New bonus rules won't achieve anything

Allister Heath

SPIN is an effective device to con the public but only in the short-term – eventually, the truth tends to prevail. Take the flagship economic component of Wednesday’s Queen’s Speech, which Her Majesty will have to read out to Parliament. As we report on page 1, the government will introduce its much-trailed law to formalise the Financial Services Authority’s code on pay. This is a big deal, which is why it is our lead story – but the actual proposal bears little resemblance to the uber-spun version parroted at the weekend.

Most voters probably believe that the government is about to cap bonuses by banning payouts above a certain sum – and given the distorted coverage of the new rules, especially by non-specialist broadcasters and newspapers, they could be forgiven for doing so.

The government, which is trying to fuel public rage at the financial services industry, is encouraging this. The truth, fortunately for London’s viability as a place to conduct business, is different: there will be no cap and no limits on “excessive payouts”. Instead, the structure of bankers’ compensation will be changed to ensure – at least in theory – that they don’t encourage excessive risk and are based on a realistic, long-term gauge of performance. Banks will still be able to pay what they want (with the exception of guaranteed sign-on bonuses) but the way they do it will be different.

New contracts will have to include deferred payouts, with around a third paid out in year one and the remainder in subsequent years. Unpaid deferred bonuses could be cancelled if the investment on which they were based unexpectedly turns sour. More bonuses will be in shares. Guaranteed bonuses will be banned. There will be no blanket ban on bonuses at loss-making banks but firms will have to explain why some individuals are still being rewarded. The new development is that the FSA will have the power to force banks to undo contracts that violate these terms – rather than merely the power to fine institutions that refuse to comply. Virtually all new contracts signed in recent months have been compliant.

Some of these reforms are sensible, especially the idea that all performance measures should be risk-adjusted. Others are less so – and will damage the City’s competitiveness given that no other major financial centre has implemented such rules. But the real problem with our obsession with fiddling with pay and bonus rules is that this won’t achieve the stated goal of improving financial stability (though it may succeed in its unofficial goal of boosting the government’s popularity).

Deferred and stock-based compensation was at the heart of Lehman Brothers’, Bear Stearns’ and AIG Financial Products’ pay policies – yet all three firms made terrible mistakes that destroyed them. The shocking truth is that there is no empirical evidence supporting the view that bonuses were the main or a key driver of the bubble (rather than other factors such as loose monetary policy or flawed models). The FSA openly admits this. Here is what it said in August in its Reforming Remuneration Practices in Financial Services: “Poor remuneration policies were a contributory factor rather than the underlying cause to the crisis and there is no empirical evidence of remuneration policies being responsible for the crisis... However, we still believe the Code will deliver benefits for the protection of consumers by addressing incentives that may undermine the adequate management of risks by firms”. It’s good to have that on the record.