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Bonus Watch '14: EU Banks Will Be Mildly Inconvenienced

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OH GOSH LET'S GET REAL ANGRY ABOUT THE EU BONUS CAP, which is moving forward and would limit bankers' bonuses to 1x base salary, or 2x with shareholder approval. It is super dumb.1 England hates it, what with having a functioning banking industry and all. Bankers hate it, being bankers.2This guy thinks it makes total sense, being a Belgian lawmaker for the Green Party:

"If I have to judge from the reaction of the [banking] industry, this will impact them. And this will also impact the overall amount of remuneration," said Philippe Lamberts, a Belgian lawmaker for the Green Party who was one of the leading negotiators for Parliament. "I think it will really hit them."

Feel free to vent in the comments, you've earned it. But this Lex column strikes me as the only worthwhile thing to say about it:

Dear Star Banker, ...

Your fixed, cash salary has been increased from €500,000 to €10m per year, roughly in line with your average total compensation for the past five years, to be paid monthly into an escrow account we will open on your behalf. By signing this contract you agree that from this escrow account a monthly net payment equivalent of €500k per year will be paid into your personal current account.

At year-end, you are entitled to the full balance of your cash salary remaining in the escrow account subject to strict clawback provisions detailed in this contract. In summary, if 100 per cent of your various targets are achieved you receive €9.5m, on a sliding scale to zero ... In addition, and based on the same formula and criteria as above, you will be entitled to a bonus worth at least 50 per cent of your post-clawback salary.

Get it? No? Consider another line of work.

I kind of mean that. The future of banking, not totally unlike the recent past of banking, would seem to involve a healthy dose of regulatory-arbitrage creativity, so if you're not comfortable with that you may not even earn your 1x bonus. This guy puts it a little more blandly than Lex did, but if you listen closely you can hear the excitement in his voice because he's going to make a lot of money off of this:

"If the cap is implemented, it could result in significantly more complex pay structures within banks as they try to fall outside the restrictions to remain competitive globally," said Alex Beidas, a pay specialist with the law firm Linklaters.

I assume that "more complex pay structures" encompasses escrowed-and-clawbacked base pay,3 for one thing. Or related things like paying your base in the form of one-year structured securities linked to the performance of your desk. [Update: In this vein, John Carney suggests that banks "form a special purpose vehicle to which you sell the rights to half of the future profits from a trading desk" and pay base salary in part in SPV shares.] Or maybe fair-value tinkering: if you get a base of €500K, your bonus can be €500K of value, but if it's €500K of creepy derivative exposure then maybe it can end up being worth a lot more than that. Or perhaps corporate structuring approaches: the rules appear to apply to EU bank employees worldwide and worldwide bank employees in the EU, potentially leaving open the door for structural tinkering for EU banks' employees abroad. Or lots of other things, which are left as exercises for the reader, or for Alex Beidas, who I suspect is beavering away on them. [Update: Also there is this.]

Bloomberg has a very nice article today about a Citi/Blackstone regulatory capital trade, in which Blackstone writes CDS on a first-loss tranche of a $1.2bn pool of Citi shipping loans, and Citi gets to dramatically decrease the risk-weighted assets, and thus the capital requirements, relating to those loans. If you just imagine that the whole loans have a 100% risk-weighting (I have no idea) and that Citi's capital requirements are 10% (for simplicity), then pre-trade Citi had $1.2bn of notional exposure, $1.2bn of RWAs and needed to have $120mm of equity capital to support them. After selling, say, the 0-to-15% tranche via a synthetic securitization, Citi still has $1.2bn of loans on its books, though it's reduced its notional exposure to $1,020mm (the last $1,020mm). But because that exposure is now very credit-enhanced, it is much safer and higher-rated (on internal models at least), and so Citi can reduce its capital requirements (and RWAs) by "as much as 96 percent." So it now those loans represent only like $50mm of RWAs, and require just $5mm of capital.

It's like Credit Suisse's PAF2 trade, only instead of shifting the risk to Blackstone and then back to itself via magic, Citi is shifting the risk to Blackstone and leaving it there. Progress!

Still, one fairly obvious thing to ponder is, how is Blackstone capitalizing the vehicle that is writing the $180mm notional CDS? Not, I will guess, with $115mm of equity capital (the amount that Citi is saving). Why would Blackstone rent its equity capital to Citi, and why would Citi want to do that? Why would Blackstone's equity capital, plus a fee, be cheaper than Citi's?4

The answer is that Blackstone is not a bank, is not subject to Basel III regulation, and can make its own judgments about how risky those loans are and how much equity it needs to support them. And presumably it came to a lower number than Basel did. And so the trade was made. And so there are $1.2bn of loans that, if Citi held them, would be supported by $120mm of equity capital, but that are instead supported by less than that. And so the banking system is safer, but only sort of.5

I submit to you that this story contains a lesson for Philippe Lamberts. Specific, detailed rules with hard numerical thresholds designed to make banking look more like what politicians want it to look like - might make banks look more like what politicians want them to look like? But they're much less likely to make the banking system considered broadly look like what politicians want it to look like. They just provide lucrative work for non-bank sources of capital relief, and for pay specialists with law firms. Making the banking system look like what bankers want it to look like, it turns out, pays better.

Bonus caps: letter to star banker [FT Lex]
EU clinches deal to cap bankers' bonuses [Reuters]
EU Reaches Deal to Curb Bank Bonuses [WSJ]
Bankers Decry EU Bonus Rules [WSJ]
UK to fight EU plan to cap bankers' bonuses [Guardian]
Blackstone Profits From Regulation With Citigroup Deal [Bloomberg]

1.I mean, I've made vague contrarian sympathetic noises. Upside comp convexity don'tcha know. But basically it's dumb.

2.Though not all of them. From Reuters:

"It's anti-capitalist," said Colin Ellis, who works in the technology division of a bank. "If you have a grocer and he sells loads of fruit, he gets to keep it (the money). When a guy on a trading desk makes loads of money, he deserves to have it."

Some disagreed. "There is a huge disparity between what senior managers and junior members get and I don't see anything wrong with a cap," said Jose, a 25-year-old who works for a bank but declined to give his second name.

You could write a dissertation on the sociology of the banking industry based on just those two astonishingly perfect quotes.

3.Incidentally I find totally unimpressive arguments that "it would be harder for banks to raise base pay this time around because of the higher capital standards that increase their costs and limit how much of their revenue they can pay out to staff." Perhaps if there is an aggregate cap on pay that would reduce pay overall, but that would do nothing to deter the raising-base-and-escrowing-it approach, or the raising-base-and-not-escrowing-it approach for that matter. Remember that banks accrue comp throughout the year based not just on the base salaries they're paying in cash, but also for bonus accruals (and that those bonus accruals can sometimes get ahead of themselves). Changing the contractual terms of what you call those accruals wouldn't change the accounting, or the cash flows, or anything economic.

4.Don't answer that. There's some chance I'm just wrong and Citi really is renting cheaper capital, which has its own issues.

5.There is a variant where Blackstone fully capitalizes the vehicle with equity but Citi's fee payments equal or exceed the amount of protection it's buying, with Citi effectively just writing off the first 10% because a 90% senior tranche requires so much less capital than the 100% whole loan that it's worth it. The last two sentences remain just as true in this version: the system as a whole has less capital.