The EU’s bankers’ bonus cap will make banks safer and richer

It looks likes bankers bonuses are going to be capped at twice their base salary. As reported in the Financial Times (£), banks will be able to offer double this with explicit shareholder approval and there are various other schemes in the offing to subvert this regulation, but the brute force of this regulation means that big change is coming to bankers’ remuneration.

I agree with Martin Wolf that this is a political clusterfuck in the making for the Tory Party (well Martin doesn’t use that term, I’m reading between the lines). Defending bankers bonuses? Good luck with that in 2015. But the big story here is that this regulation has the potential to really improve bankers’ incentives and the productivity of the whole sector.

Bear with me. This post will essentially be me shuffling together this Lex post and this Chris Dillow post, so if you’d rather read the originals and cascade them together yourself go ahead, otherwise, I’ll continue.

The most promising scheme to circumvent this bonus ban is to replace it with vast base salaries and subject to strict clawback provisions. A rather smug sounding fictional letter in Lex puts it so:

Your fixed, cash salary will be increased from €500,000 to €10m per year…to be paid monthly into an escrow account. At year-end, you are entitled to the balance of your cash salary in the escrow account subject to strict clawback provisions detailed in this contract…

Theoretically this should produce precisely the same ex post  payments and ex ante incentives that bankers currently enjoy (and we endure). The escrow account will be an accounting reality but an economic fiction. Meet the new system, same as the old system bankers will be told.

But, this misses a lot of the vital psychological differences between bonuses and fines. A bird in the hand is worth two in the bush is just folk psychology justification of endowment effects. This is how airlines get people to pay extra charge after charge while their booking. Once you have that plane ticket in your basket its “yours” and there is a psychological cost to giving it up.

The money in bankers’ escrow account is this plane ticket and this set up will produce a different set of incentives. Will this incentive structure improve the operations of the banking system? I would suggest it will. Chris Dillow pointed to research two years ago from the University of Nottingham which suggested that fines provide better incentives than bonuses.

Economists got subjects to play an inspection game. This comprises two players – an employer and a worker. The worker can choose either high or low effort. The employer chooses whether to inspect the worker’s effort or not. Both inspection and effort are costly… The result of this experiment were clear. Fines induce more effort than bonuses. The joint earnings of bosses and workers were 18.6% higher in the fine experiment than in the control one, and 18.1% higher than in the bonus one. Bosses’ earnings in the fine experiment were 36.5% higher than in the control test, and 80% higher than in the bonus test.

One of the leading contributors to the economic fragility which led to this little depression was excessive risk taking, outright deception, fraud and opacity in the financial sector because bankers were able to extract a huge amount of the surplus from the activities of banks. Realigning incentives so that banks can control their employees and run more safely is in everyone’s interests.

The costs of this to the financial sector are pretty clear. Let us look at AIG’s share price:

AIG collapse

Whoops!

We’re also on the hook too of course. In 2009, Andy Haldane puts the figure for direct financial support from the US at $100bn and from the UK at £20bn. World output then was around 6.5% lower it would have been without a crisis. In the UK, the loss was around 10%. In money terms, that translates into output losses of $4 trillion globally and £140 billion for the UK. Those figures are out of date now: the UK loss is now much, much larger.

The pollution that is excessive risk taking in finance then appears to have an answer, changing remuneration away from bonuses and towards fines. It is in the interest of both those who own banks and those who bail them out.

Theoretically then, we will have a test of Chris’s questions.

Why is the [bonus] system so much more common than the [fine system]? It can’t be that banks are run for the benefit of employees, can it?

If this new compensation scheme is adopted, and if our theory of fines and bonuses are correct (big ifs!), it will improve banks performance. If banks are profit maximising operations they will not leave Europe. Indeed, banks currently operating overseas will seize this opportunity to tame their rapacious staff and will or will threaten to move their operations to Europe.

Of course, if banks are run for the benefit of their employees, if they are institutions captured by their senior staff, banks will leave and carry on paying inefficient bonuses. As Jamie says, when life gives you popcorn, then eat popcorn. Let’s wait and see what happens next. One way I’m richer externally as the financial sector becomes safer and more productive, the other I’m richer internally as I get to say “I always told you they were wrong’uns.”

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