Tilting the playing field - The Economist
Finance Minister George Osborne and his London colleagues argued, unsuccessfully, that the EU’s cap on bankers’ bonuses would drive up base salaries, reducing the money that could be clawed back and leaving total compensation unchanged. This is incorrect. Bankers’ bonuses should be capped, and not for the schadenfreude of seeing it done.
Banks intentionally skew compensation towards bonuses so that they can radically alter compensation year-to-year. This shifts risk from the bank to its employees. Banks can revise bonus policies for individual employees based on performance, or across the board in a downturn.
This, however, creates skewed incentives for bankers. For any compensation year, a banker can at worst lose their job, representing a 100% loss of base pay, or at best rake in a large bonus representing a 500-1,000% gain on base pay. This asymmetric payoff effectively converts every decision they make into a “hail-mary pass”: they undertake exceedingly risky bets knowing their losses are in a sense capped while gains can rise astronomically.
By capping bonuses at 100% of base, the EU policy restores symmetry to bankers’ incentives. Their maximum downside is 100% of base pay (getting fired) and their upside is exactly the same. This will certainly result in base pay increasing as bonuses decrease, and that is the point. With relatively more to lose, bankers will think twice about taking undue risk.
But will the rise in base pay equal the reduction in bonuses, as Mr. Osborne suggests? The answer is no, and any banker worth his salt knows this. Consider two pay packages, an ‘old’ one with $500,000 base and $1.5 million bonus, and a ‘new’ one with $1 million base and $1 million bonus. To Mr. Osborne the two are equivalent, but to a bank the new package is vastly more expensive. The reason is because a greater portion of pay in the new package is ‘locked-in’ in the form of base pay, leaving the bank with a greater share of the risk.
As a result, the EU policy will actually drive down total compensation for bankers. Banks will effectively charge their employees a premium for the additional safety provided by a larger base salary. Thus, the shift in the mix of bankers’ compensation will simultaneously reduce compensation across the board and eliminate the incentives for many of the most odious behaviors that drove the global economy to crisis. Mr. Osborne should welcome the change.