Friend or Foe? The Impact of Basel III on the Association
Between Remuneration and Performance
Wesley Aartsen
Abstract. In this paper I examine how prudential regulation impacts the
relationship between managerial remuneration and firm performance in the banking industry. More specifically, I assess how this relationship is affected by Basel III, implemented in the European Union (EU) as the Capital Requirements Directive IV (CRD) IV. Drawing on a sample of 1782 banks in 18 EU countries, I test if after the implementation of CRD IV the relationship between firm performance and managerial remuneration is affected. I find evidence of a significant positive relationship between managerial remuneration and firm performance. However, I do not find evidence for a significant impact of CRD IV on this relationship. My findings have policy implications, as they indicate a lack of impact of a very important banking regulation.
Keywords: Executive compensation, Firm performance, European Union, Financial crisis, Banking industry
2 1. Introduction
This paper investigates whether there is an effective relationship between managerial remuneration and firm performance under the new regulations of Basel III. Since previous research has not been able to bring empirical evidence regarding an effective link between managerial remuneration and firm performance, this paper fills this gap in the literature. A recent Financial Times article concluded that CEO’s in the banking industry are earning more than twice of their base salary in terms of bonuses, stock and options. Thereby stated that; “high pay can only be justified if the bank’s returns are exceeding the cost of equity. However, European banks have been struggling the past few years to earn profits above the cost of equity”1. This conflicting evidence calls for regulators to interfere in the banking industry. The high amount of variable remuneration is meant to be regulated by the recent regulations introduced in the EU: The Capital Requirements Directive IV (CRD IV). This new regulation represents the enactment of Basel III in the EU. CRD IV introduces new rules concerning the variable remuneration to be at most 100 per cent (200 per cent with shareholder approval) of the base salary. This calls for an assessment whether banks in the European Union have implemented the new regulations of CRD IV. Moreover this research covers some important consequences of this implementation. The new rules are limiting the ability of the remuneration board or committee to compose a suitable compensation package for their CEO. Therefore it might be difficult to give the CEO the right incentives to act in the best interests of the shareholders. Moreover, to grant the same amount of total remuneration to their CEO, the remuneration committee can increase the fixed remuneration, which may ultimately lead to excessive risk taking by the CEO. In summary, this paper investigates whether there exists an effective link between managerial remuneration and firm performance in EU banks and whether the new regulations of CRD IV have an impact on this relationship. By relying upon a sample of 1782 banks, I find supporting evidence for a positive impact of managerial remuneration on firm performance. However, I do not find evidence for a significant impact of CRD IV on the relationship between managerial remuneration and firm performance.
The Treasury Select Committee, appointed by the House of Commons, issued a report on bank pay short after the financial crisis of 2008. According to this report, the financial crisis of 2008 had exposed serious shortcomings in the remuneration policies in the banking
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industry. The high-bonus pay culture encouraged excessive risk-taking and therefore endangered the long-term existence of the banks. Besides, this excessive risk-taking was not in the best interest of the shareholders2. The financial crisis resulted in measures in the banking industry causing the end-of-year compensation to fall steadily over the years.3 Currently, CEO pay is rapidly returning to its levels before the crisis of 2008. Nonetheless, this is only true for the CEO’s of JPMorgan and Morgan Stanley. Their salary has been raised by respectively 124 per cent and 66 per cent while other banking directors have only seen their salaries being raised by an average of 17 per cent.4 The Financial Times researched the evolution of executive pay in the banking industry from 2009 till 2014. Their results show that almost each banking CEO earned more than twice their base salary in a cash bonus and stock, options.5 These high amounts of variable remuneration are contradicting with the regulations of CRD IV and therefore these banks need to adjust their remuneration policies in order to operate in compliance with CRD IV.
The financial crisis of 2008 also revealed important deficiencies in the financial regulation, which were not covered by the regulations of Basel II. In order to prevent the banking industry from being exposed to these unidentified risks again, Basel III was developed. The purpose of Basel III was to strengthen the capital requirements through increasing the liquidity and decreasing the leverage. To implement Basel III in the EU, the European Commission adopted a legislative package of measures to strengthen the regulation, namely CRD IV. Even if CRD III already mentions remuneration, it does not impose restrictions and it does not define fixed and variable components in remuneration. These topics are nonetheless covered in the recent CRD IV. The requirements of CRD IV introduce the EU-wide bonus cap that has been established since early 2014. This bonus cap introduces new standards concerning the variable remuneration of CEO’s. Bonuses cannot be higher than 100 per cent of the base salary. This may be raised up to 200 per cent with shareholder approval.6 Besides, the regulators are planning for an extension of the claw back period for bonuses. The plan is to extent the seven year period with an additional three years. This means that managers may be obliged to repay an earlier received bonus, because of special circumstances
2 http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5328193/Bonus-culture-to-blame-for-banking-crisis-say-MPs.html 3 http://www.nytimes.com/2015/11/09/business/dealbook/bonus-pay-on-wall-street-is-likely-to-fall-a-report-says.html 4 http://www.ft.com/intl/cms/s/0/146fc048-1f77-11e5-aa5a-398b2169cf79.html#axzz3vWFAx9X2 5 http://www.ft.com/ig/sites/2015/bank-ceo-compensation-2015/ 6http://www.ft.com/intl/cms/s/0/3e65d76c-198b-11e5-a130-2e7db721f996.html#axzz3vWFAx9X2
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or bad performance. These measures come with the intention that “people in positions of responsibility are awarded for behavior that encourages a culture of effective risk management and therefore promoting the safety and soundness of the financial institutions”.7
This study is timely and contributes to a vast literature stream on managerial compensation. Gomez-Meija and Welbourne (1989) analyzed in their literature review of managerial compensation more than 250 empirical papers, dating back to the 1920s, which researched the association between CEO compensation and firm performance. Extant research calls for empirical evidence on an effective link between managerial remuneration and firm performance (Goergen & Renneboog, 2011).
This paper is structured as follows: Section 2 provides the theoretical arguments and literature background. In Section 3 I describe the hypotheses. Section 4 contains the methodology and the research design. In section 5 I provide the empirical results. Section 6 contains the conclusion and discussion, as well as some important limitations of this research.
2. Theoretical Background 2.1. Agency theory
The managerial remuneration has to be seen in the context of the agency theory. The agency problem is concerned with the contract between the principles (shareholders) and the agents (managers). The agents are obliged to perform a service on behalf of the principles and thereby they are given some decision making authority. If both the principles and agents are utility maximizers, the agents have the incentive to act in a self-serving way and therefore act not always in the best interests of the principles (Jensen & Meckling, 1976). It is possible for the agents to act in their own interest because of the information asymmetry. This is caused by the fact that the agents control organizational resources and are most likely to know more about the tasks they perform for the principles (Pratt & Zeckhauser, 1985). In order to counter the information asymmetry problem, the principles seek to devise ways, which will incur agency costs, to prevent the agents from making decisions in a self-serving way (Tosi & Gomez-mejia, 1989). “Previous studies by Grossman & Hart (1983) and Lambert (1983) have shown that the agency costs are minimized if the managerial compensation has been linked to firm performance and other variables that yield information regarding the actions taken by the
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executives”(Murphy, 1986). Given these outcomes, the compensation structure is an important incentive for the agent to act in the best interests of the principals.
According to the research of Prendergast (1999) there are three important assumptions within the agency theory. The first assumption concerns with the fact that there exists a conflict of interest between the shareholders (principals) and the managers (agents). The second assumption is about the possibility of the shareholders to motivate the managers using a performance-related pay method. The third assumption is that the contracts of managers have been created in such a way to facilitate the pay for performance method as mentioned in assumption two. In order to solve the agency problem or diminish the consequences of the agency problem, the shareholders have the opportunity to choose between two different types of general approaches (Young et al., 2012). The first approach is to specify the work activities of the agent and monitor the behavior and performance of the agent. The problem of this approach is that it assumes that the work activities are known beforehand and the high expenses that come with the monitoring systems. Besides, the information asymmetry causes another problem. The manager has superior knowledge about the work activities performed, compared to the shareholders. Subsequently, even if the shareholders manage to monitor the actions of the manager, the shareholders lack sufficient knowledge about the tasks performed by the manager. Therefore they might be unable to determine the work activities to be monitored. The consequence of this is that it might be impossible to monitor all actions performed by the manager. The other approach is to link the managers’ remuneration to a performance measure.
2.2. Remuneration as a powerful contracting tool
Previous research of Murphy (1986) presented evidence for the remuneration being a powerful contracting tool in order to direct the actions taken by the managers. Moreover, if the managers’ remuneration is linked to a performance measure, then this corresponds to the second assumption of Prendergast (1999). The implication of this performance-related pay is to create a financial incentive for the CEO. Given the fact that the manager is a utility maximizer and acts in a self-serving way, there will be a reason to act according to the incentive. “The financial incentives can be used to motivate the individuals to pursue assigned goals in terms of the direction, duration and intensity of their efforts” (Bonner & Sprinkle, 2011).
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Motivation can be defined as the inner force that drives individuals towards the achievement of organizational and personal goals (Lindner, 1998). Deci (1971) discerns two different types of motivation, namely intrinsic and extrinsic motivation. Extrinsic motivation refers to what is done by others to motivate the individual person in order to satisfy the needs of that individual person (Frey & Oberholzer-Gee, 1997). This might for example be performance-related pay (Bender, 2004). Intrinsic motivation is not related to influences from the outside, but relates to the individual person and the actions being undertaken by that person because one likes it or derives some kind of personal satisfaction from doing it (Frey & Oberholzer-Gee, 1997). According to previous research, intrinsic motivation has a greater influence on the motivation of an employee, compared with extrinsic motivation (Gerhart & Fang, 2015). The cognitive evaluation theory of Ryan & Deci (2006) explains how extrinsic motivation can enhance intrinsic motivation and thereby enhance the total motivation of the employee. It depends on whether the extrinsic motivation will be seen as informational or controlling. The informational aspect of extrinsic motivation can be seen as having a positive effect on intrinsic motivation (Gagné & Deci, 2005), whereas the controlling aspect will be having a negative effect (Ryan et al., 1983).
In this research, I focus on the extrinsic motivation only, because the compensation package is concerned with extrinsic rewards in order to motivate the managers to act in the shareholders interest. The compensation package can directly influence the motivation of the manager due to the possible rewards that might be received if the goals, set by the shareholders, are
achieved. Besides, the extrinsic rewards might influence the motivation of the manager indirectly, through intrinsic motivation. According to the research of Gagné & Deci (2005) and Amabile (1993) the extrinsic rewards can positively affect the intrinsic motivation of an individual person in case of the rewards being seen as confirming the competences of that person and providing useful information in a supportive way, instead of the rewards being seen as controlling. Given the definition of motivation by Lindner (1998), an enhanced motivation will increase the inner force of individuals to achieve organizational goals. Practically, this means that individuals will be more willing to put effort in achieving the goals that have been set by the organization. Corresponding with this statement is the suggestion of Khan et al. (2010) that motivated employees are more willing to align their personal goals with the goals of the organization and that these employees will be directing their effort in that direction. Consequently, organizations with motivated employees will be
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more successful because of their employees constantly searching for ways to improve their performance.
2.3. Related Research
Concerning the previous research, it is not possible to draw a universal conclusion about the relationship between managerial remuneration and firm performance. Coughlan & Schmidt (1985) have researched the effect of the usage of internal managerial control mechanisms by the board on the firm’s performance in means of stock price performance. The internal managerial control mechanisms are the compensation plans and management replacement decisions. Coughlan and Schmidt (1985) found supporting evidence for the proposition that there is a positive correlation between changes in managerial compensation and abnormal stock price performance. Therefore they conclude that managerial compensation plans tend to align the incentives of the managers with those of the shareholders. Loomis (1982) however claims that there is no link between managerial compensation and any measure of firm performance. This is explained by the fact that agency problems are a result of the management having monopoly access to the information required for the compensation plans. Besides, Coughlan & Schmidt (1985) mention that some argue that the boards are captives of the management and that these boards make the compensation decisions based only on the information supplied by the management. Ciscel & Carroll (1980) conclude that firm size in terms of sales is the only important determinant of the compensation plans and the performance in terms of profitability plays at best a minor role. Murphy (1985) presents evidence for the same conclusion. If the compensation is tied to the sales growth, the outside events that normally would affect the stock price will be excluded. Baumol (1967) asserts that firm size or growth is a more important determinant of managerial compensation as well. According to Baumol (1967) compensation plans link to these characteristics and the higher compensation comes with the greater prestige of large firms. Finally, Ozkan (2011) researched the effect of managerial remuneration on firm performance. His research included evidence from 390 listed firms in the UK. Ozkan (2011) concluded that there was a weak relationship between managerial remuneration and firm performance in the UK. This conclusion is the opposite of results of previous research in the USA. Conyon & Murphy (2000) allocate these different outcomes to the institutional and cultural differences between the UK and the USA. Besides, the compensation packages of CEO’s in the USA include more compensation in terms of bonuses and stock options. Jensen & Murphy (1990) researched the sensitivity of the pay-performance relationship and found in their research that there exists a
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positive relationship between pay and performance. However, this relationship is relatively weak and has declined over time. This is explained by the fact that political forces have imposed constrains on the upper tail of the earnings distribution, because of public disapproval of high rewards. In order to preserve the equilibrium in the managerial labor market, the lower tail of the earnings distribution has been adjusted as well. Moreover, Jensen & Murphy (1990) observed a declining pay level since the 1930’s, which they explain by the interference of political forces as well. Crawford et al. (1995) investigated the effect of regulation and deregulation on the pay-performance relationship in the banking industry. They concluded in their research that the relationship between managerial remuneration and firm performance became more sensitive in times of deregulation. Crawford et al. (1995) explain the increase in pay-performance sensitivity by the expanded opportunity set in times after deregulation. If the managerial remuneration is tied to performance metrics, then the CEO is encouraged to search for projects with a positive net present value (NPV). The projects with a positive NPV are beneficial to shareholders and therefore this is a possibility for shareholders to reduce the agency problems. (Crawford et al., 1990). Moreover Smith and Watts (1992) concluded that there exists an inverse relationship between the degree of managerial discretion and the degree of regulation. Thereby given that the research of Lanen & Larcker (1992) found a positive relationship between managerial discretion and pay-performance sensitivity, this corresponds with the finding of Crawford et al. (1995) that deregulation leads to an increase in pay-performance sensitivity.
3. Hypothesis Development
Davis et al. (2013) define the total compensation package of a manager with three including elements. First of all, cash compensation, which contains a base salary and annual bonuses. Moreover the package contains long term incentives; these may be stock options, deferred compensation or restricted stock. Finally there can be supplementary benefits and perks, which can for example be memberships, insurance, retirement plans and non-cash rewards. For the purpose of this paper, I have only focused on the first two elements of the compensation package defined by Davis et al. (2013). Firm performance can be defined in several ways. A broad definition is to what extent the organization is capable of making a profit. The profit can be measured by taking the revenue and decreasing this number with the expenses directly related to this revenue. In this case the firm performance has been measured as the net result from continuing operations. Practically this means to what extent the organization is capable of making profit with day to day activities. In this paper, the Return on
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Assets provides a good proxy for firm performance. Cheng and Farber (2008) used this proxy for firm performance as well. This gives an indication to what extent the firm is able to make profit with its assets and therefore this proxy is able to avoid the influence of firm size.
3.1. Hypothesis 1
In order to solve the agency problem, shareholders (principals) need to monitor the actions of the managers. Due to the information asymmetry problem, this is not always possible for the shareholders. Therefore they might try to align the interests of the managers with their own interests. To do so, the manager has to be given incentives to perform actions in the best interests of the shareholders. These actions have as consequence the incurring of agency costs. Given the outcomes of Lambert (1983) and Grossman & Hart (1983) the agency costs are minimized if the managerial compensation is tied to firm performance measures. By linking the managerial remuneration to firm performance, the shareholders are striving to motivate the manager to pursue a course of action to maximize the shareholder return (Davis, 2011). To do so, the compensation can be tied to a performance measure that benefits the shareholders as well.
3.1.1. Motivation
Financial incentives can motivate the manager to pursue goals that have been set by shareholders in order to maximize their own interest, because they will get an additional bonus or higher variable compensation if they perform well for the shareholders (Bonner & Sprinkle, 2011). Lawler (1971) concluded in his research that managerial compensation is one of the most important elements in an organization to motivate employees to increase their performance. Frijters et al. (2004) found in their research in Germany that, as with previous studies in other countries, the total income is a very important predictor of life satisfaction. Given these outcomes, the compensation package is an important motivation for the manager. The compensation package of a manager is generally a form of extrinsic rewards. These extrinsic rewards can have an influence on both extrinsic and intrinsic motivation. The extrinsic motivation comes from the potential rewards which can be received if a goal has been achieved. Moreover, the indirect motivation can flow from rewards which are being seen as a supportive or a competence confirming way (Gagné & Deci, 2005, Amabile, 1993)
10 3.1.2. Creativity
Managerial compensation can have another positive outcome as well, namely an increased level of creativity within the organization. According to the research of Eisenberger and Shanock (2003), an individual becomes more creative when they believe an additional reward can flow from being creative. This expectation can stimulate individuals to explore novel ways of carrying a task out. These novel ways can enhance the efficiency and effectivity of the task to be performed. The increased efficiency and effectivity can result in an improved individual performance. Eisenberger and Armeli (1997) found evidence that rewards which were given for simple or conventional performance in tasks lead to a decrease in creativity and therefore lead to uncreative solutions for conventional tasks. This corresponds with the expectation that superior performance and thus higher variable compensation leads to enhanced creativity and therefore better individual performance.
3.1.3. Competences
The managers’ compensation can also be based on several other measures, for example on the competences of the manager, the complexity of the role in the firm and the degree of responsibility that comes with the role in the firm. This means that a manager with higher compensation has more competences and is better able to oversee the complexity of the firm. Consequently, a firm with higher-paid managers should be able to perform better than a firm with lower-paid managers. This is explained by the fact that a manager with higher compensation has more competences and therefore this manager should be able to increase the efficiency and effectivity of the firm. Given the fact that firm performance is measured in terms of Return on Assets, the higher-paid manager should be able to increase the efficiency and effectivity of the use of the assets. This can result in the daily activities being carried out in a more effective and efficient way.
The composition of the compensation package of the manager can be an important contracting tool for the shareholders to direct the actions of the managers. The prospect of additional compensation can motivate the manager to strive for a better performance. This incentive can also enhance the creativity, because of managers searching for novel ways to perform tasks and thereby enhancing their performance. Moreover, managers with higher compensation should have more competences. These managers can enhance the firm performance by increasing the efficiency and effectivity of the daily activities of the firm.
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Hypothesis 1: Firm performance is positively related to the different types of remuneration of
the manager.
3.2. Hypothesis 2
In the Financial Times analysis of bank chief executives’ pay during the period of 2009 till 2014, it became obvious that bank chief executives’ variable remuneration for several banks in the EU is more than twice the base salary.8 This compensation structure wherein base salaries are relatively low and variable remuneration is heavily relied upon by managers has been sustained since a long time in the banking industry. The purpose of this compensation structure was to keep the fixed costs of managers under control and to give the managers additional bonuses in profitable years. Likewise the managers would receive a low variable remuneration in years with low profits. Since the financial crisis of 2008 the bonus culture in the banking industry has been a highly controversial subject. The bonus culture encouraged excessive risk taking at the expense of the shareholders and the health of the banks.9 Excessive risk taking can be defined as actions being taken in order to increase or decrease the assets of the company, but these actions are expected to have a negative impact on the value of the assets (Bebchuk & Spamann, 2010). Murphy (2012) concluded in his research that asymmetric rewards and penalties are the root causes of excessive risk taking. This means that good performance is rewarded with high compensation, while bad performance does not lead to serious penalties for failure. De Figueiredo et al. (2015) found in their research that excessive risk taking is an important cause for performance declines. Managers being under their incentive threshold will be taking excessive risks in order to achieve the threshold and thus obtain some variable remuneration. These excessive risks are not in the best interest of the firm and neither in the best interests of the shareholders.
The consequences of the financial crisis were clearly sensible for the CEO’s in the banking industry. As became clear in the remuneration analysis of Murphy (2013) (see Appendix 1), the variable remuneration, compared to the fixed remuneration, fell significantly. In order to deal with the serious shortcomings in the banking industry that were exposed during the financial crisis, the European Parliament imposed the guidelines of CRD IV, including new regulations having a direct effect on the compensation structure of risk takers. The most important consequence of CRD IV for the compensation structure was the cap on the variable
8 http://www.ft.com/ig/sites/2015/bank-ceo-compensation-2015/ 9 http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5328193/Bonus-culture-to-blame-for-banking-crisis-say-MPs.html
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remuneration. The guidelines of CRD IV imply that the variable remuneration of risk takers may not exceed 100% of the fixed remuneration, referred to as the base salary. This ratio can be extended to 200% with the approval of the supermajority of the shareholders. The most important objective of these new guidelines was to decrease the incentives of managers to take excessive risks. Moreover, the purpose of CRD IV was to reduce levels of remuneration that would be seen as excessive.
Murphy (2013) states that; as a consequence of the new regulations in CRD IV, the fixed remuneration will be increased. The increase in fixed remuneration is a direct consequence of the cap on variable remuneration as a reaction on the guidelines of CRD IV. Managers will have to compromise a part of their variable remuneration. To compensate for this, their fixed remuneration will be increased. Hence banking institutions will lose some part of their flexibility, because the salary costs will become a larger fixed expense (Murphy, 2013). Moreover, Murphy (2013) argued that under the old regulation, banks paid their CEO’s a relatively low base salary. In case of poor performance by the managers, the low base salary will function as a penalty for failure. Since the fixed remuneration will increase as a consequence of the regulations in CRD IV, the impact of a penalty in case of poor performance decreases. Consequently this will lead to more incentives for managers to take excessive risks, given the increased asymmetry of rewards and penalties. In addition the new regulation provides incentives to take bad risks, because the downside of these risks is capped at a higher base salary, and to avoid good risks, because the upside potential of these risks is capped at a maximum variable remuneration.
Well-designed bonus plans can motivate the manager to take actions that create value for the company by designing an effective link between pay and performance and therefore providing incentives to do so. The bonus cap, introduced by CRD IV, diminishes the opportunity of the board or the remuneration committee to provide powerful incentives for the manager to strive for a better performance. By limiting the variable part in the compensation structure, the sensitivity of the link between pay and performance has been reduced. Besides, compared to non-EU banks, the competitiveness of banks in the European Union reduces because of the limitations of CRD IV (Murphy, 2013). In bad years, EU banks are more likely to have lower profits than non-EU banks. While non-EU banks can pay their managers lower remuneration in bad years, EU banks are tight to the high expenses from fixed remuneration. Finally, the lower upside potential for remuneration can have a loss of talent as a consequence. All in all
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the restrictions for EU banks can result in a reduced level of creativity, flexibility and innovation.
The regulations of CRD IV had the objective to reduce the excessive risk taking of managers in the banking industry. However, the restrictions may have the opposite effect as a result. Through increased fixed remuneration and the asymmetry of rewards and penalties, managers might have the incentive to take excessive risks. Moreover the bonus cap can reduce the sensitivity of the link between pay and performance and reduce the competitiveness of the banks in the European Union. As a consequence, the performance of EU banks is expected to be negatively affected by the regulations of CRD IV.
Hypothesis 2: For banks in the EU, CRD IV adoption negatively affects the relationship
between managerial remuneration and bank performance. 4. Methodology
4.1. Sample and data
To test the hypotheses mentioned above, this study uses archival data. Data has been collected for all banks in the European Union for the period between 2008 and 2014, because of CRD IV only having an impact on the banks in the European Union. The data for the implementation of Basel III/CRD IV has been hand-collected by a group of six students. Ultimately the hand-collected data has been combined in a separate excel workbook. With regard to the data about the implementation of Basel III, we have consulted the annual reports of 2014 of all banks in the European Union. Subsequently it had to become clear in the corporate governance section whether the banks implemented the new guidelines of CRD IV concerning the remuneration of managers. Moreover we have searched for remuneration data of these banks and checked whether the variable remuneration exceeded the cap introduced by CRD IV. If this cap was exceeded, information about shareholder approval to extend the cap to 200% of fixed remuneration had been searched for.
The data concerning firm performance and managerial remuneration for the period between 2008 and 2014 have been collected from database ‘Bankscope’. In order to measure firm performance, I have collected data for net income and total assets. To calculate Return on Assets, the proxy for firm performance, I have divided the net income by total assets. To measure the different types of remuneration, first of all I have obtained data for the base salary, which accounts for the fixed compensation of the manager. Moreover I have collected
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data concerning the end of year bonus and the value of stock options. The variable compensation has been calculated by adding up these two amounts. In addition the total compensation has been calculated by adding up the fixed and variable compensation. At last the data for control variables has been collected from Bankscope. To calculate the leverage, I have collected data for total debt and total equity and I have divided the debt by the equity. The firm age has been accounted for by obtaining the year founded and subtracting the year founded from the corresponding years (2008-2014).
Ultimately, this resulted in a sample of 2469 observations. Investment firms were excluded from the total sample, because of these firms being subject to other regulations than Basel III. Moreover we excluded banks from which no remuneration data were available and banks that had no information about total assets, leverage ratio and firm age, resulting in a sample of 1782 banks from 18 different countries. Subsequently I have checked for outliers in the sample by winsorizing the data. All observations with a value of (mean +/- 3*Standard deviation) were corrected to the minimum or maximum value of that formula. Moreover, I have used a LN transformation for the different types of compensation and total assets (firm size) to reduce the impact of a skewed distribution.
4.2. Data analysis
In order to test the hypotheses, I estimated a regression analysis of managerial remuneration on firm performance using IBM SPSS. Subsequently I tested the influence of CRD IV on the relation between managerial remuneration and firm performance by using dummy variables. The dummy variables allowed for testing whether there have been differences in years before the implementation of CRD IV and the year after. The empirical model has been drawn upon the models used in Murphy (1985) and the definition given by Davis et al. (2013). Murphy (1985) used this type of empirical model in order to determine the remuneration of the manager. This empirical model is transformed the other way around in order to determine the performance, based upon the remuneration of the manager. Davis et al. (2013) defined the remuneration of the manager as the total compensation package including base salary, bonuses, stock and stock options. Therefore I include 𝑇𝐶𝑖𝑡 as total compensation in the empirical model. Moreover, CRD IV ( 𝐶𝑅𝐷𝑖𝑡 ) has an impact on the variable compensation of the manager and as a consequence the fixed compensation might be adjusted as well. Therefore I include 𝐹𝐶𝑖𝑡 and 𝑉𝐶𝑖𝑡 in order to measure for the impact of CRD IV.
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The empirical models are as follows:
𝑃𝑒𝑟𝑓𝑖𝑡 = 𝛼0 + 𝛼1 𝑇𝐶𝑖𝑡+ 𝛼2 𝐹𝐶𝑖𝑡+ 𝛼3 𝑉𝐶𝑖𝑡+ 𝛼4 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑖𝑡+ 𝜖 (1)
𝑃𝑒𝑟𝑓𝑖𝑡 = 𝛼0 + 𝛼1 𝑇𝐶𝑖𝑡+ 𝛼2 𝐹𝐶𝑖𝑡+ 𝛼3 𝑉𝐶𝑖𝑡+ 𝛼4 𝐶𝑅𝐷𝑖𝑡+ 𝛼5 𝑇𝐶𝑖𝑡 𝑥 𝐶𝑅𝐷𝑖𝑡+
𝛼6 𝐹𝐶𝑖𝑡 𝑥 𝐶𝑅𝐷𝑖𝑡 + 𝛼7 𝑉𝐶𝑖𝑡 𝑥 𝐶𝑅𝐷𝑖𝑡+ 𝛼8 𝐶𝑜𝑛𝑡𝑟𝑜𝑙𝑖𝑡 + 𝜖 (2)
4.3. Variables
4.3.1. Dependent variable
The dependent variable (𝑃𝑒𝑟𝑓𝑖𝑡) is the firm performance of firm i in period t, where Return on Assets serves as a proxy. Cheng and Farber (2008) used Return on Assets as a proxy for firm performance. By using ROA as a proxy, the influence of firm size as a predictor for either firm performance or managerial remuneration has been eliminated. Moreover, ROA gives an indication of how efficient the manager is making use of the assets of the firm in order to generate a profit. Higher paid managers should have more competences and should therefore be able to use the assets more efficiently than lower paid managers. Previous research used several other definitions of firm performance. Murphy (1985) for example used the return realized by the common shareholders as a measure for firm performance. This measure of firm performance has a significant disadvantage, as it is an imperfect proxy for the managerial effort (Gibbons & Murphy, 1990). The shareholder return is not only the outcome of actions performed by management, but there might be external events influencing the shareholder return as well. These events might be changes in inflation or interest rates or unexpected world events like natural disasters or terrorism. Other research most frequently used Tobin’s Q, Return on Equity and Return on Assets as proxies for firm performance (Lin, 2011). Li et al. (2015) use Return on Equity (ROE) as a proxy for firm performance. This reflects to what extent the organization is able to generate profit with the money invested by the shareholders. Aggarwal and Samwick (2006) use Tobin’s q to measure firm performance in their research. Tobin’s q is measures the assets of a firm in relation to the market value of the firm. Practically this means that if the Tobin’s q is between 0 and 1, it will cost more to replace the assets of the firm than the firm is worth. Dybvig and Warachka (2015) criticize that Tobin’s q does not measure firm performance, because underinvestment increases Tobin’s q rather than decreasing it. They show in an example that the Tobin’s q can decrease despite an increase in the net present value of the firm. Besides, to maximize shareholder value, the firm should increase its investments until the marginal profit is zero, so underinvestment will harm the
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shareholder of the firm. This ratio will give an indication to what extent the firm is capable of making profit relative to its total assets. Return on Assets can be used to give an idea about how efficient the manager is using its assets to generate profit.
4.3.2. Independent variables
The independent variable is the managerial remuneration. To test the influence of managerial remuneration on firm performance, I use three proxies for managerial remuneration. First of all I use the total compensation ( 𝑇𝐶𝑖𝑡) of the manager. The total compensation equals the fixed and variable compensation of the manager. Secondly, I test whether there exists an effective link between fixed compensation ( 𝐹𝐶𝑖𝑡) and firm performance. The fixed compensation equals the base salary of the manager. At last I test whether the variable compensation ( 𝑉𝐶𝑖𝑡) of the manager has an influence on the firm performance. This variable compensation has been measured by using the annual bonuses and the value of stock and stock options of the manager.
In order to control for other factors having an influence on firm performance, I have included several control variables in this research. First of all, the different years serve as a control variable in order to prevent the impact of fluctuations in the economy. Besides, the size of the firm serves as a control variable. In previous research by (Majumdar, 1997) it became clear that firm size had a positive effect on firm performance. This is explained by the standardization of procedures in the firm, which can lead to operations being exploited in a more effective manner. Moreover, firm size can be seen in the context of market power (Shepherd, 1986). Market power for example can allow larger firms to outperform in competitive pricing compared to smaller firms. These factors can allow larger firms to achieve superior performance to smaller firms.
Firm age has been included as a control variable as well. Loderer & Waelchli (2009) found in their research that firm age is negatively related to firm performance. This negative relation is explained by older firms generally have poorer governance, higher CEO pay and larger boards. Besides, Loderer & Waelchli (2009) explain this by the rigidity of older firms. This rigidity comes with lower growth percentages, lower R&D expenses and obsolete assets. Finally the leverage serves as a control variable. Previous research by Opler & Titman (1994) found that highly leveraged firms have a higher chance of getting into financial distress. This financial distress will come with significant indirect costs, eroding the performance of the
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firm. Moreover, high leveraged firms will have an increased chance of reporting an agency problem between shareholders and debtholders (Jensen & Meckling, 1976). This can result in higher agency costs and therefore in lower firm performance.
5.1 Results
In this section I analyze the results of the tests performed to examine whether the hypotheses can be accepted or should be rejected. First of all, the observations will be set out in a table in order to check the descriptive statistics. Subsequently a correlation table will be provided to check for an initial link between different variables. Further a regression analysis has been performed in order to check for significant relations between variables and for hypothesis testing. Finally I have performed some sensitivity checks to check for the robustness of the results.
Table 1: Variable definitions
Variable name Definition
ROA Return on assets, measured by dividing the net income by the total assets
TC (LN) Total compensation of the manager, is the sum of fixed and variable compensation. This amount has been transformed using the LN function in order to reduce impact of a skewed distribution
FC (LN) Fixed compensation of the manager, this equals the base salary. This amount has been transformed using the LN function in order to reduce impact of a skewed distribution VC (LN) Variable compensation of the manager, this equals bonuses and the value of stock options
that were received in that specific year. This amount has been transformed using the LN function in order to reduce impact of a skewed distribution
Firm Age Firm age, measured as the corresponding year decreased by the year wherein the firm was founded.
Firm Size (LN) Firm size, measured by total assets. This amount has been transformed using the LN function in order to reduce impact of a skewed distribution
Leverage The leverage or debt-to-equity ratio, measured by dividing total debt by total equity. CRD IV The influence of CRD IV (Basel III), included as a dummy variable wherein a 1 stands for the
years that CRD IV has been applied and a 0 stands for the years that CRD IV has not been applied.
Table 2: Descriptive Statistics
N Minimum Maximum Mean St. Dev
1 ROA % 1782 -8,28% 9,06% 0,45% 1,91% 2 TC 1782 20.000 85.807.185 14.941.635 20.004.875 3 FC 1782 0 46.929.002 6.667.438 10.040.710 4 VC 1782 -8.000 52.830.033 7.823.674 12.065.951 5 Firm Age 1782 16 542 123,12 80,62 6 Firm Size 1782 377 2.018.760 358.141 532.612 7 Leverage 1782 -65,51 91,44 16,70 14,47
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As described in the method section already, the observations with no value for remuneration, total assets, firm age or leverage ratio were excluded from the sample. All in all this resulted in a sample of 1782 observations. These observations serve as the total population for the hypothesis testing. As becomes clear in table 1, there are enormous differences in amounts of remuneration across banks in the European Union. Further analysis of the data highlights that the highest paid managers are leading the largest banks in Germany and the United Kingdom. On the other hand, managers of smaller banks are generally earning the lower amounts of the population. Moreover, it is remarkable that a big difference in the leverage ratio. The negative minimum leverage ratio is caused by the fact that some banks have a negative amount of equity on their balance.
Table 3: Correlation table
1 2 3 4 5 6 7 1 ROA % - 2 TC (LN) 0,17** - 3 FC (LN) 0,11** 0,62** - 4 VC (LN) 0,13** 0,35** -0,04 - 5 Firm Age -0,06* 0,03 0,06* 0,23** - 6 Firm Size -0,29** 0,14** 0,05* 0,01 0,03 - 7 Leverage -0,18** 0,10** 0,03 0,10** 0,10** 0,41** -
***, ** and * coefficients are statistically significant at the 1, 5 and 10 percent level.
Table 3 shows the correlation within different variables. The correlation table gives a first indication of whether there will be a significant relationship between different variables. As table 3 presents, there are significant correlations between the different types of remuneration and firm performance, measured by Return on Assets. The positive significant correlations suggest a positive relation between remuneration and firm performance and give a first indication of the acceptance of hypothesis 1. Moreover the correlations of firm performance with its control variables show a significant correlation as well. Remarkable is the negative correlation of firm size and firm performance. As became clear in previous research, firm size is generally positively related to firm performance. Finally, the correlation analysis tests for multicollinearity between variables. If the beta of the correlation between variables is higher than 0,7 or -0,7 there might be an issue of multicollinearity. This means that there is a high chance of one variable predicting the other variable based on the model. In table 2 it is obvious that there is not an issue of multicollinearity.
19 Table 4: Regression Analysis
Model 1 Model 2 Model 3 Model 4
Intercept 3,77*** -1,28 3,487*** 0,45*** Control variables Firm age -0,00* -0,00*** -0,00* -0,13*** Firm size -0,24*** -0,26*** -0,24*** -0,53*** Leverage -0,01*** -0,01*** -0,01*** -0,18*** 2008 -0,28* -0,18 0,05 0,03 2009 -0,17 -0,07 0,16 0,07 2010 -0,06 0,05 0,27* 0,11** 2011 -0,96*** -0,87*** -0,63*** -0,22*** 2012 -0,39** -0,32** -0,06 -0,02 2013 -0,33** -0,26 - - Main effects Total Compensation - 0,20*** - 0,31*** Fixed Compensation - 0,00 - 0,06 Variable Compensation - 0,04*** - 0,19*** CRD IV - 0,33** 0,09* Interaction (Moderation) TC x CRD IV - - - -0,05 FC x CRD IV - - - 0,01 VC x CRD IV - - - -0,01 R Square 0,11 0,17 0,11 0,17 Highest VIF 1,98 2,26 1,85 2,32
***, ** and * coefficients are statistically significant at the 1, 5 and 10 percent level.
In order to test the hypotheses, I have performed a linear regression analysis. This approach is generally known as the Ordinary Least Squares (OLS) method. In table 4 it becomes clear that there is a significant negative relation between firm performance and the control variables. The firm age is negatively significant on the 10 percent level, whereas firm size and leverage are negatively significant on the 1 percent level. The negative significant negative relationship between firm age and leverage and firm performance is consistent with results in previous research. However, the significant negative relationship between firm size and firm performance in contradicting with previous results. This negative relationship might be explained by the impact of the financial crisis of 2008 and the bigger banks suffering from higher losses. I have performed a sensitivity check for firm size in order to control for the impact of the financial crisis. Moreover I have controlled for influences from different years and thereby the influences of fluctuations in economy. In Model 1 2008, 2011, 2012 and 2013 are years with a significant lower level of firm performance than 2014. In addition, model 1
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has an R square of 0,11, which means that the control variables account for 11% as a determinant of firm performance.
In model 2, the different types of remuneration have been included in the linear regression analysis. It becomes obvious that total compensation has a significant positive impact on firm performance on the 1 percent level. Moreover the variable compensation has a significant positive influence on firm performance on the 1 percent level as well. Nonetheless, the impact of total compensation is much higher (0,20) than the impact of variable compensation (0,04). Finally, I have not found a significant relationship between fixed remuneration and firm performance. This might be explained by the fact that the total compensation takes all the significance for fixed compensation, because of the total compensation being the sum of fixed and variable compensation. I check for this explanation in a sensitivity check. In model 2 the control variables are again highly significant at the 1 percent level. In addition firm age is significant at the 1 percent level, contrary to the significance at the 10 percent level in model 1. Moreover, in model 2 it becomes clear that only the years 2011 and 2012 have a significant lower level of firm performance than 2014. The year 2013 is not significantly different than 2014 anymore. The R Square of model 2 is 0,17, which is 0,06 higher than model 1. The R square change of 6% reflects the significant influence of the different types of remuneration. Thereby given that the beta of the regression analysis is positive, I can conclude that firm performance is positively related to the different types of remuneration. All in all, hypothesis 1 can be accepted.
In model 3 I have included the impact of CRD IV on firm performance. Because of CRD IV being introduced in 2014, it serves as a dummy variable. In order to test for the influence of CRD IV, I have excluded year 2013 as well. In model 3 it becomes clear that CRD IV has a positive relationship with firm performance on the 5 percent level. This means that in 2014 the level of firm performance is significantly higher than the level of firm performance in 2013. Besides, the firm performance in 2010 was significantly higher than in 2013 and in 2011 the firms performed significantly worse than in 2013. Moreover it becomes obvious that Model 3 has an R square of 0,11. This implies that this model, including CRD IV, predicts 11% of the firm performance.
In Model 4, CRD IV has been included as a moderator variable on the relationship between remuneration and firm performance. Model 4 shows the significant positive relationship between total remuneration and firm performance and the significant positive relationship
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between variable remuneration and firm performance. Besides, model 4 shows the significant better firm performance in the year (2014) of CRD IV than in 2013. However, the interaction between the different types of remuneration and CRD IV show no significant relationship. This implies that there is not significant evidence for an influence of CRD IV on the relationship between remuneration and firm performance. Therefore I have to reject hypothesis 2. Finally I have performed tests concerning the multicollinearity between different variables by using the VIF. If the value of VIF is higher than 10, this indicates for a multicollinearity problem. In all of the 4 models, the VIF value is not higher than 2,32, therefore I can conclude that there is not a problem with multicollinearity in the models.
5.2 Sensitivity Checks
The results concerning the relationship between firm size and firm performance were not expected. Previous research found a significant positive relationship between firm size and firm performance, however in this research I find a significant negative relationship. A possible explanation for this negative relationship might be the financial crisis of 2008. The banks with a high amount of total assets may have been hit harder by the negative consequences of the financial crisis. Therefore these banks may have suffered from bigger losses than banks with a lower amount of total assets. To test whether the financial crisis caused the negative relationship between firm size and firm performance, I have excluded the data for 2008 and performed a linear regression with the remaining data. This resulted in a significant negative relationship again. However, the results concerning the relationship between the different types of remuneration and firm performance have not changed. Therefore I can conclude that the results are robust for the fluctuations in the economy, especially for the financial crisis of 2008. Besides, I found no significant evidence for a relationship between fixed remuneration and firm performance. The reason for this might be the inclusion of total compensation in the regression. The total remuneration equals the sum of fixed and variable remuneration. A significant positive relationship between total remuneration and firm performance can therefore induce a positive significant relationship between fixed and variable remuneration and firm performance. To test whether fixed remuneration is truly insignificant, I have performed a linear regression with fixed and variable remuneration as independent variables only. The results of this regression are that there exists a significant positive relationship (0,03***) at the 1 percent level between fixed remuneration and firm performance.
22 6. Conclusion
By relying upon a sample of more than 1700 banks in 18 different countries in the European Union, this study contributes to the vast stream of literature concerning the relationship between remuneration and firm performance. The results of this research suggest a significant positive relationship between remuneration and performance. The positive relationship can be explained by the remuneration being a powerful contracting tool for the shareholders in order to direct the actions of the manager. The financial incentive of an additional reward by achieving a target set by the shareholders can result in an increased motivation of the manager to perform in a course of action that is in the best interests of the shareholders (Bonner & Sprinkle, 2011). Therefore by using remuneration as a contracting tool, the interests of managers and shareholders will be more aligned (Khan et al., 2010). This study contributes to the literature by obtaining new evidence for a positive relationship between pay and performance. Previous literature found diversified conclusions concerning this relationship and therefore it was not possible to draw a universal conclusion. With the outcomes of this study, the positive effects of remuneration on firm performance have been sustained. Practically, this implies that shareholders can direct the actions performed by managers by composing a suitable compensation package for the manager.
Moreover, this study tested for a significant impact of a newly introduced regulation for banks in the European Union; the Capital Requirements Directive (CRD) IV. However a negative impact on the relationship between remuneration and firm performance was expected, the results of this study have shown that it is not possible to conclude for significant evidence concerning the impact of CRD IV. A possible explanation might be that only a small part of the observations consisted of banks with variable remuneration being 100% or more of fixed remuneration and therefore CRD IV only has an impact on these banks concerning the remuneration part. The number of observations of managers having a variable remuneration of 100% or more of fixed remuneration might be insignificant, leading to an insignificant impact of CRD IV.
There are some limitations concerned with this study. I have only included banks from the European Union in the sample, because of these banks being subject to the new regulations of CRD IV. Therefore it might be difficult to generalize the results to another sector or to another geographical area. Moreover, this study includes observations from all banks from 2008 till 2014. Given that CRD IV has been introduced in 2014, it might not be possible to
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draw a universal conclusion concerning the impact of CRD IV, because of an insignificant number of observations of banks that introduced CRD IV. Finally, the observations concerning the financials of the banks have been collected from the database ‘Bankscope’. Given the time constraints, I have not been able to hand-collect all data for the relevant banks. Consequently the data might consist of errors that have not been accounted for.
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28 Appendix 1
