
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.
7 Comments
Charlie says:
I felt the booze parallel misleading: To me, it’s less about limiting your late night intake as a function of your early evening intake, more about limiting your daily intake as a function of your long-term daily average.
This won’t address alcoholism- it’s not meant to. However it is meant to help people avoid chronically over leveraging themselves on a Friday night in town. Fittingly, it’s the tax payer who gets to clean up that mess too.
23rd of January, 2014Claudio says:
It’s fine saying what won’t work – but what will work?
Any ideas?
I liked the idea from a friend – make them beg for it in public: that way we could see how much they really want it. Want rather than deserve because this is all about want.
23rd of January, 2014Ross says:
It seems unlikely that caps on executive compensation will have any useful effect. If shareholders are pursuing short term profits, that is what banks will generate.
On a lighter note – One of the best suggestions I have heard for reducing exec pay demands is to force them to wear items on clothing sized according to the ratio of their pay to that of the lowest paid member of staff.
24th of January, 2014Paul says:
I like the idea that bonuses should be paid in the same assets the bankers trade for their clients, with a time limit on disposing them (say 6 months). So, the trader holding a portfolio of trashy assets would get their bonus effectively paid into this portfolio, and have to hold onto the risk of them declining before they’re able to sell.
Obviously, a bunch of difficulties for people e.g., in high frequency trading and esoteric financial instruments, and I imagine some buggers would try to manipulate their markets 6 months later to get a better pay-off, but I like the principle a lot.
24th of January, 2014Pidge says:
I don’t understand the proposed cap enough to support or defend it, but could it not be the case that the purpose of it is not merely to try and limit the overall size of the pay package, but to limit the amount of that pay packet which is made up of bonuses?
If one regards excessive bonus payments as a catalyst for reckless behaviour and pursuit of short-term targets, then it could well be a sensible approach.
To put it another way, the cap doesn’t care whether you earn €1,000 or €1,000,000, it just doesn’t want a proportion of that to come from bonuses, which have encouraged reckless and irresponsible behaviour.
2nd of February, 2014Idwal says:
I would be very interested in reading your thoughts on why banks are able to pay large basic salaries and bonuses at all. They are so profitable, I think, only because they are able to leverage up more than any other kind of company. This is a result of banking regulation and, to some extent, state deposit guarantees. Their function as intermediary between depositor and borrower is pretty simple isnt it? Would banks be able to lend more if they retained less in compensation costs and profits? And would that make the economy more productive?
2nd of February, 2014Paulcoombes says:
In response to Claudio:
2nd of February, 2014Remove the government guarantee of savings and never, ever use tax payers money to bail out a bank i.e. let them go bust.
Oh, and leave the EU.