Capping bankers' bonuses

The European parliament has grasped the nettle when it comes to bankers' bonuses. They have passed a law that mandates a 1:1 limit on the salary to bonus ratio. This can be go up to 2:1 with shareholder approval. The move has raised a storm in London where bankers and politicians believe that the proposal will undermine the City's importance as a financial centre, perhaps by causing banks to move key personnel to locations where the caps would not apply. FT has a primer on the new regulations.

One obvious response on the part of banks would be to increase base pay so that the overall compensation is not affected. But this has its own problems: it raises a banks' fixed cost and leaves it vulnerable in times when revenues and profits shrink. The EU banks fear that the proposal would confer American banks, operating in the US, with an advantage. (Presumably, the rules would apply to American banks' subsidiaries in the EU). Andrew Hill has a critique in the FT, but I am not convinced by his arguments.

The cap on bonuses follows regulations that require banks to defer the vesting of stock options over a longish period. Increasing the requirement of bank capital, which will reduce returns to equity in banking, should also help address the issue of systemic risk posed by large bank bonuses.

Incidentally, we are seeing the first major attempt at clawing back bonuses. Barclays is clawing back 300 million pounds paid to its bankers. The claw back follows huge fines the bank has incurred for Libor rigging and mis-selling various products.

Where does all this leave banking? The outcome, one imagines, would be to reduce incentives for taking excessive risk. Will it curb innovation? Perhaps, but, then, there is the perception that much of the innovation we have seen in recent years is of dubious value. A certain imbalance has crept in between the financial sector and the real economy. There is such a thing as excessive 'f'inancialisation' of the economy. Tackling compensation in banking is one element in addressing the larger problem of systemic risk in banking.