Flawed logic at heart of bonus rules
JUST a few years ago, it would have been unthinkable that governments would seek to regulate the way employees were paid by private firms. The recession changed all of this: it soon became the received wisdom that large banks deemed “too large to fail” should have their pay policies regulated by the state to make sure they don’t encourage staff to take large risks which could jeopardize the economic system. Yesterday, the authorities signalled a further extension of their powers with the FSA’s announcement that the number of firms affected by the pay rules will jump from 27 to 2,500, including stockbrokers, asset managers, hedge funds and others. The FSA is playing catch-up: it is implementing directives laid down in Brussels. Bonuses are not being capped – but many employees will see 40-60 per cent of their compensation deferred over three year periods and paid out in equity or equity-like instruments.
It makes sense for pay policy to be reformed, of course, and for companies to align their interests with those of their staff. Some firms did incentivise some of their staff – especially those with a sales role – to behave in excessively exuberant ways; it is good that the largest institutions have cracked down on this. Yet to acknowledge the need for reform does not mean accepting that the best way forward is for the government to step in.
Three points were never answered adequately by supporters of regulation: first, why – given that everybody has learnt at least some lessons from the crisis – would chastened shareholders not force firms to make sure that pay policies were sufficiently long-termist? After all, the bonus rules are meant to protect shareholders against their own staff, in a bizarre form of reverse Marxist logic. Second, if short-termist bonus policies were so important in fuelling the bubble, why is there no robust academic evidence that demonstrates this? Why are serious academics more concerned with other factors, such as low interest rates, faulty capital adequacy or incorrect mathematical models? Third, how come Lehman, AIG and other flawed firms actually paid a large proportion of their bonuses in shares? For some reason, what now passes as best practice didn’t save them.
I’m not the only sceptic: at last September’s Mansion House speech, Lord Turner, the FSA’s chairman, pointed out that “it is possible to overstate the importance of bonus structures in the origins of the crisis: they were, I believe, much less important than huge failures in capital adequacy and liquidity regulation.” Needless to say, nobody listened, not even Turner’s own FSA.
There is a big difference between arguing that a few systemically important banks should have their pay regulated and saying that all financial institutions should face the same rules, even if they are too small to pose a risk to the economy. This massive extension of the state’s power to regulate private contracts is therefore unnecessary, wrong and counter-productive. The new rules will merely guarantee less wealth and prosperity for London. Over time, activity will migrate to Asia, to the Middle East, to Switzerland and even to the US. The rest of the EU doesn’t care; as far as Paris and Berlin are concerned, London deserves to suffer. But the coalition government should have stood up for the City; it beggars belief that it has not done more to protect London’s competitiveness and jobs.
allister.heath@cityam.com