Discussion on
“Bonus Caps, Deferrals, and
Bankers’ Risk-Taking”
Ka Kei Chan
University of Westminster
21st May 2016
Key objectives and conclusion
• To study how bonus caps (EU policy) and deferrals (Dodd-Frank Act)
affect bankers’ risk-taking incentive
• By constructing a rigorous theoretical model
• By careful calibration using US bank data between 2004-06
• Key theoretical suggestions
• A series of interim cash bonuses are worth more to bankers than a lump sum
at the end of a period
• A bonus deferral is not an effective policy for lower risk-taking
• A bonus cap can be an effective policy for lower risk-taking
Strengths
• The topic is very tropical and has been heavily discussed after the
2007 crisis
• The construction of the model is very strong, with clear assumptions
and rigorous derivation for propositions and lemmas
• A lot of effort has been spent on calibration and robustness check
(over 30 tables!)
• Very good attempt to compare the effectiveness of EU policy (cap)
and Dodd-Frank Act (deferral) on banker bonus
Comment and Suggestion 1
• Although vanilla call option has a lot of similarities as bonus (nonnegative, fixed maturity, dependence on a targeted return), it has
some limitations, especially on capturing the bonus deferral
Assuming bonus is paid at the end of the 2nd year
Year
1
2
Total Profit
Actual Bonus
Profit of Bank A
1
1
2
?
Profit of Bank B
10
-8
2
?
• In the case of Bank B, after seeing the massive loss of “-8”, the profit
of “10” would be a distant memory to the stockholders
• Efing et al (2014) found evidence that there was a robust correlation
of pay incentives with the bank’s trading income and its volatility
• I think this weakens the bonus deferral suggested in Dodd Frank Act
• Delaying the payment of bonus should not be a simple policy which
only allows bonus to depend on a longer term performance, but also
allows investors to ‘judge’ whether the good performance comes
from a good investment strategy or a risky one.
• If vanilla call option can be replaced by barrier call option which
expires immediately when the target return falls below a threshold, it
may better capture the richness of bonus deferral.
Comment and Suggestion 2
• The model does not capture capital requirement, which weakens the
comparison of the policies.
• Cost function cannot capture the fact that there is a limit to a bank’s
ability in raising capital, and hence capacity for risky investment
Comment and Suggestion 3
• The key theoretical results in introduction (page 4) do not really
match the key propositions in the paper; in fact, it waters down the
richness of the propositions
• Example 1: “Series of cash bonuses are worth more the higher the
bonus frequency is” page 4.
• This follows directly from the non-negative nature of option
• Example 2: “The higher the bonus frequency is, the higher the
banker’s risk-taking incentive” page 4.
• This follows directly from the assumptions that there is no natural
incentive for banker to limit risk-taking (because call options are
convex), therefore
• Higher frequency  Better bonus  Stronger risk-taking incentive
• Similarly
• Cap restriction  Less bonus  Lower risk-taking incentive
Very Minor Points
• The economic intuition and argument of the model can be explained
more carefully; i.e. the economic explanation on the underlying
reason for the model to obtain the propositions
• The paper uses “cost of changing the risk level” and “cost of risk
taking” interchangeably (e.g. in page 21). The two concepts are very
different and should be treated more carefully
• Too many footnotes in introduction and too many tables with limited
explanation
Reference
• Efing, M., Hau, H., Kampkotter, P. and Steinbrecher, J. (2014) Incentive
Pay and Bank Risk-Taking: Evidence from Austrian, German, and Swiss
Banks. Working paper.
Year
1
Yearly bonus (10%)
Max(0, 10*0.1) = 1
Biennially bonus (10%)
(Profit =10)
2
(Profit = -10)
Max(0, -10*0.1) = 0
Max(0, (10-10)*0.1) = 0
Total Bonus
1
0
• Fewer offsetting of profits and losses will definitely provide a higher
(or at least equally good) bonus to bankers