Populist Legislation Sure to Destroy London’s Economy

Well, this is turning into a delightful little serial isn’t it? Today, I would like to discuss the most controversial of all issues concerning investment banking: remuneration. This has been a hot topic since the (thoroughly understandable) moral outrage at bankers still raking in massive bonuses following the crisis. Whilst I understand this viewpoint, there is a piece of legislation coming in from the EU that is pretty much sheer insanity; which will almost certainly destroy our financial services sector and deepen any future recessions. I know everyone dislikes bankers these days but I can’t help but feel we might miss the substantial amount of GDP and tax they contribute once the EU has decimated what was once the jewel in the British economic crown.

Of course, I am discussing the proposed cap on bonuses. I believe the only reason this suggestion has actually got through is because to anyone involved in the industry and to British politicians, it was so utterly ludicrous nobody gave it a second thought. For those unaware, the EU is proposing a 1:1 cap of variable:fixed income in a banker’s pay (i.e. your bonus is capped at 1x base salary). There is a clause to allow for 2x base salary with shareholder approval, which I would be astonished if any banks fail to get.

In my mind, this is a bow to populism with very little thought put into the damage it could do. Or possibly, in the case of Germany and France – long embittered by having to pay the downside of our risks whilst we reap all the benefits – a great deal of thought put into the damage it could do. Essentially, the reason this won’t work is because it’s aimed at reducing total compensation. I would be amazed if that happens.

An investment bank (I’m talking pure corporate advisory at the moment) is a human capital-intensive business. Their only expenditure is their employees. As such, why on earth wouldn’t they give as much as they possibly can to their employees? It makes economic sense. The purpose of a public company is essentially to generate value for their shareholders. If they don’t pay out as much as possible of revenue to the bankers who generate the money, what are they going to do with the rest? They could sit on it in a large cash pile; that screams incompetent corporate governance. They could invest it into the company to drive up the stock price. That would be good. That is exactly what they do by paying their best bankers generously. They are investing their capital in the most effective way possible. Consequently, the chances of them substantially reducing compensation are pretty much nil. This is not good.

The reason this won’t work is because it’s aimed at reducing total compen-sation. I would be amazed if that happens.

Let’s say we have a rock-star managing director. He brings in over £100m a year in fees, so consequently gets a £600k base salary and £9.4m bonus. There is no way an advisory firm would let this employee go if he continues to perform. Consequently, they will end up paying him a £5m base salary, which is pure insanity. Let us now propose there’s another recession. This company has many similar rock-star MDs (they only hire the best). Sadly now there’s no business to go around, no matter how good you are at making deals. Previously, the bank’s intrinsic risk management system – and yes, that is effectively what bonuses are – would’ve kicked in. The £9.4m bonus would’ve been axed, the MDs could all have kept their jobs and continued contributing to the economy, albeit at a lower rate. If the bank has a £5m fixed cost, they cannot do this. A large proportion of the MDs would have to be fired for the business to remain profitable. Not only would this destroy corporate value in the long term (if you don’t see how this affects you, imagine what it will do to your future pension if all finance equities slide 70%); it would also make the recession that triggered this scenario an incredible amount more severe.

I personally think the sane answer to the compensation question for bankers who work in risky divisions, such as debt packaging (or, you know, trading: that division whose sins bankers often have attributed to them), is bail-in able bonds. Cap cash bonuses at 1x base salary, sure: that’s definitely a good idea, as high cash bonuses do tend to encourage reckless risk taking. But allow bankers to have a higher variable payment than this in the form of bonds that will be the first port of call when the company needs a bail-out. Keep the heady compensation, as much as it angers the populace, but make these bankers the first port of call when it hits the fan. Maybe, if the bankers were aware the majority of their compensation was up for grabs if their actions turned out to be too risky and have a negative effect on the bank, nothing would ever hit the fan. Or, you know, you could just cap all bonuses and drive up fixed costs. In this scenario, who will be responsible for taking the financial burden of bailing out the banks when it all inevitably goes wrong again? That’s right – you, the taxpayer, not those dastardly bankers who caused all the trouble in the first place.