Tackle bondholders – not staff pay

Allister Heath
ALMOST incomprehensible. That is the only way to describe the rules governing pay and bonuses for the financial services industry unveiled by the European Union on Friday. Only one thing is clear from the 82-page document, which could affect up to 2,500 UK firms: it will make many lawyers and compliance officers rich.

It makes sense for companies to align long-term interests with those of employees; this has already happened across the financial services industry. Some firms did incentivise some of their staff – especially those with a sales role – to behave excessively exuberantly. Yet to acknowledge the need for reform and for staff to have more skin in the game does not mean accepting that the best way forward is for the government to step in (even the EU does not put a quantitative cap on total compensation, or even a blanket rule on the proportion of total pay that can be accounted for by bonuses).

Supporters of the EU’s proposals – which restrict the proportion of cash in bonuses and ensure that they are deferred over 3-5 years – must answer the following questions. First, why would chastened shareholders not force firms to make sure that pay policies were sufficiently long-termist? Second, if short-termist bonus policies were so important in fuelling the bubble, why is there no robust academic evidence that demonstrates this? Third, how come Lehman, AIG and other flawed firms actually paid a large proportion of their bonuses in shares, as the EU wants, and yet they still went bust, wiping out many ordinary employees?

Luigi Zingales of the University of Chicago, co-author of Saving Capitalism from the Capitalists, puts it well. He points out that “there is no evidence” supporting the view that bonuses fuelled excessive risk-taking. He says that “much research has tried to establish a connection between bankers’ compensation schemes and risk-taking, but has failed to find one. At most, such research has found that more highly paid executives took greater risks, but it is unclear whether this is a cause or an effect.”

One problem is that there is limited available data to establish whether any causal relationship exists between performance-related pay and risk among lower-level managers, as opposed to directors. This may change once America’s Financial Crisis Inquiry Commission, which has subpoena powers, eventually publishes its report, but is doubtful whether academics will ever show anything more than a minor causal link between bonuses and the crisis.

The real driver of risk was that bondholders knew they would be bailed out and ceased to care; the cost of credit collapsed and risk premia fell to near zero. Seeing this, shareholders had an incentive to ensure their bank levered up as much as possible – having access to subsidised credit, courtesy of the government, promotes gambling at taxpayers’ expense. It is this moral hazard that must be tackled, via systems that allow firms to go bust and bondholders to be wiped out. The best way to reduce excessive risk-taking is to reintroduce capitalism and the fear of failure, not to hit hundreds of thousands of employees with new rules.

As Zingales points out, restricting staff incentive pay without changing shareholders’ and bondholders’ incentives will only make shareholders want to be more actively involved and find other ways to increase risk-taking. It is a shame that the EU, in its obsession with regulating pay, cannot see this.