Compensation has always been a big topic in the capital markets, especially when business is bad, jobs are being cut across the Street, and regulatory changes in how people are paid are afoot — such as right now.
In the aftermath of Brexit, the UK government is keen to rework the country’s rules to make it (or the City of London at least) a more attractive place for banks and their staff to ply their trade. It is right that the system should change, and the government has an opportunity to optimise it by taking a fresh approach.
In this white paper, which carries an introduction by former prime minister Boris Johnson, the benefits of Brexit are summarised in buzzy phrases such as “taking back control” and instituting “a global Britain”. Crucially, the report suggests that the UK can now uncouple itself from the “rules, regulations and institutions of Brussels”.
While many people have struggled to spot an abundance of perks from Brexit, beyond the thrill of having one’s passport stamped — itself undermined by the extra queueing involved in obtaining that privilege — at least there have been attempts to change the rules governing the financial services in the UK’s favour.
In September, Kwasi Kwarteng, during his brief stint as chancellor of the exchequer, and with the backing of his ally and boss Liz Truss, who was prime minister almost as briefly as he was chancellor, announced that he intended to scrap the cap on bankers’ bonuses that the EU had imposed in 2014.
Arguably, removing the cap was one of the few sensible policies in Kwarteng’s notorious mini-budget, which cost him and Truss their jobs, and the money of UK citizens through them paying higher mortgage payments and higher Gilt coupons after the sterling rates market plunged into chaos following its announcement.
Ditching the bonus cap would be a step in the right direction towards deregulating the financial services sector, as it only served to jack up fixed pay and ushered in paying staff bonuses via the backdoor, through role-based allowances (RBAs).
The cap did little to achieve its aim of reducing excessive risk taking, which was better managed through enforcing other regulations on how banks are capitalised and operate.
A bad cap
The cap limited the size of an annual bonus to no more than 100% of fixed annual pay (or to 200% with shareholder approval).
With the European rules now dictating where certain types of market activity can take place in an effort to draw business away from the City of London, the UK government would hope that removing the cap will encourage global banks and their staff to operate from this country, rather than other financial hubs.
Since Kwarteng’s announcement, scrapping the cap has been widely debated. In September, GlobalCapital published an article that suggested City bankers wanted, by and large, to keep it in place.
“I haven’t come across a single person who’s thrilled,” said a senior equity capital markets banker in London at the time. “I think everyone thinks the timing is appalling.”
This comment on Kwarteng’s timing reflected a fear that bankers would be perceived as taking ever-bigger bonuses during the cost-of-living crisis, which would do the City no favours in the popular imagination.
But it missed the point that bonuses are just one element of pay, and there are other means of compensating staff if bonuses are limited — which brings us to the topic of RBAs.
The downside of increasing bankers’ base pay and paying them RBAs, which were introduced to get around the EU’s bonus cap, is that compensation remains high regardless of performance — certainly not what was intended. And in years like 2022, it means banks have to make redundancies or stop paying bonuses to the staff they want to encourage out of their doors, in order to save on staffing costs.
Surely, a more flexible scheme that enables banks to “dial back variable compensation in order to manage their costs” would be far better, Craig Coben, Bank of America’s former co-head of global markets, told GlobalCapital last month.
Coben lamented the end of lower base salaries and higher bonuses, which he said “created a very sharp incentive system for performance” and the introduction of RBAs.
Closing the loopholes
In 2014, after RBAs’ introduction, the European Banking Authority (EBA) reminded financial institutions that had to ensure that their compensation schemes complied with EU law.
The regulator’s report said RBAs were not fixed remuneration, as had been suggested, but were “discretionary, not predetermined, not transparent, not permanent, or revocable” and so “should not be considered as fixed remuneration but should be classified as variable in line with CRD IV [the EU Capital Requirements Directive]”.
Since Brexit, RBAs have been used in the UK. And since the possibility of removing the bonus cap was raised, there have been rumours within Morgan Stanley and Goldman Sachs that the firms will end RBAs to help control staff costs.
A proper regulatory regime would permit flexibility around staffing costs, and would remove the need for banks to keep paying people who have not earned the revenue to warrant their rewards.
And as the bonus cap was ineffective at curbing unwelcome institutional risk taking, there should be no fear of it increasing should it be removed.
Ditching both the bonus cap and RBAs would be a positive thing for banking, as it would allow banks to provide a greater incentive for individual performance but in a regulatory environment that has toughened up since the crisis of 2008, in an effort to curb some of the excesses that led to it. This should go some way to rein in attempts to book long-term positions that pay banks and bankers well at the end of the year but go south in following years, costing banks, their shareholders, other bankers and ultimately taxpayers, rather than the banker that put the trade on.
But what of the long-term performance conundrum? Here further thought is needed.
Holding bonuses as shares in escrow is all well and good, but individual bankers have little influence over their firm’s share price. (Credit Suisse is perhaps an exception, wags may suggest.) A better system would be one that commits bankers to have more skin in the game, such as schemes or models like those used in private equity or partnerships. Such structures curb excessive risk taking by linking the fortunes of the risk taker with the institution in whose name they take risk.
A portion of bonuses could also be ringfenced in a pool that tracked performance, be it at the individual, desk or divisional level, and the excess made in good years used to cover losses in leaner times or during disasters, but only made redeemable after a long vesting period — say five years.
There would be wrinkles to iron out if this was to work — not least ensuring the controversial tax breaks that private equity barons enjoy are not made available — but nothing that would be insurmountable for an industry, the business of which is apportioning capital.
Such a system, if executed correctly, would be a win for banks and their shareholders, allowing institutions greater flexibility over costs, while rewarding long-term profitability. It would also be a win for bankers, by helping to dispel the public perception that they are rewarded for doing nothing and ensuring only those who delivered long-term profits were well paid. And it would be a win for the government, by providing the UK country with a marketplace where talented financiers could make a lot of money (and pay a lot of tax) without the need for taxpayers to clean up their mess should their plans blow up.