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Europe’s Bizarre Bonus-Capping Plan

A picture taken on December 15, 2011 in the northern city of Lille, shows a coin of one Euro and banknotes of 10, 20 and 50 Euros. AFP PHOTO PHILIPPE HUGUEN (Photo credit should read PHILIPPE HUGUEN/AFP/Getty Images) No bonus for you, monsieur.

The FT reports that the European Union, which seems to like its bankers even less than we like ours, is preparing a plan to cap bonuses for bank employees.

I'm on record as saying that I think bank bonuses are not evil in and of themselves since they allow firms to minimize their fixed cost structure and since capping them — while cathartic in theory — often just leads to banks raising their employees' salaries accordingly and can result in them laying more people off when times get tough.

Unlike the bonus caps that were proposed in the U.S. during the 2008 bailouts, the EU's plan is not a fixed cap that limits bonuses to, say, 300,000 euros. It's a ratio cap, which is just as easy for banks to get around.

Here are some specifics:

The European parliament and negotiators for member states drafted a deal in Strasbourg on Thursday that would impose a 1:1 bonus to salary ratio, which can be increased to 2:1 with the backing of a supermajority of shareholders.

To see why this doesn't work well in practice, imagine you are a highly paid employee of Credit Suisse or UBS or another EU-based bank. You make $400,000 a year, $100,000 of which comes in the form of your salary and $300,000 of which typically comes as your year-end bonus. And even though a supermajority of your bank's shareholders have voted to increase the EU's new bonus cap to 2x base salary, that still leaves you in a bind because your bonus is 3x your salary.

So you stride into your boss's office and have the following conversation (except probably in French):

"Hey, uh, boss? What are we going to do about this new law?"

"What do you mean?"

"Well, my bonus was 3x my base pay last year. And, um, I would like to do that again?"

"Oh, duh. We've already adjusted all our numbers. You'll make $133,333.34 as a base salary, and $266,666.66 as a bonus. Problem solved."

"Gee, thanks boss!"

As I explained earlier this week, I support capping bonuses at firms that are being bailed out by governments, as it's a symbolic move that shows taxpayers that their money is not being used to reward failure. It's clear to me that a firm like RBS, which is still majority-owned by the British government, should have some kind of hard cap on pay, though I'd rather see a progressive cap that limited high-level executives more than mid-level or junior employees.

But the EU's bonus-cap plan would apply to every bank, no matter how stable its finances are, which suggests that European leaders don't care what the actual effects of a bonus cap are (or if, as the FT suggests, banks raising their fixed costs by adjusting salaries upward could "backfire and increase financial risk by detaching performance from pay"). From looking at the statements of the various ministers involved, it's clear that they see cutting bonuses as a symbolic gesture meant to appease their constituents' anti-bank rage rather than as an actual step to lower overall compensation in the financial sector.

This quote sort of says it all:

One senior eurozone diplomat involved in the talks said many countries had taken the decision to broadly accept whatever compromise was reached in the negotiations with the parliament. “We don’t care about the number, there is no way we are standing up for excess pay,” he said.

As with the U.S., I'm sure that European bankers are, by and large, overpaid. But conflating "excess pay" with "too-high bonuses," while admitting that you care more about the political optics of the bonus caps you're proposing than the actual results, is, as they might say in Strasbourg, un peu stupide.

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Photo: PHILIPPE HUGUEN/2011 AFP