Bank compensation regulation is a new tool that was introduced after the financial crisis of 2008-2009. The most prominent example of such regulation is a part of the EU’s 4 th capital requirements directive (CRD IV) which requires the deferral of compensation and restricts incentive compensation for bank managers, including CEOs. This type of bank regulation intervenes in banks’ internal corporate governance and attempts to constrain bank risk taking through managerial incentives. Such regulation is very effective if the board delegates the choice of strategy to the CEO, and much of the regulatory debate seems to implicitly assume a setting of delegation where CEO’s make independent and final decisions.
We study limits of compensation regulation that arise from corporate governance structures in which CEO compensation is not the only instrument shareholders use to control actions of bank managers. Specifically, we consider an active board that monitors and intervenes in the CEO’s strategy choice in accordance with shareholders’ preferences.
Compensation regulation reduces CEOs incentives to pursue strategies that increase risk and increases their incentives to pursue strategies that decreases risk. To the extent that an active board relies on the CEO to propose strategies to increase risk, compensation regulation reduces the bank’s adoption of new risk strategies. However, an active board can veto strategies to reduce risk and thus CEO compensation regulation does not increase the bank’s adoption of risk reduction strategies.
A lack of risk reduction strategies can be particularly important when a crisis unfolds. For example, while CEO compensation can provide the CEO with incentives to sell troubled assets at the start of a crisis, an active board may not approve such a sales.
Analyzing the role of active boards is important, as regulators demand a stronger involvement of boards. Moreover, compensation regulation increases shareholders’ incentives to implement an active board, while it reduces the effectiveness of compensation regulation. In the presence of active boards, it is optimal to combine compensation regulation with capital regulation that directly addresses shareholders’ risk-shifting incentives.
Our paper provides an important contribution to the regulatory debate on the interaction of different regulatory tools by showing why and how regulators optimally combine compensation and capital regulation.