Europe’s Plan to Shrink Banker Bonuses Is Très Stupide

By

The good part about having elected politicians devise rules for Wall Street banks is that it provides a democratic check on the otherwise unfettered power of the financial sector. The bad part is that the rules politicians make are often very badly written, filled with loopholes, and generally do a fairly poor job of achieving the desired result.

Europe is about to learn this the hard way. The EU Parliament and EU member states are close to settling on a rule this week that will limit the size of the bonuses given to European bankers. And while you could theoretically argue that capping bonuses is a good way to reduce the overall risk and recklessness in the financial sector, Europe's proposed cap system is so poorly conceived that most bankers aren't even mad about it, because they've already figured out how to get around it.

The EU's rule isn't finalized yet, but in its basic outline it will limit bank bonuses to 100 percent of an employee's annual salary, with special shareholder dispensation required to bump the bonus up to a 2:1 bonus-to-salary ratio. The rule will also likely apply to employees of European banks who are based in the U.S., as well as the European outposts of American banks. So if you make a $100,000 salary at Goldman in London, your bonus will be limited to $100,000 as well, or up to $200,000 if you're willing to beg for it.

I'm on record as saying that I think hard bonus caps are a bad idea — since many banks will just raise employees' base salaries to make up for the missing money, increasing their fixed cost structures and making them more volatile in tough times.

But the E.U.'s rule doesn't worry me that much, if only because it looks so incredibly easy to dodge. It took all of a few hours for people to come up with clever pay gimmicks that would allow banks to keep paying their people big bonuses. One way to go about it, outlined by Lex, would be to create special escrow accounts for all bank employees, depositing their expected bonus payments inside the accounts at the beginning of the year, then clawing back money in the event that employees don't do well that year. Another way, outlined by John Carney, would be to create a whole bunch of special purpose vehicles containing the profits of individual trading divisions at a bank, then dividend out each trader's pay at the end of the year.

So, if the EU's rule wouldn't reduce risk in the financial system, and it wouldn't reduce the actual take-home pay of anyone currently working at a European bank, what would work?

Well, it's kind of hard to say. You could ban all forms of year-end cash payment and move banks to giving out deferred stock that vests over a multi-year period, although as DealBook points out, this is kind of what's happening already. You could, as Matt Levine suggests, let bondholders of banks vote to approve all pay packages. You could come up with some kind of career-long, clawback-able comp scheme like this guy suggests, although honestly I'm not even sure how that would work. (What happens if you get a new job? Do you have to give up ten years' worth of bonuses?) You could even go Antony Currie's route and pay bankers like restaurant waiters, with "tips" given by clients for good service.

I think the right model for banker pay probably looks something more like a tougher version of the one Citigroup is using to set its executive bonus levels, where it's mostly guided by a strict formula (X percent of your unit's profits, or some other concrete performance metric) with a tiny bit of discretion built in so that management can still adjust pay within a narrow range as they see fit. But I have no idea.

What I do know is that, if it goes into effect as currently proposed, the EU's rule will almost certainly not work as intended. There will be some momentary fear and outrage among bankers who think it will destroy the industry as they know it, and some self-satisfied grandstanding from EU officials who think they've really taken it to bankers this time. And then, the loophole-finding will begin, and bank bonuses will still be outlandishly big, and politicians won't really know how it happened, and universal equilibrium will have been restored.