By the Blouin News Business staff

Caps not in fashion among London’s high-earning bankers

by in Europe.

london-skyline

Photo Credit: Getty Images/Peter Macdiarmid

London’s bankers are thumbing their noses at proposed new E.U. caps on bonuses due to be brought in next year. These would limit bonuses for European bankers earning a basic salary of €500,000 ($680,000) a year or more to the same as their basic salary — or twice that salary, if given explicit shareholder approval.

Newly published data from the European Banking Authority (EBA) shows that in 2012, investment bankers in the U.K. — where three-quarters of Europe’s bankers who earn more than €1 million a year work — had an average bonus-to-salary ratio of 370%. This is up from 350% in the previous year. In France, the ratio was 495%. In Germany, which has the second-highest number of top-earning bankers after the U.K. (212 vs the U.K.’s 2,714, 2,188 of which were investment bankers), the ratio was 211% — the only big European economy anywhere close to the proposed E.U. requirement. (Full list of country-by-country data available here.)

The banks that employ these high earners and the regulators drafting the rules governing their compensation are playing a game of whack-a-mole. In response to the caps, banks are raising basic salaries and drawing up plans to pay monthly allowances on top of salary, which will not, at least as yet, count as bonuses. The regulators continue to adjust their draft proposals. At the same time the banks are bemoaning that the caps weaken the link between performance and pay, and threatening to move their payrolls to Asia.

The rationale for the E.U. introducing remuneration caps was to prevent excessive payouts and curb irresponsible risk-taking, mixed with a dose of post-2008-global-financial-crisis populism. Behind that, though, lies the innocent assumption that bankers act rationally to make themselves richer and the less rich they can get the less incentive there will be to take risk. It is the second half of that premise that is upside down.

The problems with the assumption are:

  • first, that the risks associated with many of the innovate financial products with which bankers now make large sums of money are adequately known. They are not with sufficient precision. That was a painful lessons of the 2008 financial crisis. Banks’ risk management has improved since, but it has not improved that much — witness the ‘London whale’ trades;
  • second, the availability of nearly free money from ultra-expansionary central banks provides the leverage to vastly expand the potential upside of banks’ bets. It doesn’t take much to up the ante when the betting chips are free;
  • third, thanks to government backstops for the biggest banks, the downside of failure is negligible in an ever-more-concentrated sector of financial services, i.e. among banks deemed too big to fail. In the U.S, the six largest banks now account for two-thirds of U.S. banking assets.

The EBA wants bankers’ pay to “provide an incentive for prudent and sustainable risk taking.” Making less money than they otherwise could is not what most bankers or banks understand by “incentive”. The competition for the best talent among investment banks in particular is fierce. Global banks, long practiced at skirting national rules and regulations, will find ways around those governing pay for a long as they deem it profitable to hire and retain the top performers.

Mandatory pay restraints rarely work at any level of an economy. If the demand for labor is there, it will find a way to pop up somewhere. The Clinton administration’s imposition of a $1 million cap on executive salaries in the early 1990s led to an executive stock-options boom later in the decade. The unintended consequence was an expansion, not a reining-in, of executive compensation — not to mention a loss of income tax revenue to the federal government because of the explosion in non-cash compensation.

Taxation is a better-proven mechanism of economic incentive to change behavior than pay caps. However, the E.U. can’t resort to direct taxation as a national government could, though even a national government might find it difficult to single out a particular subset of high earners for punitive taxation. If the E.U. wants to set rules to make bankers be more prudent in their risk taking, it would be better off abandoning bonus caps and making banks align compensation with long-term performance and not paying bonuses until that long-term performance has been demonstrated. One way (for employees of publicly-listed banks, at least) would be to require all remuneration above a given threshold to be paid in stock that doesn’t vest until at least the current business cycle is past.