Brexit took effect five years ago and last year the UK’s financial authorities lifted the EU-created cap on bankers’ bonuses, in an attempt to increase competitiveness. Rukaiyat Adebusola Yusuf and Mamiza Haq examine the impact of executive pay restrictions and high CEO compensation on bank performance. They write that the UK will continue to face the challenge of balancing regulation and competitiveness.

In August 2024, Barclays lifted the cap originally imposed by the European Union on bankers’ bonuses. The move followed an earlier decision by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) to “remove the existing limits on the ratio between fixed and variable components of total remuneration (the bonus cap)”. This marks a significant shift in the regulatory landscape of the UK financial sector post-Brexit, potentially opening the way for banks to revert to more traditional bonus structures.

The EU introduced the bonus cap in 2014 in response to the excessive risk-taking that contributed to the 2008 financial crisis. That crisis led to unprecedented government interventions in the financial sector particularly in the UK, where two banks became effectively state-owned. The government had to acquire 43 per cent in Lloyds Banking Group and 84 per cent in Royal Bank of Scotland (now Natwest) to halt their near collapse.

The UK Turner report had suggested in 2009 that the structure of executive compensation played a role in the financial crisis. The belief that executive pay needed reform due to its role in the crisis influenced the terms and conditions of the UK rescue plan.

Rescued banks were required to sign up to Financial Services Authority (FSA) agreements on executive pay and dividends. Additionally, regulatory reforms such as the Capital Requirements Directive (CRD IV), which included the bonus cap and the FSA remuneration code, were introduced to address the structure of executive compensation. The cap that limited bonuses to 100 per cent of fixed salary, or 200 per cent with shareholders’ approval, was an effort to align bankers’ incentives with long-term stability rather than short-term gains.

In our research, we examined the effect of restrictions on executive pay and high CEO compensation on bank performance following the “2008 UK bank rescue policy”. We hypothesised that, by removing the financial incentive to perform, executive pay restrictions negatively affected the performance of rescued banks relative to non-rescued banks. And indeed, this is exactly what happened.

After the rescue, executive compensation was restructured. In 2014, banks introduced a new fixed pay component in executive compensation packages in response to the bonus cap. Although banks have used various terms such as role-based allowances, fixed share award, fixed pay allowance and fixed share allowance, their goal was the same: to provide competitive rewards globally.

This new fixed pay circumvented the regulatory requirements and rewarded executives handsomely, even in the light of deteriorating performance. And it did not exclude rescued banks who were subject to further restriction on their executive compensation as a condition for their rescue.

Our research found that 11 years post-rescue the relationship between executive compensation and performance in rescued banks was weaker than in non-rescued ones. Perhaps executives of rescued banks were not being held accountable by virtue of being bailed out in the first place. The main motivation for bank executives is their pay. If compensation remains unchanged despite poor performance, it could exacerbate the agency problem and increase moral hazard.

This, combined with “gratuitous goodbye payments” to departing chief executives despite poor performance, could signal to incoming CEOs that there is little incentive to perform well, further exacerbating agency problem.

In fact, we observed that executives in banks that were not rescued reacted more favourably to increased compensation levels following the bailout period. They had to be more accountable to the shareholders who provided additional capital during the crisis, which meant the government did not need to intervene.

Although the government disposed of its remaining stake in Lloyds Banking Group in 2017, it still owns 22.5 per cent in Royal Bank of Scotland (now Natwest) 15 years post-rescue. Given our research findings, which indicate that rescued banks did not significantly alter their business models post-rescue and perhaps continued to make inefficient decisions, the removal of the cap could exacerbate existing issues.

If all banks follow Barclays’ lead, it could result in increased risk-taking and further misalignment of incentives, potentially undermining the stability achieved through the 2008 rescues. The collapse of large banks could trigger a domino effect, resulting in a systemic crisis.

Governments, therefore, face a dilemma: they must balance the need to prevent such crises with the desire to avoid encouraging excessive risk-taking behaviour. This situation underscores the importance of strong regulatory frameworks to manage these risks and prevent similar scenarios in the future.

Thus, the lifting of the bonus cap is likely to have a significant impact on CEO compensation. Without the cap, banks may offer higher bonuses to attract and retain top talent. This could result in a shift in the balance between fixed salaries and variable bonuses, with a greater emphasis on performance-based pay.

The Prudential Regulatory Authority indicated that lifting the cap could also remove its unintended consequences such as the new fixed element of pay introduced by banks. However, the risk remains that this change could encourage the kind of risk-taking behaviour that the cap was designed to prevent.

The long-term effect of lifting the bonus cap on the UK banking sector remains to be seen. While it may enhance the sector’s global competitiveness, it also raises questions about the potential for increased risk-taking, increased compensation levels and its impact on financial stability.

Navigating the post-Brexit economic landscape, the UK will continue to face the challenge of balancing regulation and competitiveness. As the financial sector adapts to these changes, it will be crucial to monitor the impact on both the industry and broader economic stability to avoid invoking the tacit “too-big-to-fail” (TBTF) policy.

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• This blog post  is based on CEO Compensation and Banks’ Performance Following Bank Rescue, in the International Journal of Managerial Finance.
• This post represents the views of its author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
• Featured image provided by Shutterstock.
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