The European Union's Cap on Banker Bonuses Is a Good Idea

November 6, 2014 2:30 PM

Recently, Andrew Bailey, chief executive officer of the UK Prudential Regulatory Authority, came out against the European Union's cap on banker bonuses. The timing of his comments was odd. They undermined the European Banking Authority's new clampdown on banks' use of allowances to get around the cap. His comments also came at a time when a fair amount of  tension has arisen between the United Kingdom and Europe. Such strains are likely to grow ahead of next year's general election in which the Prime Minister's Conservative Party risks losing votes to the anti-EU party, the United Kingdom Independence Party (UKIP). This should therefore be a time when responsible adults tried to dampen UK-EU tensions, but maybe Bailey thought these underlying tensions gave him political cover for his comments.

The EU bonus cap restricts banker bonuses to 100 percent of salaries or 200 percent if they get shareholder approval. There is no limit on salaries and so it is a cap on the proportion that can be paid in bonus, though it will likely have the effect of lowering total compensation. With the kind of dismissive superiority that does not go down well abroad, Bailey said at the "City Banquet" at Mansion House that the cap is the wrong policy, that the debate about it is misguided and it will have unintended consequences. He said the Bank of England's preferred route is a long-term clawback provision on bonuses, in which the bonuses would be returned up to seven years after they were awarded in the event of activities the employee was involved in going bad.  

Having spent a couple of decades as a senior executive at investment banks, I have experienced many different bonus structures, both as a recipient and as someone setting bonuses. I can now afford greater detachment than some former colleagues and perhaps deeper perspective than some regulators. My conclusion is that while I am deeply uncomfortable about governments getting involved in the detail of private pay, maybe banking is a special case and the European Union's cap is a better policy than Bailey's clawback.

To invert former Federal Reserve chairman Ben Bernanke, a bonus clawback is a policy that works in theory but not in practice. Turnover in the financial sector is rapid. A typical employee is poached after three years and is offered a new set of deferred bonuses to replace the ones they will lose by leaving. I once had a deferred bonus that essentially replaced the deferred bonus of a previous employer that was replacing the one before that. 

Further, let's say a banker makes a loan—though in reality this is done by committees, not individuals—and the loan goes bad five years later and long after the banker has left the department. With each year that passes, circumstances change and events arise that diminish his or her contribution to the success or failure of that loan. Assessing the banker's role and appropriate level of clawback would be fraught with measurement, legal, equity, departmental in-fighting and other challenges.

Moreover, loan failures are like London buses in that they either don't come or come in bunches. This is because they are connected to the macrofinancial climate, which is determined by collective lending and borrowing behavior. Adding all of this together means that long-term clawbacks do not connect an individual's pay with individual responsibility.

The financial sector is the only place I have worked where every employee has a well-developed dream of departing quickly. A culture of get rich quick is risky for everyone—employee, bank, and the wider economy and society. If a smaller proportion of compensation were paid in discretionary bonuses, it would tilt banks and employees away from searching for life-changing gambles towards building long-term customer franchises, taking less risk, and investing more in preserving reputation. From a macro and microprudential perspective, the European Union's bonus cap is the better policy.