EU caps on bankers' bonuses: the perfect regulatory storm?

The discussion over bank bonuses has been heating up inrecent days. Discussions between EU ministers, the European Parliament and the Commission (so-called trialogues) are restarting today as the three try to reach an agreement on the rules for bank bonuses to be included in CRD IV (the EU’s legislation implementing the Basel III rules and more).

The parliament is pushing for a stringent cap on bank bonuses of 1:1 ratio with fixed salaries, which could be increased to 2:1 with approval from a majority of shareholders.

There is a lot going on here, beyond the actual proposal, including:

• The UK is in a clear minority in categorically rejecting a cap, but unable to block a rule with disproportionate impact on the UK - courtesy of QMV and co-decision.
• Germany being the swing state - no surprises there - having first supported the UK's position, it has shifted as part of a wider political push to get tough on bankers, which strikes a chord with German voters. The revelation in December that Deutsche Bank hid $12bn worth of losses during the crisis and the growing Libor and Euribor rates scandals, haven't exactly helped...
• The European Parliament flexing its muscles, successfully managing to tap into the public mood, breaking the Council common position, which is unusual. (Don't worry, any favour EP thinks it wins with the electorate, would be ruined if it voted down Ministers' proposal for a reduced long-term EU budget).
• "Anglo-Saxon capitalism" in the docks - perception is one of a continental attack on British bankers (ironic since a large part of the talks have focused on making CRD4 more flexible to allow the UK and others pursuing tougher capital rules for banks). This will not make the City any more EU-enthusiastic.
• No one wants to be publicly seen to back bankers - even the UK government itself is keeping a low profile.
• Changing incentives as part of the eurozone banking union, with the club within a club dynamic again coming to the fore (see our December 2011 report to see what we mean). Looking forward, the question is, if a country decides to remain outside the banking union - therefore signalling that it will stand behind its own banks, come what may - should it not also have more discretion in getting the incentive structure in the banking sector right?

So what does the UK want?

On Friday the UK submitted a paper to its EU partners to put forward it’s case. We've seen the paper, and here are some thoughts / points - which also have been largely reported in the media:

• The UK argues against a firm cap. Any extended remuneration should be determined by shareholders (although the UK proposal does water down the size of the majority needed to approve remuneration slightly).
• The UK is pushing for a focus on non-cash deferred bonuses. This is included in the current proposal to some extent but the UK fears (with some grounding) that the current proposal will encourage an increase in fixed salaries and a focus on upfront cash bonuses - and reduce firms' ability to cut costs during a downturn, potentially leading to more lay-offs and less lending (on a bit less solid ground here, we think).
• It also argues that deferred non-cash bonuses (over three years) should not fall under any cap, while also rejecting the proposal that all employee benefits, above those mandated by law, should be categorised as a ‘bonus’.
• The government is also keen to see that subsidiaries of EU banks located in the rest of the world should not have to adhere to the rules. Furthermore, EU subsidiaries of banks headquartered outside the EU should not have to implement the rules (although their bonus plans will still need to be judged ‘prudential’ by the relevant financial supervisor).

So is this special pleading? Well, to some people in the City, the world will end if this comes into force - which is not quite the case. In fact, there's no surprise that politicians seize the opportunity to strike down on bankers' pay, given that many banks have been forced to seek taxpayer-backed bailouts and the rest of it. So the first message to the financial sector is: if you don't want to be subject to tougher regulations, stop screwing up.

But it could still be damaging and there are questions over how much difference a cap would really make on incentives and the distorting effects this could have across the board. Ultimately, the risk taken on and the decisions made by banks are dictated by much more than just bonuses - it is just a small part of a wider culture which needs to be reassessed. Targeting and correcting perverse behaviour still seems to be better done through more effective supervision and tighter regulation - the irony should not be lost that many of those pushing for a cap are also the ones advocating a maximum limit to capital levels and supporting watering down the Basel III liquidity requirements (see here for details). And there should be no doubt that this could make talent less likely to choose the EU over other part of the world, which clearly isn't in anyone's interest.

In the end, bank bonuses are also only a small part of the much larger CRD IV legislation. There is unlikely to be a formal vote on bank bonuses itself - and Ministers rarely vote in the Council - but the UK seems to be heading for a defeat on a pretty symbolic issue at a sensitive time.

On the other hand, if the UK government can pull this one off, it should be given a lot of credit. Ultimately, the final outcome of CRD IV as a whole will be the more important bellwether by which to judge UK success or failure.