(Victoria Jones/PA)
(Picture: PA Wire)Four days before Christmas in 2015, a hefty 173-page document landed on my desk at work. It was filled with big, bewildering words like ‘prudential consolidation,’ ‘solvency buffer,’ and ‘ex post risk adjustment mechanisms,’ and it was about to wreak havoc on Europe’s big financial institutions.
The document’s tangled title reflected its origins, in years of discussion, research, and consultation on how to reign in the excesses of the global banking industry in the wake of the 2008 financial crash. The Guidelines on sound remuneration policies under Articles 74(3) and 75(2) of Directive 2013/36/EU and disclosures under Article 450 of Regulation (EU) No 575/2013 ran to 326 separate paragraphs of rules, but they had a pithier purpose: setting the EU’s bankers’ bonus cap. It would also shine a spotlight on the internal operations of Europe’s big banks, who had never experienced this degree of scrutiny and were not accustomed to interference with how they paid their staff.
The cap was designed high above East London’s financial centre, on the 46th floor of One Canada Square, the tallest building in Canary Wharf, and the base of the European Banking Authority, an EU rule-maker in a building that symbolised the financial deregulation of the Thatcher era and the industry’s freewheeling growth after the Big Bang reforms. The document came as an early Christmas present to regulators and consultancy firms across Europe, who would have to spend most of the next year working out what on Earth any of it actually meant for bankers and the finance industry.
In truth, most banks didn’t have a clue how to handle it. Administering pay was the responsibility of a firm’s HR department, not famed for employing the sharpest minds in the business, and they struggled to figure out how to organise their existing work around hundreds of new rules. They ended up turning to big consulting firms, such as the one I worked at, and signing six-figure contracts with them to figure out what it all meant on their behalf (we weren’t all that sure either, but we took the money and gave it our best shot).
The cap set limits on the ratio of fixed pay to variable pay: a banker’s bonus couldn’t be more than double the size of their salary. The cap only applied to “MRTs” or ‘material risk takers’: those who had a say in where large parts of a bank’s capital were deployed. The rationale was that bankers had got bigger bonuses by investing in evermore risky classes of assets in order to muster larger returns – a key contributor to events leading up to the financial crash. A smaller bonus meant ‘material risk takers’ would avoid taking material risks, and banks would gently plod along making moderate profits, investing in nice stable things without collapsing the economy.
The cap was met with staunch opposition the moment City financiers in London caught wind of it. George Osborne, then the chancellor, quickly picked up the mantle and battled the EU to scrap it -- or at the very least, find some exemption for London. Osbourne went as far as to insinuate the cap was illegal. He complained of “badly designed rules” that “are entirely self-defeating” and “are pushing up bankers’ pay not reducing it.” Osbourne’s arguments were readily rebutted by an adviser to the European Court of Justice, after which the chancellor swiftly relented, and the new rules became law. Compliance with them would cost millions of pounds and thousands of man-hours in restructuring banks’ internal operations (including my own efforts), but once the work was done, the industry moved on.
Despite his strong rhetoric, Osbourne would later campaign for the UK to stay in the European Union during the 2016 Brexit referendum. Even after Britain voted to leave, successive Conservative governments – and successive chancellors -- didn’t bother to disinter old arguments about banker bonuses. I wrote to the UK’s financial services watchdog, the Prudential Regulatory Authority, as recently as 2020 to see if there had been any movement on changing the rules on the cap. The reply was a firm ‘no’: the PRA wouldn’t do anything to hamper London’s chances of being given ‘equivalence’ – a regulatory status afforded by the EU which would ease restrictions on financial services trade with Europe post-Brexit. Even if they wanted to, the government was too busy managing the aftermath of Britain’s divorce with the EU to devote time to the minutiae of remuneration in financial services.
So it came as a bit of a surprise when last month, with war waging in Ukraine, inflation at a 40-year high and recession on the horizon, Britain’s latest chancellor thought it was high time to dredge up old arguments over bank pay.
But dredge them up he did. Just days into his new job, Kwasi Kwarteng stood at the dispatch box in the House of Commons and proclaimed the cap was for the can. “We need global banks to create jobs here, invest here, and pay taxes here in London, not Paris, not Frankfurt, not New York,” he bellowed, to a somewhat indifferent audience.
“All the bonus cap did was to push up the basic salaries of bankers, or drive activity outside Europe. It never capped total remuneration, so let’s not sit here and pretend otherwise. We’re going to get rid of it.”
Kwarteng’s opposition to the bonus cap is based on a few different premises. First, the libertarian instinct to avoid meddling with the way a boss chooses to manage his business. Second, the belief that regulation is burdensome: fewer rules lead to greater innovation and more rapid growth. Third: scrapping the cap wouldn’t change levels of banker pay anyway.
One the first argument, he may have a point. No other industry faces such a mountain of regulation every time they choose to reward a member of staff for doing a good job. In no other industry must someone consult a 170-page rulebook every time they hold a performance review. Of course, the intention of the rules is to pre-empt dangerous decision-making, but it’s difficult to establish if they’ve made any contribution to that end, and thus, quite hard to justify their existence.
Kwarteng may have a point on the second argument too. The growth of European banks over the past decade compared to their American counterparts is paltry. Between 2008 and 2018, ‘return on equity’, a key metric of a finance firm’s success, was about double the size in the US relative to Europe. The reasons for this are complex, but European regulations are unlikely to have helped close the gap. But outside the economic burdens of regulation, there are human ones. A bank with a handful of material risk-takers now requires an army of compliance officers to ensure their pay cheques don’t fall foul of the law. Something about this feels quite insane. It is also huge waste of time on the part of those officers –which could have been better spent doing more fulfilling things like baking or gardening.
Kwarteng is almost certainly right on the third argument. The EU never set an upper limit on how much anyone in the financial services sector could earn – in that respect to speak of a ‘bonus cap’ is something of a misnomer. And levels of bank pay haven’t changed much since. At Deutsche Bank, one of Europe’s biggest banks, average compensation costs per employee in 2021 were some 25% higher than in 2009 – indeed, compensation levels leaped 10% year-on-year in 2016, the first year the cap was introduced.
So there is quite a strong case, at least in theory, for scrapping the banker bonus cap in its current form. But the problem with Kwarteng’s decision is the timing. It’s one thing to be so tone-deaf as to lift a cap on bank pay when millions in the UK have gone on strike, protesting at a real-terms drop in their wages -- that is ultimately a political gamble. It’s another thing, though, to re-introduce an incentive on risk-taking at a time when the economy is in such a precarious state -- that is an enormous economic gamble.
European regulators may have been totally misguided when they thought it was bonuses that tipped over the first domino in a path to the near-collapse of the financial system. But is now the time to put their views to the test? It defies common sense that Kwarteng thought the risks were worth the reward.
In the current climate, deregulating bank pay hasn’t been widely advocated as a policy lever to escape recession – not in the UK, nor in Europe or elsewhere. It isn’t something, as far as I can tell, that banks themselves are keen on. It is a complete mistake.
Less than a month after announcing his so-called mini-Budget, Kwarteng has been sacked. His successor Jeremy Hunt now has the chance to choose which parts of the mini-Budget policies will go with him. Reversing the ditching of the banker bonus cap should be pretty high up the list.
