Regulation alone won’t curb bonuses

August 13, 2009

Less than a year after the financial system nearly collapsed, investment banks are once again preparing to shower their employees with mega-payouts. Many had hoped regulators might impose tighter rules in the wake of the credit crunch. But they have proved reluctant to stray too far into this territory.
 
Britain’s Financial Services Authority has just weighed into the debate with a code of practice on remuneration for the UK’s 26 largest banks and investment banks. Its broad objective is to  prevent banks from paying their employees in such a way that encourage them to take excessive risks.
 
To do this it wants to ensure that bonuses are paid out of profits, adjusted for the risks involved, rather than as a proportion revenues. It also wants bonuses to be spread over a number of years — at least for senior bankers and traders.
 
Banks that do not honour the code will be required to hold more capital or — in extreme cases — find themselves on the receiving end of FSA enforcement.
 
This is all sensible, as far as it goes. It would prevent the likes of Royal Bank of Scotland, which paid out large cash bonuses to bankers and traders whose risk-taking ultimately cost British taxpayers billions, from making similar mistakes in future. If other countries took a similar approach, it would probably help make the banking system safer.
 
But it will not satisfy those who believe it is wrong for bankers to be paid so much, or to share in the profits of their employer while things are going well, while leaving taxpayers on the hook when it blows up.
 
Such critics overestimate what regulation is capable of achieving. Most investment banks have made huge trading profits this year because of the cheap liquidity the central banks have supplied. This has very little to do with the “talent” that investment banks continually talk about recruiting and retaining. Nevertheless, the “talent” will end up pocketing a large chunk of those profits at the end of the year. The FSA’s proposals will not prevent this.
 
The FSA will also not attempt to place an absolute cap on bonuses. Critics claim the regulator is pandering to fears that excessive regulation would drive traders offshore. True, no country can afford to act alone if others will not follow. But there are other factors at work. Regulators around the world are raising capital requirements for trading businesses, which is likely to make these operations less profitable for banks in the future. If, as is widely expected, future returns in banking are lower than during the boom, the bonus pool will also shrink.
 
Hector Sants, the FSA’s chief executive, is surely right when he argues that, as long as bonuses are based on risk-adjusted profits and do not threaten the stability of the institution, it is not obvious that there is a reason for the regulator to step into the fray. It is then up to the bank and its shareholders to decide how those profits should be carved up. If their decisions on this infuriate the public — and the politicians they elect — it is up to parliament to legislate to introduce higher rates of tax for top earners.
 
As long as employees of large, systemically important financial institutions are able to earn vast sums, some critics will argue that the regulators have failed. In fact, the FSA’s proposals are a step in the right direction. Stamping out the bonus culture in financial services however, will require much more drastic action.

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