You would think that European regulators have a lot to worry about with their banks but they’ve got time for a surprising distraction: finalizing a plan to cap bankers’ bonuses at 1x base compensation*:
Bankers’ bonuses across the European Union are set to be limited by law, with many bank lobbyists admitting in private that they have lost the fight against a European Parliament initiative to limit the size of bonuses relative to salary.
Some banks still hope to increase the proposed ratio from 1:1 to 2:1 or beyond, while others are trying to limit the restriction to upfront cash bonuses, excluding deferred payouts. But many bankers now accept the principle of a ratio as inevitable.
“It’s dawning on many banks that this is game over,” said one senior lobbyist. “Many are now resigned to the 1:1 ratio.”
Assuming – as is currently the case – that the caps will be only on the ratio, not the amount, this is a somewhat weird move. Banks in Europe, as you may have heard, are somewhat undercapitalized. They also continue to need to employ bankers, and the going rate for senior bankers in Europe seems to be around 2.5x their current base salaries,** which are already up due to previous noise (and action) about bonus caps. A cap like this should push them up further, increasing banks’ fixed costs at exactly the moment they can’t afford to pay them.
But of course the regulators know that and view it as an acceptable trade-off for the benefit of the bonus cap, which mainly to nudge banks’ culture away from levered risk-taking and toward … I’m gonna say bureaucracy? We talked a bit yesterday about how giving risk-takers too much equity in their risks attracts riskier risk-takers; giving risk-takers too little equity in their risks is a very blunt instrument – it makes them pay less attention – but it does have the advantage of attracting fewer risk-takers. If you want your annual compensation to be a levered derivative on your performance, you go to a hedge fund. If you want it to be mostly fixed and only dimly related to your performance, you go to the European bank of the future. You’d expect the latter group to be a bit duller and more conservative than the former, and dull and conservative may be what the European regulators want want.
Except that they may be looking at the wrong continent. It’s possible that JPMorgan’s comp practices for its Chief Investment Office ended up drawing risky types to the CIO, and signaling to them that they should take more risks. And maybe that led to them putting on a hedge or pseudo-hedge that was a profit center, and then a loss center, and then the center of a Congressional hearing, and then the central argument for taking back their comp. And maybe US bankers are in fact unable to resist adding a little bit of trading risk to whatever they do, and maybe the reason is that they just like their bonuses so much.
But Europe’s banking problems, at a caricatural level, are less about risk-taking by highly compensated risk-takers than they are about lending to homeowners and governments, and the effect of the global downturn on those loans. Here is the IMF report on Spanish banks, for instance (boldface mine):
The initial impact of the global financial crisis was relatively mild. The banking sector weathered the first wave due to robust capital and provisioning buffers. However, banks, like many of their international peers, lost access to wholesale funding markets. During this initial phase of the crisis, the authorities took measures to assist bank funding rather than to inject capital, in line with EU policies.
The second-round effects were severe. The domestic economy entered into a sharp recession, with construction activity collapsing, unemployment soaring, and with the contribution of foreign demand insufficiently strong to clear imbalances. This particularly affected the former savings banks, also reflecting weak lending practices during the economic upswing. In response, the authorities launched a restructuring and recapitalization scheme and tighter minimum capital requirements, thereby encouraging the transformation of these institutions into commercial banks.
The third phase of the global crisis is still underway, reflecting concerns about sovereign debt markets. The defining challenge of this phase is the strong interconnection between the sovereign and its banking system — with the former affecting the financial health of the latter, and vice versa.
In other words, European banks are in trouble, very broadly speaking, not because they are stuffed with degenerate gamblers but because they are stuffed with, well, bureaucrats. Their trouble was not taking big intentional risks via complex trades, but failing to identify that boring mortgages and lending to their own governments would get them in trouble. The problem was not risk appetite, which is increased by a bonus culture, but inattentiveness, which is decreased by it. Perhaps they could have even used a whale in their corner to throw on some macro hedges. And with the new bonus cap, they’re less likely to get one.
* Maybe. Or 2x. Or 5x:
Denmark, which is negotiating for all 27 member states, on Wednesday put forward a potential compromise package at its own initiative. It included a bonus cap of three times fixed pay for top executives and five times fixed salary for “risk takers”, along with a provision that empowered shareholders to set a higher ratio.
But 1x seems to be in the lead.
** That’s from page 16 of the linked report:
The data show that the median of the average ratios [of bonus to base] among [European Union member states] is 122% for executives and 139% for the other identified staff. The highest value of the average ratios that were reported by the MS was 220% for executives and 313% for the other identified staff.
“Identified staff” is a more senior group than just “staff,” but basically the average senior but non-executive European banker has a total comp of 2.4x his or her base. The highest ratio at a European bank was 10.4x, which seems more robustly American.