A provisional EU agreement has been reached on the principle of capping bonuses in the European banking industry. Sony Kapoor and Philippe Lamberts present a case in favour of such a cap, arguing that the current skewed incentives faced by bankers drive excessive risk-taking, which ultimately has to be paid for by taxpayers

Kapoor, Sony

Lamberts, Philippe

English

LSE Research Online

blo gs.lse.ac.ukhttp://blogs.lse.ac.uk/europpblog/2013/03/01/cap-on-bankers-bonuses-limit-excessive-risk-taking-taxpayer-eu/Canary Wharf, Lo nd o n, Cre d it: David  Il i ff (CC BY SA 3.0)A cap on bankers’ bonuses is needed to limit excessive risktaking and the associated costs to the taxpayer.by Blog AdminA provisional EU agreement has been reached on the principle of capping bonuses in theEuropean banking industry. Sony Kapoor and Philippe Lamberts present a case in favourof such a cap, arguing that the current skewed incentives faced by bankers drive excessiverisk-taking, which ultimately has to be paid for by taxpayers.The European Parliament is right to limit the maximum bonus bankers can command as aproportion of  base salary. This will help tackle the culture of  excessive risk-taking and thebending of  rules that has now become endemic to banking. Undertaking this at an EU-widelevel will also limit any large-scale migration of  the so-called ‘talent’, an argument of tenadvanced by the opponents of  bonus caps. More importantly, it will reduce the risks borneby tax-payers and go a long way toward rehabilitating the industry, f orcing it to f ocus onserving the real economy again.Whatever one might think of  base salary levels in f inance, it is the possibility of  largebonuses that has been a major driver of  many of  the most pernicious problems in banking.The risk-reward landscape f aced by bankers is highly skewed. Traders and deal-makers, in particular, canearn multiples of  base salary on the upside. Retail banking has also seen a prolif eration of  perf ormance-linked pay, where selling large volumes of  products, such as payment protection insurance, is highlyrewarded. The downside, if  things go wrong, is limited to getting f ired and losing one’s salary. Criminalprosecution and prison, no matter what the degree of  malf easance or irresponsibility, remain an exception.The costs of  things going wrong are of ten borne by taxpayers.These skewed incentives drive excessiverisk-taking among traders, promotingmarginal and sometimes “value-destroying” mergers and acquisit ions byinvestment bankers, and the sale ofinappropriate f inancial products by retailbankers. All else being equal, larger, riskiertrades, bigger mergers and higher volumesof  products sold are more prof itable. Asthe Libor scandal, the widespread mis-selling of  f inancial products and supportf or dubious tax-evading activit ies all show,the starry-eyed pursuit of  ever- largerbonuses also drives bankers to cutcorners with the law. As a consequence,the f inancial system ends up being larger,more complex and has more f requent transactions than is socially optimal or f inancially necessary tosupport the real economy. Rent seeking at an individual level by bankers, where they can pocket the gainsand impose losses on taxpayers and thus the rest of  society, is ref lected at an aggregate level by abanking system that has become prone to parasit ic rent-seeking.Controlling bonuses f or eventual losses is not enough (the so-called claw-backs), because risks will onlysometimes materialise into losses, particularly if  bankers load up on low probability, high impact systemicrisks. When such risks materialise, as they did in 2008, the whole banking system then needs to be proppedup, or the economy f aces collapse. The bending of  rules at institutions also of ten goes undetected. Inmost years, bankers will be heavily rewarded f or behaviour that at the outset is harmf ul f or the whole ofsociety.Linking pay-outs to the risk f aced by the f irm will not work either, as even the largest traders will onlyaccount f or a f raction of  the f irm’s overall risk. The sensit ivity of  bonuses to prof it attributable to a bankerremains much larger than to any increase in f irm-level risk. It remains entirely rational to load up on risk, nomatter if  one gets paid in coco / bail- in bonds. Paying bankers in shares or options can actually becounterproductive as such packages f urther increase the asymmetry between the good and bad states ofthe world. The downside of  shares or options is limited whereas the prof it potential is enormous. Paymentin share options has been known to get executives even more f ocused on short term gains, even when itcomes at the cost of  long-term pains.In f act, there are only two ways to address the heavily skewed incentive structure bankers f ace: byincreasing downside risks f aced by individuals or by limiting rewards. Since we are not about to starthanging bankers, the excessive risk taking that is endemic to the f inancial system can only be tackled bycapping rewards.Bonuses supposedly reward ef f ort or ability, but are usually based on outcomes, because these are easierto measure. A reasonable case can be made f or rewarding ef f ort with prof it- linked pay in the real economy.The longer a good dentist works, the more income he can generate, but there are only 24 hours in the day.In f inance, the link between ef f ort and prof it is much less robust than in dentistry or manuf acturing. Biggeror riskier trades can generate much higher prof its, but the link to additional ef f ort is weak. Should activit iesthat bend rules to generate higher prof its be rewarded in proportion to these prof its? Banking is “scalable”,like creative prof essions such as writ ing or acting. In these areas, a relatively small personal ef f ort cangenerate huge prof its: JK Rowling, the creator of  Harry Potter, is now a billionaire.However, there are three important distinctions between such creative prof essions and banking. Theaverage author and the average actor are poor, while the average banker is not. Writers have to beexceptionally talented or exceptionally lucky to make it, bankers do not. Reading Harry Potter or watchingTom Cruise (personal taste aside) adds to the lives of  millions of  people (at least it does not make themmiserable and you are f ree not to engage). Problems in Banking, on the other hand, can and do pose anexistential threat to whole societies, irrespective of  our individual choices.Additional considerations of  f airness only add to what is already otherwise a very sound stability case f orimposing bonus caps on bankers. This would also produce subsidiary benef its of  a banking system that issimpler, smaller and more ethical, support f or which has snowballed since the f inancial crisis.Note: This is the original longer version of an Opinion Piece arguing for imposing caps on banker bonuses thatappeared in the Guardian newspaper on the 25th of Feb 2013.Please read our comments policy before commenting.Note:  This article gives the views of the author, and not the position of EUROPP – European Politics andPolicy, nor of the London School of Economics.Shortened URL for this post: http://bit .ly/ZLOMS1 _________________________________About the authorsSony Kapoor – Re-defineSony Kapoor is Managing Director of  the Re-Def ine, Chairman of  the Banking StakeholderGroup of  the European Banking Authority and a Senior Visit ing Fellow at the London Schoolof  Economics.-Philippe Lamberts – European GreensPhilippe Lamberts is a Member of  the Committee on Economic and Monetary Af f airs at theEuropean Parliament and the spokesperson on economic and f inancial af f airs f or theEuropean Greens.Related posts:1. While Europe’s polit ical leaders continue their diplomatic dance, real power in theeurozone has shif ted to central bankers. (7.8)2. Polit icians in Cyprus need to move on f rom the ‘blame game’ f or the country’s economic woes if  theyare to make badly needed economic ref orms. (7.5)3. The European Central Bank has delegated its lender of  last resort duty to panicky bankers who arethe slaves of  market sentiments. Pumping in over 1,000 billion Euros this way has not stabilizedEurope’s sovereign debt markets. (9.6)

A cap on bankers’ bonuses is needed to limit excessive risk taking and the associated costs to the taxpayer

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