It is not surprising that such a law would prove politically popular – a similar but even broader initiative in Switzerland received 68% of the votes in a referendum this past weekend. After all there are far more non-bankers than bankers and financial institutions in Europe and the US have not exactly covered themselves in civic glory across the financial crisis large trading losses and LIBOR-rigging sanctions-evading and money-laundering scandals. However if popular appeal is to be the measure of financial policy making then I would propose draft legislation requiring the ECB to deliver a one kilo gold bar to each non-banker in the 27-member Union.
It is said that bankers are "overpaid" and that the nature of their bonus compensation drives them to take wild risks with the capital of their institutions and thereby put the savings of ordinary citizens and the finances of national treasuries at risk. Experience over the past five years has indeed suggested that many financial institutions were able to "privatize the gains but socialize the risks." However this to me supports the case for higher capital requirements firewalls to protect depositors enhanced oversight and trading rules for derivatives and even rules requiring clawbacks and deferred equity payouts. It does not make the case for caps on bonuses unless the purpose is not promoting a more sound financial system but either societal revenge for bad banker behavior or a Continental stitch-up of the City of London.
First let’s look at the issue of whether bankers are “overpaid.” What does this really mean? Overpaid relative to the tellers (if any remain) in the bank? Relative to teachers firemen or other professions of perhaps greater societal value? I could get comfortable with such claims if applied consistently across all endeavors. Thus are Lady Gaga Tom Cruise and Wayne Rooney not similarly overpaid? While these individuals no doubt possess good performing or sporting talent can it really be said that their contributions to society are worth millions? Are they more deserving? Do they work longer hours? I think not. They are simply the beneficiaries of specialized labor markets in the entertainment and sports industries. While it is true that a Rooney scoring slump is unlikely to cause a global financial meltdown neither do I believe that capping bonuses are the best means to reduce systemic financial risk and protect small account holders.
Second let’s look at the form in which compensation is delivered. Banks have traditionally paid most of their professionals a large portion of their total compensation in the form of variable pay (bonus) not salary. This has the virtue of not burdening the institution with high fixed costs during weaker periods and paying their top performers more than their weaker ones. So for example if a star banker can bring in $25 million in business for the year would shareholders begrudge paying her 10% of the revenues and keeping the other 90%? Under prevailing practice such a banker is usually paid a base salary between $200000 and $400000 per year; however if her bonus is now capped at one times base she cannot be paid more than $800000 under the new law. The immediate answer is to raise her salary to $1000000 and then she can be paid total compensation of between $2000000 or $3000000 (if shareholders approve). However this leads to two unintended consequences. First if the banker in our example has a bad year and only brings in $5000000 in business we will have grossly overpaid her in salary for weak performance. Second we will have driven up the fixed cost base of the bank and in the event of a downturn the firm will have little choice other than to make deeper job cuts even if this is not in the interest of the bank its shareholders or our banker.
Finally my issue with the proposed bonus cap approach is that it will drive economic activity away from the regulating geography and away from banks into the large shadowy world of non-bank banks such as hedge funds. While the proposed EU legislation is intended to apply to the worldwide operations of EU domiciled banks and to the operations of foreign banks in the EU it still leaves many institutions out of its ambit. So for example a Hong Kong based trader for Bank of China could be paid a 500% bonus but his counterpart across the street at HSBC in Hong Kong would be limited to no more than 200%. How long do you think it will take for our trader to cross the road? How about HSBC itself? Have we forgotten that this mighty UK headquartered institution is after all the Hong Kong and Shanghai Bank? How long until it repatriates? Pity that the Prime Minister exhausted his goodwill in Brussels with his December 2011 veto of the Euro treaty rather than a fight such as the current EU attack on the primacy of the City – a set of rules which will actually hurt the UK economy.
A larger problem with the proposed EU legislation is that it only purports to cover “banks.” However there are thousands of “non-bank banks” making loans trading derivatives and making markets in over-the-counter securities among many other bank-like endeavors. The London based colleagues of our HSBC trader need only drive from Canary Wharf to Mayfair to join a hedge fund and be compensated freely. While it is true that hedge funds by and large do not serve small depositors their investors do include the pension funds in which many ordinary workers participate and if protecting depositors and the public treasury is the goal there are as argued above better ways than compensation controls to meet these policy objectives.
The only good thing I can think to say about the new EU bonus-capping legislation is that it will serve as a stark reminder to other industries of the need to police their own houses lest they wish to let the politicians in to botch the job for them.
