Chapter 12: Reviewing Institution’s Remuneration Requirements: From European Legislation to German Implementation^☆

This chapter analyses the implementation of remuneration policies in German banking institutions starting from European legislation standards. The regulations are examined with respect to appropriate prerequisites of incentive-compatible remuneration systems.

The risk-taking behavior of the financial sector was an important driver of the financial crisis of 2007–2009.¹ Consequently, supervisors and banking authorities were required to develop effective rules for sustainable financial stability. For managers, excessive risk taking could be an incentive when profits and losses are rewarded asymmetrically. This means that managers expect high compensation payments related to short-term profits while losses do not necessary lead to negative rewards. From a scientific perspective, the moral hazard problem is induced by the behavior of managers and investors. Both profit from unlimited upside returns, while downside risk is limited due to government intervention. This is the case when institutions are regarded to be systemic relevant or “too big to fail.”² The problem of moral hazard could be solved by implementing systems that are able to control management activities. Implementing and operating systems would cause agency costs. A number of papers have analyzed the impact of moral hazard, for example, Jensen, M.C. and Meckling, W. H (1976). Authors investigate the general nature of “agency costs generated by the existence of debt and outside equity.”³ In the case of the financial crises where losses are socialized and tax payers had “to pay the bill,” a significant reduction of social welfare is the consequence. In the case of systemic relevant institutions, excessive protection payments could destabilize economies and increase the risk of government illiquidity. To avoid this scenario, clear rules of banking supervisors help to insure the safety of the financial system. Although this causes agency costs, the implementation of rules can be expected to be significantly cheaper than costs induced by the retrieval of an insolvent major institution. Consequently, banking supervisors started to develop and implement prudential rules on an international level. For example, the Basel Committee on Banking Supervision (BCBS) defines Compensation Principles and Standards Assessment Methodology in 2010 (BIS, 2010), which can be regarded as recommendation for banking systems worldwide. The European Parliament and Council has adopted remuneration policies (EU Directive, 2013), namely Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (CRD IV). European standards are subsequently implemented into German legislation via legal acts, denominated as Regulation on the Supervisory Requirements for Remuneration Systems in Institutions (“Verordnung über die aufsichtsrechtlichen Anforderungen an Vergütungssysteme von Instituten – InstitutsVergV”).