Brussels versus the bankers

The EU is passing laws that will put a cap on bankers’ bonuses. But will the law have the desired effect? And will it hurt Britain’s economy? Matthew Partridge reports.

The EU is passing laws that will put a cap on bankers' bonuses. But will the law have the desired effect? And will it hurt Britain's economy? Matthew Partridge reports.

What happened?

Banks are under attack from Europe. The European Parliament has agreed on new rules that will cap the annual bonus bankers can receive to no more than their annual salary. This can be extended to twice their salary if shareholders agree.

It also forces banks to disclose the number of staff paid more than €1m. Despite British protests, the new rules are expected to kick in next year. If ratified, the rules are likely to be extended to the employees of other financial institutions.

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Why the change?

German MEP Udo Bullmann thinks that, "with the rules on banker bonuses, we will change the culture in management boards and on the trading floor, putting an end to short-sightedness for the mere sake of high pay". Belgian politician Philippe Lamberts claims that, "when banks are putting together remuneration schemes [where there] are very strong incentives to take excessive risk, if not to breach the law, then we have to intervene".

The EU also argues that capping bonuses will free up more funds for lending and strengthen balance sheets. Irish finance minister Michael Noonan says the changes "will make sure that banks in the future have enough capital, both in terms of quality and quantity, to withstand shocks".

Are bankers overpaid?

Karl Sternberg, writing in the FT, argues that the real problem is not the absolute level of pay, but the fact that bankers receive too great a share of revenues. By the time the crisis began, banks "had reached a state of communist perfection. The workers took home everything; the capital holders were left with nothing."

Indeed, "if Karl Marx had been alive in 2007, he would have been working for a bank". According to The Daily Telegraph, the CEO of Morgan Stanley thinks that, even now, "there's way too much capacity and compensation is way too high".

That said, the FT suggests that this wasn't a big problem just before the crisis in 2006, when staff costs were 58% of revenues at big international banks, roughly in line with most service industries. However, they have now increased to 81% as profits and dividends have plunged.

Will it work?

Probably not as intended. As The New Statesman's Alex Hern points out, "if you cap bonuses at the same level as salaries, and put no limit on salaries, it's clear what's going to happen". The Centre for Economics and Business Research notes that the total UK bonus pool has fallen by over 85% from £11.6bn in 2007/2008 to £1.6bn in 2012/2013. Meanwhile, "city firms are increasingly substituting salary for bonus".

City AM's Allister Heath worries that this means that, "when business volumes drop, the only answer will be to sack people, rather than cutting bonuses. This is tricky and will further increase cyclical risks for the banking system."

Are there better alternatives?

As Heath says, "the challenge is to design contracts properly and put in place strict monitoring systems to prevent unintended consequences". Hern agrees that Brussels made a big mistake when it rejected British plans that would have forced a large portion of any bonus to be deferred, or converted into share options.

That would "encourage bankers to act in the long-term interest of their company, not merely boost their returns for that year to enhance their bonus".

Deborah Hargreaves, the head of the High Pay Commission, a pressure group, writing in The Guardian, wishes the EU had been braver and scrapped individual bonuses completely. Bankers should get a share of the profits, in proportion to their salary as employees do at the likes of retailer John Lewis. That avoids reward for apparent failure "when banks pay bonuses without actually making any money. If there's no profit, there shouldn't be any profit share."

Is this a "war on the City"?

Mayor of London Boris Johnson worries that the rules will be a "boost for Zurich and Singapore and New York at the expense of a struggling EU". Since most of Europe's financial sector, including 75% of derivatives trading, is in London, the rules could hit the capital hard.

The Daily Telegraph's Ambrose Evans-Pritchard agrees that the EU has launched a "regulatory assault on the City". This includes proposals for a "Robin Hood"-style European financial transactions tax and attempts to force banks to move more of their operations within the eurozone.

The economic effects could be serious, especially in terms of lost tax revenue. The Centre for Economics and Business Research estimates that tax revenue from lost financial-sector salaries and profits has gone down by as much as £30bn from its peak in 2007/2008. No wonder UK enthusiasm for the EU is waning.

The Swiss precedent

Law firm Shearman & Sterling has questioned the legality of the EU move to dictate private-sector pay. But there is a Swiss precedent. After a public outcry over a $71m payment to the departing CEO of Novartis, Swiss voters approved a law that bans special payments to executives when they join or leave a firm (known as golden handshakes' and golden parachutes'). It also limits the terms of board members and makes shareholder votes on pay mandatory.

It applies to firms based in Switzerland, even if they are listed on foreign stock exchanges. There have been calls for Germany to implement similar laws. Der Spiegel, a newspaper, hopes such a move will shame other firms into reducing pay. "Pressure on executives in listed companies will increase. Exorbitant salaries will need to be explained not just to shareholders but to the public."

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri