BANKERS ON A TIGHT LEASH.

Mary Bogan asks will pay caps work?

The Sword of Damocles that hovered menacingly over the pay packets of Europe’s bankers has finally fallen. Barring a major upset, when the annual bonus season begins in London in January 2015, the eye-watering windfalls that have become a standard feature of remuneration for the industry’s best or scarcest talent will be a thing of the past.

The so-called bonus cap, which limits bonuses to a maximum of one times salary – or two times with the permission of shareholders – will have a broad reach. It applies to all EU banks, no matter where in the world they operate, as well as non-EU banks doing business in Europe and affects any bank employee earning over 500,000 euros a year. According to the European Banking Authority, the new rules will capture some 4,800 risk-takers and high-paid individuals in 23 banks, and are therefore likely to have a major impact in London which has a much higher proportion of big earners compared to other European financial centres.

Designed by EU regulators to curb the worst excesses of risk-taking in banks, the bonus cap has found support not only among voters in austerity-ridden Europe but also in some influential areas. According to Re-Define, the think-tank set up by former investment banker Sony Kapoor, it is life-changing, skewed bonuses and incentives that have driven excessive risk-taking among traders, promoted marginal, sometimes value-destroying merger deals by investment bankers and the sale of inappropriate products by retail bankers.

Support for a type of bonus cap as a tool for limiting bank risk has also come from academics such as Dr John Thanassoulis at Oxford University. He argues that if banks were prevented from paying out more than a fixed proportion of their shareholder equity in bonuses, pay at the weakest institutions would be restrained, the bonus “arms race” between banks would end and banks would still have flexibility as to how they motivate and reward individuals.

More generally, however, the bonus cap has come in for fierce criticism in London. “This cap will not be effective at all in reducing risk”, says Carl Sjöström, head of executive reward at Hay Group. “Unless there are wider changes in banks, there will still be high earners taking high risk. All the bonus cap will do is increase fixed pay at a time when pressure on pay in the sector has been downward. Freezing incentives will lead to bizarre pay structures where some top earners are overpaid and, because a bigger proportion of pay will be fixed not variable, cost structures will become more rigid and harder to manage in difficult times.”

A recent poll of institutions attending Towers Watson’s Global Financial Services conference supports Sjöström’s view that fixed pay will rise with over half of City HR professionals saying they expect higher salaries to rise to offset the shortfall in employee incentives.

Unintended consequences

The bonus cap though could also have other perverse outcomes. “A cap will only force banks to do what they have done in the past and to look for other, more covert ways to reward employees whether it’s housing allowances, loyalty payments, holidays or yachts,” says Kent Matthews, Julian Hodge professor of banking and finance at Cardiff Business School. “Strong caps also lead to a misallocation of resources so, for example, it becomes more difficult to attract the best people into banking. While some may say that is a good thing and we need more talent in innovative manufacturing companies, we still need a competent, efficient banking system to kick-start the lending process. Innovative companies are also high risk and who is going to lend to them if it’s not the banks?”

For some experts in remuneration, the critical issue is not whether bonuses should be capped or not but whether bonuses and other forms of variable pay, designed ostensibly to reward performance, are effective or desirable at all.

“Performance-related pay is a broken concept,” says Luke Hildyard, head of research at the High Pay Centre (HPC). “Most of the evidence shows that far from encouraging good performance, this kind of pay is damaging, encouraging employees to focus on narrow targets – which are hard to design for most roles – rather than the wider demands of the job and the organisation.”

Doubt is also cast on the motivational impact of bonuses certainly at top levels. One study by PricewaterhouseCoopers, for example, found that the higher people climb the corporate ladder, the less incentivised they are by financial rewards.

But the biggest problem with the bonus cap, says Kent Matthews, is that it only treats the symptoms of banking’s current malaise not the underlying disease. “High bonuses are an effect not a cause of excessive risk-taking by banks. It is the fact banks have been allowed to become too big to fail that has increased their risk appetite. Incentives that reward and attract high risk-takers have flowed from that. Banks design remuneration contracts to achieve their business objectives.”

After the Great Crash of the 1930s and strict regulations governing interstate banking and the separation of investment and commercial banking activities, explains Matthews, the difference between the pay of bankers and similar professionals was small. From the eighties onwards, however, that spread widened sharply. “What changed was deregulation,” he says. “It opened up a whole new way of thinking about banking. The bigger a bank got, the stronger, more competitive, more powerful it was seen. And part of the economic rent you earn from being big and powerful is you know there is a safety net underneath when risk-taking fails.”

Given a “no bailout” policy is not credible, and in the absence of rules to separate out the risky parts of banking, it’s the new controls on capital, liquidity and leverage that stand most chance of curbing high risk-taking and high bonuses.

And there is certainly some evidence that new capital controls are changing attitudes to risk and pay in the City. Many organisations have introduced deferred reward and claw-back schemes to deter reckless risk-taking and over 55% of staff either received no bonus or a reduced bonus this year, according to a Hay Group survey. Meanwhile the Towers Watson poll found most financial service organisations (56%) are now looking to rewards other than money to offset the impact of lower bonuses and revealed an interesting and significant organisational shift away from banks buying or poaching talent to growing, retaining and engaging their own.

“Some will do it (offset bonus caps) through higher fixed pay or increased pension contributions, but many companies are planning to invest in training and career development, healthcare and flexible working programmes,” says Mark Shelton, managing director of the talent and reward practice at Tower Watson.

Others argue, however, that little has changed in the City, pointing not only to the large bonuses paid this year to the bosses of taxpayer-funded banks like RBS but also to the huge salaries earned by senior managers in non-revenue earning roles, such as the £1.3m pay package allegedly offered to head of corporate affairs, Matt Young, at bailout bank Lloyds.

Even claw-backs appear have no teeth, says HPC’s Hildyard. “Look at the Co-op. Here is a bank on the brink of going to the wall yet its executives still received performance bonuses. If you can’t claw-back a bonus in these circumstances, when can you? Pay in financial services has got out of control and rewards are disproportionate to the employees’ hard work, talent and contribution to the economy.”

Introducing employee-wide profit-share schemes, along the lines practiced by John Lewis and Swedish bank, Handelsbanken, elected employee representation on the remuneration board and transparency on the pay ratios between banks’ highest and lowest earners, are some of the interventions the HPC recommends to harness the worst excesses of City pay.

But Sjöström at Hay Group is sceptical that tinkering with how banks determine pay or structure rewards will change much. “The problem is cultural. In 2007, the bank that provided a perfect example of what rewards should look like, along lines now proposed by regulators, was Lehman Brothers. Salaries didn’t rise fast, bonus targets were leading edge, incorporating employee and strategic objectives and earnings were deferred, sometimes until retirement. What was missing was a culture that minimised risk.”

The challenge facing banks today, says Sjöström, is to define their offering in a new business reality shaped by scarcer capital, the threat of competition from new entrants and low levels of public trust and to create a culture that supports it. “Banks needs to win back trust. That rests on offering a good business model which is clear in purpose and direction and allows for balanced risk and banks being clear about who they are and how they operate. It also requires changes in leadership behaviours and how people act. Compensation can help this but can’t drive it.”

©BestExecution 2013