Do CRD-IV Manager Compensation Incentives Work for Small Cooperative Banks? Special Session on Cooperative Finance

Institutional reactions to the Great Financial Crisis (GFC) brought about in depth overhaul of rules and regulatory authorities. The main piece of new EU regulation was CRD-IV, passed in 2013. Besides incorporating the Basel... [ view full abstract ]

Institutional reactions to the Great Financial Crisis (GFC) brought about in depth overhaul of rules and regulatory authorities. The main piece of new EU regulation was CRD-IV, passed in 2013. Besides incorporating the Basel III Accord prescriptions on capitalization, leverage, and liquidity, CRD-IV includes key innovations to banks manager compensation. It mandates that managers compensation should be limited in its variable part and feature deferral, malus and claw-back mechanisms. The basic idea is that widespread use of compensation incentives related to short-run performance was a chief cause of banks excess risk exposures leading to the GFC. Eradicating short-run profit incentives is thus sought for.
We contend that, while it makes sense for profit maximizing banks, that approach is faulty to tame risk exposures of small cooperative banks (SCBs). First, by their mutual mission SCBs should not maximize profit – which, in any case, they cannot pay out as dividends – but the welfare of a wide set of stakeholders beside shareholders. Second, managers incentive-pay may be tiny at SCBs compared to other banks. Third, financial risk – creating short-run profit in the GFC, as usual – may be incommensurably smaller for SCBs vis-à-vis other banks.
We test our contention via unique data freshly assembled by an ad-hoc survey on managers compensation and banks risk taking in Europe before and after the introduction of CRD-IV. In general, the data lend strong support to our hypotheses. First, we confirm that SCBs have lower ROE. Second, we verify that managers variable/total compensation at SCBs is below one sixth – both before and after CRD-IV – of that at other banks. Third, we prove that SCBs focus much more on traditional business and much less on investment and asset management.
Our problematic policy conclusion is that the managers compensation rules of CRD-IV provide a further example of how EU regulators appear out of touch with proportionality. Applying a one-size-fits-all approach – something not done in the U.S. – builds needless but real burdens on SCBs that may even endanger these banks’ viability.