Forget EU Bonus Limits, Give Us More Capital

a | A

By Mark Whitehouse

European lawmakers are moving toward imposing one of the world's toughest limits on banker bonuses. Hopefully, the effort won't divert attention from a more important goal: making sure banks have enough capital.

European Union officials have reached a tentative deal with lawmakers to cap banker bonuses at no more than twice annual salary, according to Bloomberg News. The agreement would further require shareholder approval for any bonuses greater than 100 percent of annual fixed pay.

Albeit laudable as a sign of political will to change the incentives that contributed to the financial crisis, the measure has little more than symbolic value. Unlike guidelines the U.S. Federal Reserve introduced in 2010, it doesn't address the issue of how bonuses are structured. So banks can keep rewarding short-term risk-taking to the longer-term detriment of their shareholders and the broader economy. Also, banks can compensate for the smaller bonuses by paying larger salaries, a move that could reduce their ability to cut costs in difficult times.

A better way to alter bankers' behavior is to require financial institutions to raise a lot more capital, in the form of equity from shareholders who would bear the brunt of any losses. The more a bank is required to finance its activities with equity, the less its executives can engage in the unnecessarily risky business of using excessive amounts of borrowed money -- also known as leverage -- to boost the measures of profitability that often drive their bonuses. And the more shareholders recognize how profitable banks actually are without extreme leverage, the more likely they are to start asking why they pay as much as they do.

Sadly, Europe hasn't yet gotten the message about equity. It will probably miss a year-end deadline to put in place the latest iteration of international bank-capital rules, known as Basel III. Even if and when it does, the minimum required level of capital under Basel III would be only 3 percent of total assets, not enough to get banks through the kind of crisis the world just experienced.

If EU lawmakers are going to take as much as an extra year to pass the new capital rules, perhaps they should use the time to rethink them. Bonus limits are no substitute for financially sound banks.

(Mark Whitehouse is a member of the Bloomberg View editorial board. Follow him on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Dec/13/2012 18:19 GMT