Promoting Bank Stability through Compensation Reform: Lessons from Iceland

Abstract

This article argues that the program of compensation reform at financial institutions -despite recent wide-ranging changes -remains incomplete. A considerable body of theoretical and empirical research has been developed which, for the most part, suggests that compensation incentives embedded in compensation contracts at banks encouraged risk-taking behaviour which contributed to the Global Financial Crisis. Extensive reforms to compensation rules at financial institutions have been implemented across the globe, including increased use of deferral, mandatory capping of bonuses and the introduction of claw-back powers. Relying on observations on the failures of Icelandic and UK banks, and legal and economic analyses of compensation reforms in each jurisdiction, this paper argues that some elements of the Icelandic and UK reform programs ought to be transposed to the EU level. Arguably, these recommendations will help improve the resilience of the European banking system and contribute to greater financial stability.

Law, Culture and Sustainability

“…64 Regulators in Europe have responded to these findings by capping the incentive pay of bankers to 50 per cent of total pay. 65 The Icelandic public gained a rare inside look into bankers' allocation of credit, through the exceptional data privileges provided by a Parliamentary Special Investigation Commission into the causes of the total banking collapse in Iceland in 2008. 66 73 Cullen and Johnsen, ´Promoting´ systemically important institutions.…”

Iceland: how social mechanisms drove the financial collapse and why it’s a wicked problem

“…It was not until the system collapsed under its own weight that there was an incentive for action. Figure 4 (Matsangou, 2015; Cullen and Johnsen, 2015; Bergmann, 2014) shows how Iceland responded in the immediate aftermath. Starting from the system practice, the banks failed.…”

“…As a result of the crisis, bankers lost their position as the “darlings of the nation” and fell from grace in the eyes of the public who saw them as “greedy and reckless” (Jónsson, 2009, p. 203). In recognition that the reward system contributed to the excesses, there has been closer scrutiny of bank executives’ salaries, with new legislation restricting variable pay of bankers to 25 per cent of their total salary (Cullen and Johnsen, 2015). Importantly, banks were no longer able to print Krona, a function returned exclusively to the central bank.…”