George Osborne’s move to reject the bonus
cap proposal is a brave one. Brave but correct. He will receive a lot of stick
from a banker-bashing electorate, but by not succumbing to public pressure, he
has voted with the UK’s best interest at heart. A banker bonus cap is purely
political. Whilst it would win a lot of public approval, it would severely
damage the UK in the short, medium and long run. The only problem is that that
UK is isolated. Out-voted 26-to-1, a bonus cap is almost a formality unless
Osborne can gain some allies before the vote in April.
The bonus cap proposal is a result of the
European parliament trying to assert some authority as we move one step closer
to a banking union. The idea is to cap banker bonuses at 100% of base salary or
200% if shareholders agree. It is perhaps quite convenient that the news of a
bonus cap was quickly followed by RBS’s announcement of a £607m bonus pool
despite £5.2bn losses. Is it fair that a bank, which is 81% owned by the
taxpayer, should reward their staff handsomely for a 400% increase in losses?
Most of the EU says absolutely not, hence
the proposal’s overwhelming support. The UK however, whose financial sector
makes up 10% of its GDP and is the biggest hub within Europe, can see past the
political support to the catastrophic unintended consequences that will result.
So much so that the UK is even considering the ‘Luxembourg compromise’ from EU
law, which allows a member state to block a majority decision if it is against
national interest.
Why cap bonuses?
A common mistake is to think that a bonus
cap is about fairness and equality. Many would argue that obscene banker
bonuses need capping simply because they are unfair or need to be brought down
in line with the rest of the economy. This is simply not the case. Nations have voting, taxation and redistribution at
their disposal to alter income inequality and to determine how rich the rich
can be. If the reason were purely political then this is an entirely different
‘Hayek vs Marx’ debate. Neo-Keynesian economics and capitalism urge the state
not to intervene in competitive markets unless there is a market failure,
especially with a draconian policy such as a salary cap.
The reason for the cap proposal is because
there was a market failure. One of
the reasons for the financial crisis was too much risk-taking. As
explained before, it is the state’s role in a capitalist society to step in to
correct market failures. In this case, to prevent future recessions. The idea
is that extreme bonuses, many multiples of a base salary, lead to a
short-termism that encourages banks and employees to take on too much risk.
CEOs have very short life spans and bonuses distort their incentives. It is
thought that this short-term outlook and the search for better returns at the
expense of higher risk was a key factor in the collapse of the financial
sector.
So the argument follows that capping
bonuses would reverse these incentives, create longer-term goals and reduce
risk-taking. There is also the accountability argument that links back to RBS.
Bonuses are paid out even though the company is mostly state-owned and has
performed poorly. In this case, it seems sensible that the shareholders should
be able to prevent extreme bonuses. Until the bank is returned to private hands
or to profitability, there is an argument to say that bonuses are simply not
morally acceptable.
These arguments are fair. I do believe that
bonuses are extreme and sometimes ironically unjust. But a bonus cap is still a
bad idea….
Avoid a Cap
Vehemently opposing a bonus cap is the only
option the UK has. A bonus cap should only be introduced if it makes the
residents of the UK economy better off. If your arguing it should be done
because it involves some sense of retribution or punishment towards banks then
you’re a biting your nose off to spite your face. The reason being that a cap
will make the UK economy worse off and no more protected from a financial
crisis. (Also while we are at it, we should probably be punishing the
regulators, state, rating agencies and indebted consumers).
The reason for too much risk-taking in the
financial services industry is because banks are “too big too fail.” The
security of a bailout leads to a moral hazard that encourages too much
risk-taking. The bonuses in itself are not enough to create a risk culture and
are in fact a result of and not a
cause of the moral hazard.
The lead up to the financial crisis was a
period of low interest rates and a savings glut. In the search for better
returns, banks looked for new ideas. Securitisation was one of them.
Securitisation on its own is not a bad thing. In fact it allows companies to
reduce and hedge risk. However, this new invention was coupled with two other
factors. The first is a dangerous lack of knowledge of the products being
created from governments, consumers and even banks. The second is the
protection of a bailout. This lead to excessive risk-taking without any true
understanding of what was happening until ex-post. The point is that the
risk-taking in the financial sector is not originating from high bonuses. High
bonuses are just another result of moral hazard.
In fact, banks pay high bonuses in order to
stay competitive and attract the best talent. After all, the firm’s capital is
their staff’s ability. Whether you like it or not, this is the culture of the
industry. Unless a bonus cap is global, it will be hugely detrimental to the
UK.
Here is what it will do... It will drive
away talent in something called a brain drain. Over time, new financial hubs
will flourish such as Singapore, Hong-Kong, China and the US. As the best
talent moves away from London, the EU banking sector will lose competitiveness
and restrict EU growth. Are we really considering damaging our true comparative
advantage? We will be simply handing our competitors the golden snitch.
The only way UK firms would be able to keep
their staff is by enlarging base salaries many times over (allowing for bigger
nominal bonuses in turn). This is what happened with RBS. Restricted by the
taxpayer, a graduate joining RBS could earn up to £60K, much more than the
going rate at bulge bracket firms. So bonuses may not even reduce the amount a
banker will be paid. In fact, bankers will go home at yearend with the same
six-figure salary but with fewer incentives to do well. With pay a lot less
related to performance, you divert incentives in the complete opposite direction.
Bonuses also allow for flexibility which large base salaries do not. We have to
remember that banks are in the business of risk management. We do not
completely want to strip banks of the incentive to search for risk and return. It
is this search for risk that allows banks to loan to small and medium-sized
companies.
Here is another key factor. Even if bonuses
do encourage risk-taking, we are not immune to financial meltdowns from outside
of Europe as proved by this recession. If banks paying large bonuses outside
the EU cause excessive risk-taking and a global meltdown then that will hit the
UK. The world is far too globalised to believe that individual trading blocs
alone can prevent a global recession.
What should be done instead?
What needs to be done is to align the
incentives of bankers and the general economy. This can be done through
regulation. We need to remove the moral hazard of a ‘too big to fail’
mentality. This involves installing a set of rules that mean banks can cover
their losses and will find it hard to take on enough risk in the first place.
This is already happening. Basel III is the
new regulatory framework that has come down from the G20 (a global level). It
is currently being implemented in the EU. It involves increasing Tier 1 capital
level, improving liquidity and leverage. It has banned proprietary trading
(Volcker rule) and has proposed to ring-fence retails arms. Whilst I believe
the regulation may have gone too far, this is the sort of regulation that will
make banks robust enough to cover the losses of a recession or prevent it in
the first place.
If the EU cannot overcome the urge to alter
salaries within the industry, then there are methods other than a damaging
salary cap. For example, the remuneration code in the UK ensures banks must pay
at least 50% of bonuses in shares (or options), which creates a longer-term
employee view. It mandates that 40-60% of bonuses must be deferred for 3-5
years and also allows banks to legally claw back bonuses preventing future
negligence and inducing accountability.
These rules and the Basel III regulation
will prevent risk-taking over the new few years, perhaps even by too
much. Robust banks are less likely to fail and capital buffers mean banks will
absorb a lot more of the losses. The legislation is already in place and being
processed. An additional bonus cap is purely political. It will damage the UK
economy, restrict growth and make everybody worse off.
In a period where the UK is desperately
looking for growth, let’s not implement rules that will push talent away and
destroy our comparative advantage.
