Why the EU’s bankers’ bonus cap will make banks safer and richer


10:55 am - March 4th 2013

by Left Outside    


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It looks likes bankers bonuses are going to be capped at twice their base salary. As reported in the Financial Times (£), banks will be able to offer double this with explicit shareholder approval and there are various other schemes in the offing to subvert this regulation, but the brute force of this regulation means that big change is coming to bankers’ remuneration.

I agree with Martin Wolf that this is a political clusterfuck in the making for the Tory Party. Defending bankers bonuses? Good luck with that in 2015. But the big story here is that this regulation has the potential to really improve bankers’ incentives and the productivity of the whole sector.

The most promising scheme to circumvent this bonus ban is to replace it with vast base salaries and subject to strict clawback provisions. A rather smug sounding fictional letter in Lex puts it so:

Your fixed, cash salary will be increased from €500,000 to €10m per year…to be paid monthly into an escrow account. At year-end, you are entitled to the balance of your cash salary in the escrow account subject to strict clawback provisions detailed in this contract…

Theoretically this should produce precisely the same ex post payments and ex ante incentives that bankers currently enjoy (and we endure). The escrow account will be an accounting reality but an economic fiction. Meet the new system, same as the old system bankers will be told.

But, this misses a lot of the vital psychological differences between bonuses and fines. A bird in the hand is worth two in the bush is just folk psychology justification of endowment effects. This is how airlines get people to pay extra charge after charge while their booking. Once you have that plane ticket in your basket its “yours” and there is a psychological cost to giving it up.

The money in bankers’ escrow account is this plane ticket and this set up will produce a different set of incentives. Will this incentive structure improve the operations of the banking system? I would suggest it will. Chris Dillow pointed to research two years ago from the University of Nottingham which suggested that fines provide better incentives than bonuses.

Economists got subjects to play an inspection game. This comprises two players – an employer and a worker. The worker can choose either high or low effort. The employer chooses whether to inspect the worker’s effort or not. Both inspection and effort are costly… The result of this experiment were clear. Fines induce more effort than bonuses. The joint earnings of bosses and workers were 18.6% higher in the fine experiment than in the control one, and 18.1% higher than in the bonus one. Bosses’ earnings in the fine experiment were 36.5% higher than in the control test, and 80% higher than in the bonus test.

One of the leading contributors to the economic fragility which led to this little depression was excessive risk taking, outright deception, fraud and opacity in the financial sector because bankers were able to extract a huge amount of the surplus from the activities of banks. Realigning incentives so that banks can control their employees and run more safely is in everyone’s interests.

The costs of this to the financial sector are pretty clear. Let us look at AIG’s share price:

AIG collapse

Whoops!

The pollution that is excessive risk taking in finance then appears to have an answer, changing remuneration away from bonuses and towards fines. It is in the interest of both those who own banks and those who bail them out.

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About the author
Left Outside is a regular contributor to LC. He blogs here and tweets here. From October 2010 to September 2012 he is reading for an MSc in Global History at the London School of Economics and will be one of those metropolitan elite you read so much about.
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Reader comments


1. Luis Enrique

surely it depends on what targets the claw backs (fines) are tied to. If it’s the same short-term trading profit as bonuses are currently based upon, and you’re saying fines are even more powerful than rewards, it sounds like this will make the problem of bankers doing anything in the pursuit of profit even worse.

plus, whilst the psychological effects might be meaningful, if we still end up with bankers getting paid billions, I think we can object the main problem still hasn’t been addressed.

imho, leaving the basic nature of banking unchanged whilst trying to legislate away high pay, is likely to fail. Although I don’t see why legislation cannot be in terms of total remuneration rather than this laughably easy to circumvent rule.

There are perhaps two problems here. One, the general ability of senior executives in large corporations to pay themselves crazy money – this isn’t just true of banking, but applies across the board. And then secondly, the particular nature of banking, which is rather like, say, the nature of professional football – individuals with very high bargaining power in a big stakes game. Individual traders and corporate financiers etc. really can make tens of millions for their employers and really can threaten to take that business to a rival if they are not paid a large enough slice of it, so I reckon unless we can figure out how to change that fundamental truth, we won’t really change anything.

(or maybe somebody could actually come up with some kickass impossible to dodge pay legislation)

Good article – interesting about fines inducing more effort than bonuses. Not altogether surprising though, do we really think that this is ever going to happen?

Nonsense I’m afraid.

All it’s going to do is increase banker’s basic salaries, and make it much harder to banks to cut costs in the event of poor performance. It’s also likely to cost jobs, as banks are forced to hire fewer but much higher paid staff.

As for risk-taking; it might reduce that, as bankers are effectively paid a lot more as a basic salary, so are less incentivised to chase larger profits to make better bonuses. My guess is they will simply work until they make enough money for the bank to hit their individual bonus caps, then stop doing anything for the rest of the year. The downside to this though is less profitable banks and less taxes for the government.

What is also very likely to happen is that a lot of the parts of the industry which are used to small pay/large bonuses will simply migrate to different countries which don’t enforce this legislation, or to different but related industries like the hedge fund industry.

4. David Ellis

Abolish the thieving banks. Today’s papers are full of the fact that wages have declined spectatularly since the 2008 bail out and on the same day HSBC announces record profits and obscene bonuses for its speculating staff. The two are related. QE is being pumped into the banks to bail them out. Much of this is going to the bankers’ billionaire creditors whilst the rest is being used to create a stock exchange bubble to boost profits and bonuses. All of it is destroying the value of the pound and rendering valuless our wages, welfare and public spending only so that eventually this bubble will burst.

Not content organising murderous Mexican drug cartels, sanction busting, manipulating interest rates and quadrupling the national debt over night when their 30-year counterfeit Ponzi Scheme collapsed overnight they are now cheating the nation’s creditors through QE but mostly its citizens who hold and are paid in an ever debased currency.

Those bonuses are not just obscene in and of themselves but they are being taken directly out of the pockets of working people, the poor, the sick, the young, the old, the disabled. Bankrupt capitalism now that growth is impossible is exposed as a zero sum game.

If the bankers the bonuses!

The bankers the bonuses!

It’s disgusting!

And secondly, if the Tories were really serious bout it they would tax the bankers the bonuses at 90 per cent.

http://www.youtube.com/watch?v=p3tUqRBiMVo

6. Luis Enrique

Tyler you didn’t read the OP did you. See the bit about “precisely the same ex post payments and ex ante incentives that bankers currently enjoy”. Understand it?

@ David Ellis

You are case in point regarding this issue. You know nothing about banking or finance, apart from the nonsense peddled in the left-wing press. Any yet you think this gives you a platform to demand changes.

“QE is being pumped into the banks to bail them out.”

No, this is the BoE trying to increase the money supply and promote lending and increase credit.

“Much of this is going to the bankers’ billionaire creditors”

No, the benefit of QE is primarily going to the government in keeping their borrowing costs down. The biggest losers are pensioners, followed by banks – both of whom are suffering lower returns because of low rates.

“All of it is destroying the value of the pound”

QE and excessive borrowing is doing that, not banks.

“manipulating interest rates and quadrupling the national debt over night when their 30-year counterfeit Ponzi Scheme collapsed overnight”

Again, it’s QE which has been the biggest manipulator of interest rates, and the national debt has been increased through government spending – nothing to do with the banks.

@ Richard W

Not sure if yoou are being serious but…let’s assume you are (and apologies if not);

“And secondly, if the Tories were really serious bout it they would tax the bankers the bonuses at 90 per cent.”

You can try what France is currently doing, but then they will simply up sticks and move elsewhere. Indeed, most banks already have a contingency plan for this. That neglects the huge amount of support industry surrounding finance which would also shrivel up and die.

Which means some or all of the massive amount of tax paid directly and indirectly by the finance industry would also be gone. Estimates are between 9% and 17% of all taxation are tied to finance.

So by all means, encourage policies that chase the finance industry out of the UK – there will be plenty of other countries to welcome it with open arms – but then don’t sit there crying when you realise there suddenly isn’t any money to pay for your precious government and welfare spending.

@ Luis

The ex/post system described above is unlikely to materialise except for the highest paid staff – board level etc. The reasons being the difficulty of implementation (it’s very difficult to arrange fair clawback procedures accross all the myriad of different jobs within a bank) and also for tax reasons…if a banker gets paid, he will pay tax on that money. If that money is then clawed back, he would be able to claim the paid tax back. That system would quickly degenerate into a massive deffered asset/deffered tax problem both for the banks themselves and HMRC.

So in theory the ex/post system could happen, but it’s unlikely. What’s a lot more likely to happen is the simplest option – where a banker’s total pay (salary + bonus) from previous years is roughly calculated, halved and that awarded as a salary. I’d also expect some sort of deffered bond/equity scheme to remain to bump bonuses past the cap, as weel as offering the chance for staff retention via deffered pay and clawbacks.

I probably should have spelled that out before jumping to the second stage of the argument though.

9. Northern Worker

I think you’ll find that this suggestion must be a bit of kite-flying. It is surely illegal under the various EU treaties to ‘fix’ anything. It strikes at the very heart of free trade, free movement of labour, etc. Please correct me if I’m wrong and the EU does have the right to fix the wages of anyone in the 27 states.

Besides, as Left Outside says, it wouldn’t take the bankers more than five minutes to get round any regulation. And if they can’t they’ll just leave for Dubai, Singapore, Shanghai …. Much as we hate them, we’ll miss the (what?) 14% of GDP contribution and all that lovely tax.

10. David Ellis

Tyler: you are an ideologue of the Tory Party and the banks. Why do you troll here? We can read your regurgitations in the Daily Telegraph or the Mail.

The bail out of the banks has added at the very least the hilarious sum of £6.7 trillion to the national debt thanks to idiot politicians in their pockets. This is being paid for by 1. Austerity, 2. Printing money and 3. Lending to the bankrupt banks at 0.5% so they can lend on at 10, 15, 20%, pay their creditors and speculate on the stock exchange for fake profits and bloated bonuses. It is the debts of the banks that are prioritised because the people who bought into their Ponzi Scheme of counterfeit bonds were mainly the bloated billionaires and millionaires who couldn’t make a profit by investing it honestly.

Get this straight: QE is going straight into a stock market bubble via the banks and their bailed out creditors. The inflation is causes is destroying the value of wages, welfare and public spending whilst the bankers pay themselves fat bonuses and the billionaire speculators are paid out by the public on their losing bets.

11. Mediastinum

@ David Ellis

‘Tyler: you are an ideologue of the Tory Party and the banks. Why do you troll here?’

I suggest it might be because he is paid to.

12. Northern Worker

@11 and 12

The debate would be the poorer for Tyler’s absence. When it comes to the world of finance he seems to know his stuff.

13. Luis Enrique

It’s more likely David Ellis is paid to comment here by some right wing mastermind who wishes to discredit the left.

@10

Please provide a breakdown of this £6.7 trillion added to the national debt. Very interested to see this!

Have you seen how much bonuses in the financial sector have reduced since the financial crises? i suggest you look it up.

The banks should have been left to fail. Unfortunately the previous government (supported by most opposition MPs as well) chose to bail out the banks. They believe the public would not want the ensuing chaos and they are probably right.

In any event, the bonus cap is probably illegal under the Lisbon Treaty. 153 (5) expressly states that pay is beyond competence of EU. Shame, but back to drawing board.

How quite so many MEPs failed to read their main governing document is beyond me, mind. It’s not even that long.

16. Mediastinum

@Northern Worker

‘The debate would be the poorer for Tyler’s absence.’

We must looking at different websites.

Also I think using the term debate to describe what generally goes on here is abusing the word. Sort of like saying the graffiti in public toilets is equivalent to the library of congress. If anyone expects more than mudslinging and unmovable opinions they will be disappointed.

17. Mediastinum

We must BE looking at different websites. sigh….

@ 10 David Ellis

“The bail out of the banks has added at the very least the hilarious sum of £6.7 trillion to the national debt”

The national debt stands at 1.114 trillion according to the ONS. A quick google search could have told you that. Makes you look pretty stupid to say otherwise.

For your information (not that you’ll believe me, I’m guessing) the NAO estimate that bank bailouts have cost the UK about 10-12bn. Not a small sum, but certainly very small in comparison to the net national debt. This money is principally tied up in RBS – the larger sums in the initial bailouts were short term loans which were repaid years ago.

I’m not going to bother arguing the rest of your points because 1. You’ll ignore me and simply revert to spouting make believe 2. I don’t think you really care 3. I’m hungover.

@ 11 Mediastinum

Yes, I make all my money by being paid to comment on LC. There is a huge right wing conpsiracy of people paid massive sums to type stuff into left-wing blogs which in truth few people actually read.

@ Northern Worker

Very kind – thank you. I have worked for several large investment banks (including the vampire quid and HSBC) over the years, in a variety of roles on the trading side. I mostly comment when markets are quiet and I am bored at work…and LC doesn’t require logging in to disqus or similar so it’s easier to post here when people like David Ellis say something truly stupid. I will also say that personally I find it very frustrating that so many people seem to know so little about how finance actually works – to the point where they encourage frankly idiotic ideas. Owen Tudor’s FTT is a great example, and almost anything Richard Murphy puts forward is almost certainly wrong. I don’t argue with them because they are left or right wing – I do so because what they are suggesting would damage the economy.

On another note, which Paul above touches on; Do we really want politicians dictating how much people in certain industries can get paid? Where do you draw the line, and do we trust them to do so?

Why should bakers have their pay regulated? Who is next? Lawyers? Footballers? Doctors? All are likely to earn more over their careers than all but the top bankers, most of whom earn well but not as much as people think.

Likewise, what do people think the reaction will be from the self-same politicians when banker salaries go up? My guess is that they will then try and regulate salaries.

It just smacks of dogwhistle politics, with bankers currently being an easy target. In my view, government should have no influence on how private companies pay their staff. Some banks and bankers indeed made massive mistakes, but many on the left seem to forget that those same people also contributed massive amounts to the treasury over the years. As Fungus says, banks should have been allowed to fail, but propping them up was a political decision.

19. Uncle Satan

@ 18 Tyler

Likewise, what do people think the reaction will be from the self-same politicians when banker salaries go up? My guess is that they will then try and regulate salaries.

You might know something about finance, but you clearly no nothing about politics – if you did you’d know that the above quote is just plain rubbish.

Politicians would never try to cap bankers salaries – they’d demand that their own should be raised in line with them :-).

20. Renie Anjeh

Disagree with this article. This is not the EU’s job and there are huge negatives that outweigh the benefits even though this proposal has very progressive intentions. I’d suggest worker representation on remuneration committees as they do in Germany and also following the route in France were corporations have to give shares to their workers on top of wages. In addition, shareholders should be able to vote on remuneration every year. Also, the FCA should be given powers to ensure that executive pay and bonuses are linked to performance.


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