A smarter way to curb bankers' pay

Top earner 25 November 2011

By Iain Stewart

Current calls for curbs on bankers' pay in Europe and the US stem from the enormous bail-outs that taxpayers funded to stabilise their economies in 2008. Today governments are exploring options ranging from a bonus tax to strict regulation to bring what many see as extravagant bankers' earnings under control. Yet recent research funded by the ESRC shows some options will fail to curb bankers' pay - and even risk making banks more unstable.

The study, by economist Dr John Thanassoulis at the University of Oxford, did find one option: a cap on the proportion of the balance sheet which a bank can use for bonuses will both limit bankers' pay and reduce the risk of a bank default.

Currently the level of bankers' pay poses a significant risk factor for banks. For example, the study notes that just before the financial crisis, staff wages and bonuses in one year at Merrill Lynch and at Morgan Stanley were the equivalent of half of their entire stock of shareholder equity. And in ten per cent of the banks and financial institutions traded on the New York Stock Exchange over the last ten years, bankers' pay (including bonuses) was worth more than 80 per cent of total shareholder equity.

Dr Thanassoulis' research, to be published in the Journal of Finance, shows that a cap that reduces the bonus pool by between US$1 billion and US$3 billion every year for each major financial institution would be at a level which minimises bank risks and maximises bank values. This calculation is based on the financial data of 20 global banks.

Dr Thanassoulis' proposal differs from the EU Parliament’s decision to place explicit caps on individual bankers' bonuses, and from the US regulators’ proposition to introduce a new system of regulatory sign-off for individual bonus arrangements. Dr Thanassoulis argues that such regulations will have the effect of forcing banks to increase fixed wages in order to attract and retain bankers.

"Unlike bonuses, banks have to pay fixed wages in bad as well as good times; so increasing risks in the banking sector. And as pay is such a large fraction of shareholder equity, this would raise bank risks significantly," he says.

On the other hand, an adjustable cap on the proportion of the balance sheet which can be used for bonuses still leaves banks with flexibility as to how they motivate and reward individuals. Such a cap hits weaker financial institutions harder by preventing those offering excessive bonuses to poach bankers - which in turn removes the pressure on other banks to drive up pay to recruit and retain talent. This lowers the overall market level of bankers’ pay, reduces bank risk, and will raise bank values.

The level of the cap would need to be determined by bank regulators, such as the Bank of England. Setting the cap at the right level will not be easy. "The cap should be the most stringent cap on the proportion of the balance sheet which can be used for bonuses without resulting in banks moving to increased fixed wages," advises Dr Thanassoulis.

The study warns, however, that 'very stringent' bonus caps, or a requirement to pay wages rather than bonuses, would increase the risk of the bank defaulting. The more widely the cap is applied across the banking sector the larger the benefits for banks, thereby reducing the level of risk to the sector as whole.

The study also argues that a policy, followed in the UK and in France, to tax banks on their bonus pools is 'ineffective' in reducing bank risk. As banks still bid for bankers up to the market rate, the risk to banks remains unchanged - so the main benefit of this policy is to raise tax revenues.