business School

Accepted by Rachel M. Hayes. This manuscript was previously titled “Regulation of Com-

pensation.” We thank two anonymous referees, Christopher Armstrong, Eli Bartov, Philip

G. Berger, Thomas Bourveau (discussant), Francois Brochet (discussant), Robert Bushman,

Hans Christensen, Johanna Cowan, Yiwei Dou, Fabrizio Ferri, Pablo Florian, Pingyang Gao,

Bjorn Jorgensen, Kinda Hachem, Sam Harrington, Mirko Heinle, Lord King of Lothbury,

Ningzhong Li, Xiumin Martin, Mihir Mehta, Joshua Ronen, Stephen Ryan, Haresh Sapra,

Ron Shalev, Douglas Skinner, Eddie Riedl, Tjomme Rusticus, Marshall Vance (discussant),

Martin Walker (discussant), Christopher Williams, Anastasia Zakolyukina, Luigi Zingales, and

the participants at the Manchester Business School Executive Compensation conference, the

2013 EAA conference, the 2015 GW Cherry Blossom Conference, the 2015 UCLA Account-

ing Conference, the 2015 GIA Conference, the NYU Stern accounting seminar, the 2016

FARS Midyear meeting, the 2016 AAA annual meeting, the 2016 CMU Accounting Mini-

conference, Rochester, Simon School accounting seminar, 2016 HKUST Accounting Sympo-

sium, HBS A&M seminar, and Stanford accounting seminar for their helpful comments and

suggestions. Anya Kleymenova gratefully acknowledges the financial support of the Account-

ing Research Center at Chicago Booth, the Harry W. Kirchheimer Faculty Research Fund, the

Centel Foundation/Robert P. Reuss Faculty Research Fund, and the FMC Faculty Research

Fund at the University of Chicago Booth School of Business, the University of Chicago Booth

School of Business, the Economic & Social Research Council, and London Business School.

˙

Irem Tuna gratefully acknowledges the financial support of the European Research Coun-

cil (Grant ERC-2010-263525) and London Business School. We are grateful to NYU Stern

V-Lab for providing us with data for SRISK measures and Brian Reis for his help with the

data. We also thank Claudia Imperatore, Jacky Jiang, Marcel Tuijn, and Yina Yang for ex-

cellent research assistance. The views expressed in this study are those of the authors and

do not reflect those of the Federal Reserve Board or the Federal Reserve System. An on-

line appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/

journal-of-accounting-research/online-supplements.

1123

© University of Chicago on behalf of the Chookaszian Accounting Research Center,2021

1124 a. kleymenova and ˙

i. tuna

Remuneration Code in 2010, which aimed to change the decision-making

horizon and risk-taking incentives of bank executives. We find that, although

both banks and nonbanks show increased contribution and sensitivity to sys-

temic risk in the United Kingdom post-2010, this increase is lower for UK

banks, in line with the intent of the regulation. However, UK banks also ex-

perience higher unforced CEO turnover when compared to other UK firms.

Therefore, while the regulation may have had the desired effect on systemic

risk, it may also have given rise to some unintended consequences.

JEL codes: G21, G28, G34, G38

Keywords: executive compensation; financial institutions; regulation; sys-

temic risk; UK Remuneration Code

1. Introduction

The level and structure of executive compensation in financial services

firms has been a frequently debated topic among politicians, CEOs, and

academics since the financial crisis of 2007–2009. Critiques of compensa-

tion practices at financial services companies often attribute the crisis at

least in part to incentive pay that purportedly encourages excessive risk-

taking.1U.S. regulators have proposed a regulation that monitors or mod-

ifies the level and structure of executive compensation in the financial

services industry.2The United Kingdom was the first to pass similar reg-

ulation on compensation following the financial crisis. In this paper, we use

the UK setting to study the impact of executive compensation regulation

on financial services firms.

In August 2009, after a consultation period and having considered the

recommendations of the Turner Review (Turner [2009]) and Walker Re-

view (Walker [2009a] [2009b]), the UK Financial Services Authority (FSA)

implemented the Remuneration Code, making the United Kingdom the

first country to regulate compensation. This was widely seen as a response

to the financial crisis and an effort to curtail pay practices that allegedly con-

tributed to the crisis. The Remuneration Code’s objective was to decrease

short-termism among executives and other employees in the position of po-

tential material risk influence by requiring them to defer a larger portion

of their bonus compensation and by introducing performance-based vest-

ing conditions for these bonuses to increase pay–performance sensitivity

1See, for example, the “Statement of Treasury Secretary Geithner to the Senate Subcom-

mittee of the Committee on Appropriations,” 111th Congress. “Financial Services and General

Government Appropriations for Fiscal Year 2010,” 16–17. U.S. Government Printing Office,

Washin gton, DC.

2The U.S. Dodd–Frank Act Section 956 explicitly requires changing compensation compo-

nents and mandatory compensation deferral for financial services employees in positions that

might increase the risk of a given institution. The U.S. financial sector regulators proposed

the implementation of this section initially in 2011 and revised their proposals in May 2016.

The 2016 proposal is more in line with the regulation implemented in the United Kingdom

as part of the UK Remuneration Code. This proposal is yet to be implemented.

regulation of compensation and systemic risk 1125

and curb risk-taking behavior. Furthermore, the Code also required banks’

remuneration committees to work together with banks’ risk functions and

provide regular reports about remuneration practices and compensation

levels to the FSA. The Code was initially applicable to the largest banks and

later extended to all financial institutions.3

Extensive academic literature discusses the relationship between pri-

vately set compensation contracts and the principal–agent problem be-

tween managers and shareholders. However, even contracts that are

privately optimal might impose externalities on outside parties due to a

mismatch between private costs and benefits and social costs and benefits,

leading to market failure and the possible need for regulation (Anginer

et al. [2018]). The theory of regulation goes back to the seminal work of

Stigler [1971] and Posner [1974], who argue that regulation might be jus-

tified if there is market failure. Market failure is defined as the existence of

externalities, such as costs that are not internalized by the market players

who give rise to them. In this case, externalities arise because the decisions

of banks and their executives affect the risk (and hence cost) borne by

other banks, the rest of the economy, and society. This phenomenon is not

specific to the financial crisis of 2007–2009 but rather applies to the more

general issue that bank failures undermine financial stability, increase the

risk of failure of other healthy financial institutions due to banks’ intercon-

nectedness through the payment system, and impact the overall economy.

Regulating compensation represents an additional mechanism over and

above existing regulation to address managers’ potentially strong incentives

to take on risk that may not be socially optimal. Traditional banking regula-

tion restricts financial institutions’ decision-making by imposing financing

and lending constraints. However, it does not impose a mechanism for en-

suring that individuals at banks consider their decisions’ negative external-

ities, some of which may take years to manifest. Although bank executives’

contracts might be perfectly aligned with the interest of shareholders (and

hence be optimal from the private contracting point of view), they nonethe-

less might impose a suboptimal level of risk on society at large (Anginer

et al. [2018]). Therefore, even in the absence of the principal–agent con-

flicts at financial institutions, there might still be room for regulation. The

UK Remuneration Code’s stated objective is to address the market failure

resulting from negative externalities that individual banks do not take into

3On April 1, 2013, the FSA was abolished and became two separate regulatory authorities:

the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), which

is a part of the Bank of England. The Remuneration Code remains in effect. The FCA oversees

most of the Remuneration Code for UK BIPRU firms; the PRA with FCA jointly oversees the

implementation of the Remuneration Code for financial institutions subject to the EU Capital

Directive IV (these banks are also known as “dual regulation firms”). BIRPU refers to firms

covered by chapter 1 of the Prudential Sourcebook for Banks, Building Societies, and Invest-

ment Firms. Throughout the paper, we refer to all affected BIPRU firms as “banks” (i.e., firms

that fall under the FSA/FCA Remuneration Code in the United Kingdom). For consistency,

we continue to refer to the FSA as the main regulator behind the Remuneration Code.