Capping Bankers' Bonuses Is a Blunderbuss Idea

Paula Dwyer writes editorials on economics, finance and politics for Bloomberg View. She was London bureau chief for Businessweek and Washington economics editor for the New York Times, and is a co-author of “Take on the Street: How to Fight for Your Financial Future.”
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The European Union is about to do something remarkably lame: ban bonuses that are more than twice bankers' salaries.

The rules, which would limit bonuses to one times salary -- two times base pay is possible, but only if a supermajority of shareholders approve -- are supposed to take effect next year. The cap would apply to EU bankers anywhere in the world.

A tentative agreement was struck today by lawmakers in the European Parliament and member states, but it still must be approved by each EU country and the complete European Parliament.

Udo Bullmann, the leading European lawmaker proposing the rule, says it would mean ``less money for bonuses and more money for jobs and investment.'' He obviously hasn't met Mr. Unintended Consequences, the invisible man who upends even the best-laid plans.

It's understandable why the EU would want to do this. The recent financial crisis began, in large part, because bankers and securities traders took on huge risks to drive up their bonuses. Payouts that are many multiples of base salaries are still common.

The possibility of huge bonuses drove the mortgage securitization frenzy, which continued long after it was clear that housing prices would collapse. Fat bonuses also provided the incentive for bankers involved in the Libor scandal to manipulate interest rates for short-term profits.

Bonuses, in fact, continue to provoke some of the worst problems in banking, including over-borrowing and holding too little capital to absorb losses. Borrowing allows bankers to take bigger risks, reap potentially bigger returns and take home bigger bonuses -- until the risks result in losses.

Losses, however, often don't materialize for many years, long after the bonuses have been paid. Even if traders who cause heavy losses are fired, they usually take their generous remuneration with them.

In short, the bonus system encourages risk-taking with little downside. Ultimately, taxpayers must step in to cover the losses and prevent an economic meltdown. Another way of saying all this is: "Heads we win, tails you lose."

So why not cap bonuses? Easy: EU banks would be at a competitive disadvantage to U.S. and Asian banks not subject to the cap, driving talent into their arms. Even on foreign soil, European banks wouldn't be able to compete because the cap would apply no matter what country they operate in.

To keep existing bankers and attract new talent, banks would need to pay higher base salaries to guarantee higher levels of compensation. Banks' fixed costs, even in lean times, would multiply. The flexibility to reduce headcount would be limited because managers' hands would be tied with multi-year contracts (which every banker would soon demand). Worse, higher fixed compensation takes away from managers the best tool they have to control behavior.

There are better ways to do this. One option is to make sure bankers' bonuses are paid out over multiple years, and can be clawed back if profitable trades turn to losses.

Another route is to pay bonuses with bonds. Unlike shares, bonds have fixed returns. Stock and stock options, now the mainstay of bonuses, give bankers every motivation to drive up profits, and thus share prices, with leverage and risky trades. UBS AG and Credit Suisse Group now include bonds in their bonus packages. It would be far better if the EU explored these options before plowing ahead with a measure that could weaken EU banks' already precarious financial position.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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Paula Dwyer at