Preventing the Next Financial Crisis? Regulating Bankers' Pay in Europe
| Published date | 01 March 2014 |
| DOI | http://doi.org/10.1111/j.1467-6478.2014.00654.x |
| Author | Andrew Johnston |
| Date | 01 March 2014 |
JOURNAL OF LAW AND SOCIETY
VOLUME 41, NUMBER 1, MARCH 2014
ISSN: 0263-323X, pp. 6±27
Preventing the Next Financial Crisis? Regulating Bankers'
Pay in Europe
Andrew Johnston*
This article offers a critical appraisal of the way in which executive pay
in financial institutions is regulated in the European Union. Despite the
widely acknowledged role of executive pay in causing the financial
crisis, regulators and policy makers were reluctant to intervene because
of the ideology of shareholder primacy and an unjustified belief that this
was a matter for companies and their shareholders alone. As a result,
the original regulatory scheme which was introduced was very weak.
The European Parliament responded to these developments by capping
executive pay. The article argues that, while this cap is a crude
instrument, it can be justified on economi c grounds because it
considerably reduces the likelihood of a future financial crisis, with
all the social costs that would entail. If it also results in much higher
fixed pay, that is a matter of concern for shareholders alone, and might
even force them into the activism so long expected of them.
INTRODUCTION
This article offers a critical appraisal of the European scheme that regulates
executive remuneration in financial institutions. This scheme is an important
part of the wider response to the financial crisis, and an essential comple-
ment to the ongoing reforms to the Basel system of banking regulation,
because remuneration schemes provide the most important incentives for
bank executives to `innovate' in ways which get around banking regulation.
Before the crisis, innovations such as wholesale off-balance-sheet financing
of loans and the use of complex derivatives increased bank profitability by
creating risks which were not visible to regulators or other actors, and
undermined the financial stability goal of the Basel system. While the recent
revisions of the Basel system specifically target some of these practices,
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*School of Law, University of Sheffield, Bartolome House, Winter Street,
Sheffield S3 7ND, England
Andrew.Johnston@sheffield.ac.uk
ß2014 The Author. Journal of Law and Society ß2014 Cardiff University Law School
regulation of remuneration is still required to prevent as yet unidentified
practices leading to future financial sector instability.
The main obstacle to the necessary far-reaching reforms is the ideology of
shareholder primacy, which insists that increases in shareholder value within the
law can be equated with the common good. This ideology continues to dominate
policy debates about corporate governance, despite recent failures, such as
Enron, which resulted in massive costs for both shareholders and employee
stakeholders, or the various bank failures which led to the current financial
crisis, which imposed huge losses on shareholders and taxpayer stakeholders.
The driving force behind both of these economic disasters was the practice of
paying executives for increasing the share price or return on equity, a practice
justified by the ideology of shareholder primacy. Even though this practice has
repeatedly led to enormous social costs, and has been widely identified as a
central cause of the crisis, key policy makers remain in thrall to shareholder
primacy and are reluctant to introduce the regulation which appears necessary.
As this article will show, they were happy to leave remuneration primarily to
bank boards and shareholders, while the national regulators, who failed to even
notice the massive expansion of credit and risk that preceded the crisis, were
charged with the impossible task of identifying when remuneration schemes
give executives incentives to take `excessive' risks. Policy makers even
recognized that this regulatory scheme would be likely to fail. This was
unacceptable to the European Parliament, which forced a more prescriptive
regulatory scheme into the Capital Requirements Directive, maintaining the
requirement that national regulators oversee remuneration schemes, but against
the backdrop of a quantitative cap on variable remuneration.
This article argues that the cap is a vital addition to the regulatory scheme.
In a broader sense the cap demonstrates an important shift in the debate about
whether markets or regulation should shape corporate governance. For the
first time, policy makers have recognized that prescriptive regulation may be
required to prevent companies setting pay in ways that produce unacceptable
social costs. This is a significant intervention into an area which has, to date,
been left to corporate boards (under the constraints of soft law alone), a policy
justified by the assumptions of shareholder-primacy ideology.
The first part of the article examines the contribution of executive pay to
the crisis. The second part offers an overview of the original regulatory
scheme, while the third part critiques it. The fourth part outlines and
evaluates the cap, and a brief conclusion follows.
EXECUTIVE REMUNERATION AND ITS CONTRIBUTION
TO THE CRISIS
It is widely recognized that the practices and structures of executive pay
played a central role in the financial crisis, although there is less consensus
on its exact contribution. The de LarosieÁre report concluded that `Remunera-
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ß2014 The Author. Journal of Law and Society ß2014 Cardiff University Law School
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