Brussels' plans to cap bonuses will be a disaster for London

Allister Heath

ONCE again, Britain is about to shoot itself in the foot. The latest proposals from Brussels – this time, to impose a cap on bank bonuses – look like they may shortly be nodded through, with George Osborne seemingly too frightened by anti-City sentiment to block them. Bonuses may have to be no more than 100 per cent or at most 200 per cent of base pay, though the devil will be in the detail.

Before I tell you why I think this latest EU plan is bonkers, bad for the UK, bad for jobs, bad for London, bad for tax receipts and bad for the stability of the financial system, let me remind readers of what reforms I do support. Prior to 2007, profits were privatised but risks nationalised, with an appalling regulatory model eliminating some core market disciplines but replacing them with nothing.

Some of the extensive reforms since then have been good, including the requirements to hold more capital and liquidity (though some of the changes have been too quick).

Pay is rightly now structured differently, with bonuses deferred to align shareholder interests with staff compensation and to allow banks to cancel payouts if they turn out to have been based on false or excessively hopeful accounting. We still urgently need proper resolution mechanisms and specially tailored bankruptcy rules to allow even the largest banks to be wound down without destroying the overall economy or triggering a Lehman-style panic in the event of failure, protecting depositors but wiping out bondholders, shareholders and senior staff. There should never be any more taxpayer bailouts.

But the bonus cap plan is wrong. It involves the biggest violation of the right of companies and employees to freely determine pay since the price and wage controls of the 1970s, hugely distorting price signals. What will start with banks will end up being applied to everybody.

It wrongly assumes that success should not be rewarded – of course, badly designed contracts can incentivise bad outcomes, but the challenge is to design contracts properly and put in place strict monitoring systems to prevent unintended consequences – such as excessive risks, Libor-style fraud, or other improper behaviour motivated by the hope of making higher bonuses. It’s not rocket science to design a system that works; yet the EU wishes to throw out the baby with the bath water.

The cap will lead to further boosts to base pay, increasing fixed costs and risk. When business volumes drop, the only answer will be to sack people, rather than cutting bonuses. This is tricky and will further increase cyclical risks for the banking system.

A banker at a US, Singapore, Swiss or Tokyo branch of a large non-EU bank will be able to earn a large bonus, but not those in the London office. People doing the same job, in the same team and performing identically will be paid differently. British or European banks will be forced to apply these rules globally, which means they will become utterly uncompetitive in overseas locations. Some UK and EU universal banks may have to quit investment banking altogether. It may even make more sense, under these rules, for the likes of Barclays to float their investment bank in New York and move as many bankers out of the EU as possible.

Given all of this, I have two questions: why are so many City firms still so keen on the EU, given its apparent determination to inflict as much harm as possible on London; and why is the industry so shy at making its case publicly and on the record, given that so many of its staff are about to suffer the consequences? It’s truly baffling.