Monday, August 13, 2012

European Limits on Banker Bonuses

By Professor Jeffery Atik

The EU's Council has prepared its draft legislative package implementing the Basel III banking reforms -- known as CRD IV. Attention now shifts to the European Parliament for its response, expected this autumn. A complex process of reconciliation will follow. On one point the Parliament has drawn a line in the sand: the eventual CRD IV must contain significant limits on contingent compensation paid to bankers. The Parliament's starting point is a one-to-one ratio cap: bankers' bonuses cannot exceed annual salaries.

Basel III did not impose any limits on bankers' compensation -- although several European members of the Group of 20 had sought bonus restraints during the negotiation. Nor does Basel III restrict the ability of Europe -- or any other Basel party -- from imposing additional requirements on its banks. Europe's imposition of bonus limits in CRD IV may be described as "Basel III Plus" -- an additional term beyond the basic Basel III mandates.

There is a broad perception that the bonus culture of New York and London contributed to the 2007 financial crisis. Bankers seduced by the prospect of large contingent payments caused their firms to undertake inappropriate levels of financial risk. New limits on bonuses, in this telling, are needed to eliminate the distortion in risk appetite generated by prevalent compensation practices. But bonuses have their defenders -- and not just the bankers who receive them. There remain policymakers (albeit more likely those overseeing markets in New York and London) who continue to believe that bonuses are necessary to attract the creative talent that will drive economic growth.

There are several important divides in the European debate over bankers' bonuses. The first is between the United Kingdom and the continentals (particularly France and Germany). The UK may be particularly solicitous of preserving large bankers' bonuses from fear of driving financial activity to other, less-regulated markets. But there is certainly a cultural element in play as well. The French and Germans frequently criticize "Anglo-Saxon" business culture as leading to social irresponsibility. And who -- think the continentals -- really deserves such large checks at the end of the year?

The second fracture is between the Council and the Commission on one hand, and the Parliament on the other. It is the directly elected Parliament -- better reflecting the popular revulsion to the excesses of Europe's bankers -- that is most firm in requiring compensation limits.

At the moment, authority over bank activity in Europe is uncomfortably divided between Brussels-level and national officials. To impose a Europe-wide limit on bankers' bonuses is to remove an issue traditionally left to the Member States and pass it on to the EU. It is remarkable that the European Parliament, which often insists on respect for the principle of subsidiarity -- that is, that matters should be left to the Member States in the absence of a clear need for Europe-level legislation, should feel so intensely that Member State discretion on compensation be terminated.

There has been push-back from the Council. One proposal would permit bank shareholders to waive the compensation limits. Were a bank's shareholders to believe that a bonus-rich compensation policy be in their interest, they should be enabled to carry it out. The shareholder democracy argument has some appeal -- but shareholder democracy cannot be confused with political democracy. The takeover of banks following the financial crisis has demonstrated a public interest external to that of the shareholders that must be protected.

Another compromise would distinguish between banks receiving state assistance and those operating without intervention. Only the first category -- the troubled banks -- would be subject to the strictest limits on bonuses, with more generous bonus practices available to other banks. This avoids the most politically troubling cases, where bonuses appear to be paid from public funds.

In the end, a compromise may result from tinkering with the bonus/salary ratio caps. The Parliament has, for the moment, indicated its strong view that one-to-one is appropriate; but the ultimate reconciliation may permit two-to-one or three-to-one payouts.

Limits on bankers' bonuses are coming to Europe. This may cause banks to shift more compensation to fixed salaries, and by so doing, de-link banker pay from banker performance. There are no proposals to impose any salary cap in CRD IV, so non-contingent compensation may increase.

It would not be surprising if some European bankers move to other jurisdictions. MEP Sharon Bowles has said it would be "good riddance." Her words express a popular sentiment that well compensated bankers may not generate as much social benefits as had been supposed prior to the financial crisis.

The author may be followed on Twitter @jefferyatik.

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