Scrap the bonus cap

The EU’s proposed cap on bonuses for the banking industry will do serious harm to its ability to compete in the global market. There are now suggestions that it may be scrapped altogether

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The bonus culture that’s surrounded the banking industry has been the target of campaigners looking to punish the people they perceive to be responsible for the economic turmoil of the last few years. There has been a groundswell of support for some form of restriction on what banking executives get paid on top of their annual salaries, with members of the public aghast at how people can be paid bonuses in addition to their basic salaries. They also see the bonuses as an unjust reflection of performance, with the top executives still paid eye-watering sums despite lacklustre results that tend to be felt most by the consumer.

The obvious counter-argument, however, is that by restricting what bankers get paid you will create an exodus of the top talent to markets without such rules. Opponents of the rules, which are set to be implemented in Europe, say that the leading minds in the financial industry will depart to Asia, the US and the Middle East, seriously harming the EU’s international competitiveness.

The rules that the EU is preparing to implement come as part of the European Parliament’s Capital Requirements Directive (CRD) IV legislative package that was voted through in April. Designed to curb excessive pay to executives at banks, the new rules will mean that bonuses for all staff must be capped at the base amount of salary, although in certain instances, when shareholders permit it, this ratio can rise to 2:1.

Despite plenty of support from politicians across Europe, German resistance held up the policy. However, their stance softened earlier this year, paving the way for the cap to be included within the CRD IV package, which will help implement the Basel III provisions for liquidity and capital requirements.

The reasons for implementing a cap on bonuses seem to stem from public outrage at how much money is given to the people they blame for economic hardships, which everyone is experiencing. Desperate to harness public opinion, politicians have seized the idea as a means of both appearing tough on the banking industry, while dressing it up as a key part of their capital requirement rules.

Those in favour of the rules make up the majority of the EU; whereas the countries that have opposed them include the Czech Republic, Sweden, and the UK. Britain has the most to lose, with its economy so reliant on the financial services industry it’s desperate not to see an exodus of talent and money from London. British MP John Redwood recently said that the cap would “make financial institutions less stable rather than more stable”.

Economics of the madhouse
A consequence of the new cap could be a significant rise in what bankers are paid. Martin Wheatley, the new CEO of UK regulator the Financial Conduct Authority, told a conference in May that salaries could double as a way of getting round the new rules. This assumption was backed in a study by human resources consultants Towers Watson & Co, who found that more than half of global banks would raise salaries in the event of a bonus cap.

The consultancy firms Managing Director, Mark Shelton, said in a statement: “[Banks] are aware that when the EU bonus cap comes into force, many of their employees are going to receive overall lower pay and they recognise the need to make up for this shortfall in a number of different ways.”

Redwood says that the current system meant that bonuses would rise and fall in line with performance, whereas the proposed cap would mean companies paying much higher basic salaries in order to retain the top talent, adding: “They’ll be far geared and so when they hit a downturn they’ll be very vulnerable. It’s the economics of the madhouse.”

Some have also questioned the legality of the cap. Writing for London-based financial newspaper City AM, Stephen Mavroghenis, a partner at international law firm Shearman & Sterling, said that the proposed cap’s legal basis was “tenuous at best”.

He added: “Formally, the EU’s purported competency arises from Article 53(1) of the Lisbon Treaty, a provision aimed at harmonising member state laws concerning the take-up and pursuit of activities by self-employed people and the mutual recognition of qualifications. On a plain reading of the text, it is difficult to see how a provision based on harmonising rules for self-employed people could constitute the legal basis for limiting bonuses. But there it is, without further explanation. It’s a Treaty that is being contorted and stretched beyond its original purpose.”

Industry opposition
The cap has also been met, unsurprisingly, with dismay from those within the financial services industry who will be affected. Pricewaterhouse Cooper’s (PwC) Tom Gosling, a remuneration partner, told the Financial Times after the proposed cap was announced in May: “Once again the rules have come in at the worst end of the industry’s expectations. By substantially increasing the number of employees affected by this rule change will magnify the problems caused by the bonus cap.”

There was also concern that the new rules would define more people within the industry as ‘risk takers’, when they may in fact just be paid a large salary for a relatively risk-free job. Jon Terry, another partner at PwC, told reporters: “This expansion of the definition of risk takers will see substantially more individuals working in the banking industry being hit by tougher pay rules, including being subject to bonus caps from next year.

“If the proposals are implemented as proposed, this will mean anyone earning over €500,000 will be deemed a risk taker irrespective of their role or impact on the risk of the firm. This will significantly increase the number of employees subject to the bonus capping, to perhaps as much as ten times for some investment banks operating in London.”

Competing globally
Elsewhere, some have raised concerns about the damaging effect the cap will have on the EU’s competiveness in the wider world. Mavroghenis went on to stress how damaging such a rule change could be for the EU’s competitiveness in the future: “Any legislation that will make the EU less competitive and disproportionately injure a single member state – by raising banks’ fixed costs to the benefit of non-EU credit institutions and encouraging a flight of talent – should, you would think, be very firmly grounded within the competency of the EU. Regrettably, that does not appear to the case. In the example of the bonus cap, legal competency appears to equate to populist and political sway.”

Despite the supposed consensus among many EU policymakers, as recently as June there were suggestions that the bonus cap could be scrapped. Sven Giegold, the German MEP that has led the way in negotiating the bonus cap, is rumoured to be looking at proposals that would place greater emphasis on tying bonuses to performance. Such a compromise should be seized before serious harm is done to Europe’s banking industry’s international competiveness. While it may not be a popular view among those facing economic hardships and wanting a convenient scapegoat, in order for European economies to get back on their feet they are going to need a competitive – and competitively paid – financial services industry.