Despite failing to prevent European finance ministers agreeing to the policy in Brussels yesterday, George Osborne was right to oppose the EU’s proposed cap on bankers bonuses for a number of reasons.
First, the legislation introducing this cap was part of CRD IV – the Capital Requirement Directive that introduces Basel III for Europe. This is aimed at ensuring banks are safer through more stringent capital, liquidity and leverage requirements. But a cap on bonuses actually makes the banks less safe as it introduces more rigidity into the system.
Banks originally introduced bonuses to reflect the fact that their revenues are volatile. Bonuses allow compensation to vary, so that it can fall in a bad year, thus protecting the bank’s profitability and the capital that underpins it. A cap at one times salary (or at best two times) will likely force banks to raise salaries to keep total compensation stable. This is exactly what happened after the last Labour government introduced its bonus tax. Salaries are much harder to adjust and most employers would find themselves infringing European employment law if they tried to do so. Accordingly, the underlying position of banks becomes less stable.
Second, one of the best improvements in compensation in recent years has been the introduction of bonus deferral and clawback. By deferring bonuses, banks create a pot of earnings which they can claw back if something goes wrong. We have just seen this in action after the Libor scandal. This system increases the flexibility of the bank to deal with adverse shocks. It also should condition behaviour so that decisions are not made that are good for bonuses in the short term, but bad for the bank in the long term.
Salaries, in contrast, are paid out in the year they are earned. So by increasing the proportion of total compensation paid out in bonuses, the regulations again undermine the stability of the banks and subvert a sanction meant to ensure bankers take better long-term decisions.
Third, the rules undermine the competitive position of Europe and European banks and, in particular, that of London. As currently proposed, the legislation would apply to European banks around the world. So anyone working for a European bank in New York or Hong Kong would be subject to the regulations, but their counterparts working for non-European banks would not. This might even tip some banks to relocate headquarters away from London. Equally, if the legislation is imposed on non-European banks in Europe, senior executives may choose not to work in Europe (and that mostly means London). Those running large global divisions can largely position themselves where they want. Why should they choose London over New York in such circumstances?
Finally, and this is important for the UK, if those bankers choose to move, the tax they pay on those bonuses will move with them. Everyone may be up in arms when a banker receives a £1m bonus, but they should realise that a large chunk is paid in tax in the UK. Lower bonuses and fewer employees mean less tax.