It Looks Like Europe Will Do The Unthinkable To Banker Bonuses

Europe looks set to limit bank bonuses

LUXURY-CAR dealers in London and posh estate agents in Paris must be spluttering. It looks increasingly likely that demands by the European Parliament for a limit on bankers' bonuses will become law. The parliament wants bonuses to be no higher than their salaries (or double their salaries, if three-quarters of a bank's shareholders agree).

That limit may yet be watered down in negotiations between the parliament and the EU Council, which consists of European governments. But the principle of a specified cap seems to have been accepted, despite opposition from Britain. Other European governments are keener to ensure new capital rules get passed--the bonus proposals have been appended to the directive implementing the Basel 3 rules--than to stand up in public to defend bankers' pay. "The British government understands they are walking a fine line between appeasing the masses and chasing business out of town," says a senior investment-bank executive. "Unfortunately they have to toe the line" if the statute passes.

The logic of capping bonuses looks appealing. Lavish payouts may create an asymmetric bet for bankers. If they take a big gamble that pays off, they get a huge bonus. If it goes horribly wrong, they face only limited downside. Sony Kapoor, a former banker who now runs Re-Define, a think-tank, says the cap will "help tackle the culture of excessive risk-taking and the bending of rules that has now become endemic to banking".

In fact, there is surprisingly little evidence to show that big cash bonuses lead to increased risk-taking or that capping the ratio of bonus to basic pay would reduce it. Rather, a cap on variable pay risks driving up fixed salaries as European banks seek to compete for talent with foreign and non-bank rivals.

A higher fixed-cost base would weaken the link between pay and performance. It would also limit banks' ability to cut costs in a downturn. Pay has come down sharply since the financial crisis, partly because higher capital ratios have reduced the profitability of banks. CEBR, a consultancy, reckons that the total bonus pool paid out to London-based bankers in the current pay round will fall to about £1.6 billion ($2.5 billion), down from a peak of £11.6 billion in 2008. That sort of flexibility is useful if you want banks to preserve capital in a crisis.

Bankers also argue that a lot has been done to pay structures to align the interests of employees and shareholders. The deferred portion of bonuses is much bigger than it was; this money can be "clawed back" if the bank subsequently does badly. Some firms are rewarding employees with subordinated debt in their own institutions, meaning they will take a hit if the bank goes bust. Unsurprisingly, the politicians in Brussels are paying little attention.

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