PAY-CAPS.

Continuing our series of articles on best practice, Bob McDowall looks at the proposed pay-caps for bankers and whether this action is supported by any research or is it a crowd-pleasing political reaction?

The European Union (EU) has passed legislation setting out the rules that will limit bankers’ bonuses to 100% of annual salary, or twice the annual salary if shareholders explicitly approve. The legislation was approved by a majority vote of EU Member States in the face of opposition from the UK, home to Europe’s largest financial centre. The new rules will come into effect January 1, 2014, but the bonus limits do not apply for work carried out before that date, even if bonuses are awarded later. The UK has warned that banks could move their operations to the U.S. or Asia, as a result of the new rules. The rules have the objective of ending a culture of excessive bonuses, which encouraged risk-taking for short-term gains. Politicians in many jurisdictions in the EU have supported the measure specifically because taxpayers have been asked to pick up the bill after the financial crisis through national government intervention and funding.

The bonus caps are being presented as part of an EU Capital Requirements Directive 4, which will oblige banks to put in place a strong financial cushion. This Directive aims to reduce incentives for the type of risky behaviour widely blamed for contributing to the global financial crisis which started in 2007.

Base salaries have risen substantially at European-based banking institutions before the introduction of the rules since they wish to retain their most talented individuals. In the longer-term the rules will inhibit banks from rewarding performance. By discouraging risk taking, the rules will propel institutions operating in the EU jurisdictions to asset gathering and fees based financial models, solid and dependable but unlikely to deliver outstanding financial results. Institutional investors are likely in the next three to five years to limit their investment in institutions materially constrained by these rules, if they deliver constrained, low growth.

At the one end of the spectrum there may be some justification in constraining bonuses in banks which continue to rely on State funding, by contrast the rules unfairly limit the opportunities for owner managed financial institutions or institutions which are run using a partnership financial model.

Alignment of pay and performance is an art rather than a science. The business ethos and culture of the institution, supported by relevant governance, compliance, risk controls and reporting, provide the calibration necessary for aligning pay and performance. A valid case can be made to defer bonuses until transactions have been completed or closed out at which point the risk has been eliminated and the profit or loss) is crystallised. Equally, long-term bonuses and deferred bonuses do strengthen the team at an institution which has a partnership culture. Such decisions should be the responsibility of the board of directors in consultation, if appropriate, with the key shareholders.

The rules for capping bankers’ bonuses, perhaps, reflect the difference in cultures both between the Anglo-Saxon world and the mainland European world of banking. After World War II there was strong US investment in the major national banks of mainland Europe, in part to encourage direct investment in commercial and industrial enterprises as part of post-war economic regeneration. Senior civil servants and bankers would cross seamlessly between senior positions in the civil service and banking institutions certainly up until the 1980’s.

Within the UK, the “Big Bang “in 1986 was responsible for breaking down the different business cultures of the commercial banks and the merchant banks and stockbroker partnerships. Strict ring-fencing of retail banking institutions is an elegant proposition, which attempts to replicate the banking environment before the “Big Bang”. There is a strong justification for discouraging risk taking in retail banks and in doing so limiting the scope for high performance bonuses assessed on strong financial performance. At the same time, a bank which is not ring-fenced, should not be permitted to threaten the stability of national or international financial systems by the scale or concentration of its transactions.

The rules on bonus caps are a reaction to the financial crisis, which started in 2007. Many banks are still suffering from the effects of the crisis because they are still carrying devalued assets and liabilities which were created by the crisis. The taxpayer indirectly and indirectly had to bail out some of the banks to stabilise the financial system. Politicians have reacted to the displeasure of taxpayers. In a television interview some years ago, towards the beginning of the financial crisis, I was asked how long I thought there would be political interference in the financial services industry. My response was short: “while politicians think there are votes in it.”