When the bonus cap was introduced, it was rightly controversial. For one thing, it was in the wrong place.
Rather than being a part of employment law, it was slipped into prudential regulation, alongside hundreds of pages designed to keep banks safe by implementing the Basel III framework. The Basel Committee never mentioned bonuses; there was, in fact, no discernible evidence that bonuses had any impact on risk-taking in banks. No matter. Steps had to be taken.
The UK government warned at the time that the cap was a bad idea — a warning that it followed up with a lawsuit. On Monday, the Prudential Regulation Authority and the Financial Conduct Authority continued the campaign of defiance by limiting the scope of the rules to large, systemically important institutions.
The reasoning of the two regulators was, they said in a joint statement, as follows: “The shift to fixed remuneration makes it more difficult for firms to adjust variable remuneration to reflect their financial health, and limits deferral arrangements that put remuneration at risk should financial or conduct risks subsequently come to light.”
These arguments are exactly as applicable to large firms as to small, but the UK authorities can go only so far on their own.
So far, the situation seems to have played out exactly as the UK authorities expected and in line with similarly glum warnings from bank management. Unwilling to lose staff, or cut total comp precipitously, most firms offer much higher fixed salaries than previously.
Salaries, in effect, come under a different area of law to bonuses and are much harder to withdraw once they are paid. They can’t usually be paid in shares, additional tier one, synthetic CDOs or anything else interesting. They are paid in monthly amounts and without deferrals.
Messing with salaries, in short, is an employment tribunal waiting to happen, while messing with bonuses is apparently acceptable. A short-lived flirtation with “allowances”, a sort of halfway house between salaries and bonuses, was quashed by the European Banking Authority.
But the arguments against the bonus cap have more resonance than ever this reporting season.
Banks, for one thing, are not making any money. Several of them are losing alarmingly large amounts of money.
In a pre-bonus cap world, this state of affairs might be matched by big cuts to compensation — that would be a fast, easy way for new chief executives to show the market they have the stones for the job. With every bank on the Street cutting staff, it’s not as if they need to worry about bankers walking.
But the world of high salaries is different. Deutsche Bank, which talked tough on bonuses, did drop them for management (who need to have their variable compensation disclosed to the market), but actually plans to add to fixed pay for most staff from 2016.
In some cases, notably Barclays, bonuses have held up as well as fixed compensation — the bank’s pool is only down some 10%-12%, probably because turmoil in the C-suite allowed outgoing CIB chief Tom King to look after his staff.
Before the bonus cap, too, cutting staff was easier and cheaper. Investment banks, particularly the institutions reporting the biggest losses and trading furthest below book value, are now pouring money into restructurings.
To choose just one example, Standard Chartered swallowed $700m of redundancy costs last year. For context, underlying profit at the firm was… $800m.
Paying lower salaries and higher bonuses makes redundancy cheaper, because redundancy costs are usually pegged to salary. More miserly management teams can also try simply disappointing someone’s expectations so drastically that they walk — the bonus offers a simple and tangible hint that one’s prospects may be better elsewhere.
Which brings us to deferrals, the human resources equivalent of non-performing loans. Previously paid compensation, which has yet to vest, simply clogs up investment bank financial statements.
The Prudential Regulatory Authority in the UK now requires three to five years deferral for any material risk taker, rising to five years for risk managers and seven for senior management. But even before the rules came in, deferrals had been rising under regulatory pressure.
There are several good arguments for structuring compensation with an element of deferral and long-term accountability, and the bonus cap has little to say on the subject. Indeed, a major part of the UK argument against the cap is that deferral works better. But it comes with unintended consequences.
Fewer bankers quit, even when pay disappoints, fewer bankers are bought out, and mismatching between staffing and business is more likely to persist. Banks have to carry on paying for compensation awarded years past. Investors trying to assess whether banks actually make money or not now need to factor in this quagmire of back pay — revenues in the febrile markets of Q4 2015 have to pay compensation earned in the back end of 2013 and 2014.
It seems doubtful that management in the banks that have reported so far will argue the point — they have PR teams for a reason — but the bonus cap is doing exactly what it was expected to do: raising fixed costs, reducing flexibility and hurting profits. The European Parliament should be pleased with that.