Why the bankers’ bonus cap should be scrapped

The new Chancellor, Kwasi Kwarteng, is said to be considering scrapping the EU’s cap on bonuses in the financial sector. This would be hard to sell to the public, but is still the right thing to do.

The ‘bankers bonus cap’ is part of the Capital Requirements Directive IV that was first applied to credit institutions and investment firms across the EU in 2014. It limits the discretionary bonuses that they can pay to senior managers and other “material risk takers” to no more than 100% of their fixed (basic) pay, or 200% with the approval of shareholders. It remains part of the UK rules after Brexit.

The case for scrapping the cap is straightforward. It is a clumsy rule whose costs outweigh any potential benefits. In particular, it has led firms to increase basic pay and made it harder for them to adjust variable pay, This has added to fixed costs and reduced the flexibility to respond to different financial conditions and to reward outstanding individuals appropriately. Indeed, the government should not be in the business of capping performance-related pay in any sector.

Arguments against scrapping the cap can be divided into three main categories.

The first comprises points about perceived ‘unfairness’ or ‘injustice’. For example, many have said that the new government should prioritise help for the lowest paid, rather than ‘City fat cats’, or that it is wrong to allow banks to pay more while calling for restraint in other sectors. Average pay in financial services is also, of course, already relatively high.

This has led to many popular soundbites and memes, but it misrepresents the issues here: scrapping the cap is not a choice between helping one group at the expense of another.

The key point is that scrapping the cap would cost the government nothing, because bonuses are paid by the banks themselves, not the taxpayer. If anything, the boost to City earnings should lead to an increase in tax revenues, thus helping to fund other measures to ease the cost-of-living crisis.

It also seems odd that supporters of the bonus cap appear to be happier with a rule which means that top bankers get higher basic pay and lower performance-related pay. It is not obvious to me how the bonus cap helps to reduce income or wealth inequality.

The second type of argument is that the bonus cap serves an important economic purpose, mainly by deterring the sort of excessive risk-taking that many believe contributed to the global financial crisis and to the taxpayer bailouts that followed. Put another way, banks are different from other businesses, because of the economic fallout if they fail.

But these points are not enough to justify a cap on bonuses. As the Bank of England itself has noted, there are many more effective ways to increase discipline in risk-taking, including the ‘Senior Managers Regime’ (which makes top staff directly accountable to regulators) and deferred bonus schemes (which allow excessive payments to be clawed back later).

It is also wrong to assume that City staff can only earn a bigger bonus by taking more (or bad) risks. For example, a senior manager in sales or dealmaking can earn a bigger bonus by bringing in more business to their employer (bonuses here can be thought of as a form of commission). Some of the highest-paid City staff also work in areas like Asset and Liability Management, which is actually about reducing risks.

The third set of arguments are more pragmatic. In short, will the economic benefits from scrapping the cap justify the political hassle? Other post-Brexit changes would have a far bigger impact, such as reforming Solvency II to free up new sources of capital to boost UK investment and growth.

The bonus cap has probably not made a huge difference to the competitiveness of the City, either. The UK has retained its top spot as Europe’s leading financial centre, despite fears over the impact of Brexit, and continues to attract a large number of highly paid staff. Scrapping the cap might therefore simply provide the EU with another excuse to be awkward.

There is a domestic angle here too. Does the new government really want to spend some of its limited political capital on a policy change that would be opposed by a large majority of the electorate? Two-thirds of respondents to a recent YouGov poll wanted to keep the cap and the opposition parties would naturally have a field day with this.

Nonetheless, I would scrap the cap now or, at the very least, confirm the intention to change the rules next year, after the current crisis has passed.

As it happens, I believe public opinion can be shifted on this issue. Many people do now get the points about performance-related pay, and the potential boost to tax revenues. It helps too that many independent commentators, including regulators, are not keen on the bonus cap either.

Above all, politicians should do what they think is right, not just what plays well in the polls. (The clamour to renationalise the Big 5 energy suppliers is another good example.) The bonus cap does not achieve any of the objectives that its supporters claim. Scrapping it would be a clear signal of the new government’s willingness to take unpopular decisions that are in the long-term interests of the UK.

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