A cap on bonuses is of little benefit

Rewards must be aligned with credible performance measures, says Tim Harford

‘George Osborne will face more pressure over bank bonuses on Wednesday, as Labour demands that he blocks state-backed Royal Bank of Scotland (RBS) from paying bonuses to senior staff worth twice their salaries’, Financial Times, January 14

What are the chances that this is going to work out well?

Pretty slim. First, it’s about bankers, so you know for sure that there is going to be a lot of yelling and not a lot of thinking about the subject. Second, this rule about bank bonuses comes from the EU. So as far as George Osborne and his Conservative allies are concerned, that means even more yelling and even less thinking. And finally there is the Ed Miliband factor – he somehow thinks that this issue is all to do with what he keeps calling the “cost of living crisis”.

He talks about that a lot, doesn’t he?

Everything reminds Ed Miliband about the cost of living crisis. And everything reminds me of hamburgers but I try not to bore people about the topic in public. (Apologies to Robert Solow.)

But what exactly is the argument about?

The EU has ruled that if a bank wants to pay senior staff a bonus larger than the basic salary – that is, more than doubling pay – then explicit shareholder permission must be granted. Regardless of permission, the rule also states that a bonus cannot be more than twice the basic salary. Mr Osborne is challenging this in the courts. But Mr Miliband wants to raise a separate but connected issue: whether Mr Osborne’s Treasury, in its role as majority shareholder at RBS, will approve these larger bonuses.

So the question is whether Osborne will give permission for RBS to squeeze through a loophole in a rule he opposes anyway. How big are the bonuses that RBS proposes to pay, then?

This is it: officially RBS has not asked the Treasury for permission, so the entire discussion is political theatre.

It’s not entirely political theatre: there is the question of whether bonus caps are a good idea.

They aren’t.

That’s surprisingly decisive for an economist.

Trust me, I’ll sit on the fence shortly. But the crude EU cap is pretty daft – and when I say “crude” I have the support of Mark Carney, governor of the Bank of England. It is the equivalent of trying to limit alcohol consumption by saying your consumption of beers cannot exceed the number of tequila shots you downed at the beginning of the evening. For a committed binge drinker, that sort of rule is not going to help. And wanting to abolish it would not make one an irresponsible puppet of the drinks lobby.

So the EU rule is just as likely to jack up salaries as to reduce bonuses?

Quite. And just because the Conservative party unthinkingly lashes out at anything that comes from Europe does not mean that the EU is always right. In this case, the EU rule is crazy and Mr Osborne is right to challenge it. By the way, it seems quite plausible that of the bankers paid well enough for the rule to apply, more work in London than in rest of the EU put together.

So Miliband is wrong?

Here’s where I climb back on the fence, because while Mr Miliband is engaging in ridiculous posturing, there is a serious point to consider. Banks like paying bonuses rather than salaries because bonuses carry fewer side perks and can more easily be cut in tough times. So, as Mr Carney says, a crude cap is counterproductive. It is in any case being sidestepped by “cash allowances”– which seem to be like bonuses except, you know, they are not called that. But one of the contributing factors to the financial crisis – one that was so clear that even we economists spotted it – was that bonuses were encouraging bankers to take risks on a “heads I win, tails the shareholders, and taxpayer, lose” basis.

So the government should mess around with RBS bonuses after all.

In principle, yes. The issue is whether bonuses are really well aligned with credible, long-term measures of performance. This seems much easier to achieve with a single large shareholder, able to pay attention to the details. Research by the economists Marianne Bertrand and Sendhil Mullainathan shows that the pay of chief executives is linked much more tightly to sensible performance measures when at least one substantial shareholder exists to act as policeman.

Do you think the Treasury will play that policing role well with politicians yelling in their ears?

I think that is a question that answers itself.

Also published at ft.com.