What it means: 2010 bonuses for UK banks will be paid without the new disclosure rules. Shareholders will not be able to challenge boards on staff pay. Public outrage, already heightened by austerity measures, will be less than it might have been, but meaningful reductions in bank pay and reform of risk-inducing compensation practices will be delayed.
What happens next: Osborne will write to European finance ministers to seek European agreement on bonus disclosure. He will find a willing audience on the Continent, especially France, but less likely in the US. The result may be European disclosure rules next year or later, watered down by the UK to compete with Wall Street. In the meantime, banks are raising basic salaries to compensate for lower bonuses.
Comment: Few people now doubt that high financial sector pay was central to the financial crisis; it feeds asymmetric risks, encourages economic rent-gouging and has contributed to the under-capitalisation of lending banks. Sir David Walker's disclosure rules were supposed to help shareholders control financial pay but now Osborne has back-tracked it is worth asking - would they have been enough, and what other options are there?
Telling shareholders how many millionnaires were created each year would help shareholders if they can react. They need separate and binding shareholder votes on compensation policies but the Walker proposals only go some of the way there. Walker planned to allow only 25% of shareholders to oust the remuneration committee chairman and reject the risk report, but do not provide for separate, binding votes on specific compensation policies.
Secondly, total employee compensation is already disclosed and has not helped much so far. Citigroup shareholders, for example, saw bank employees last year walk off with a quarter of the bank’s core equity value in pay while shareholders got nothing. Perhaps well paid shareholders felt uncomfortable challenging pay, or (more charitably) did not care as long as other quarterly returns were good and their funds were not lagging their peers. Either way, shareholder engagement and incentives need to be much better for disclosure to work.
Thirdly, bank pay is only half the problem. Hedge funds and private equity firms share a revolving a door with banks and have a strong cultural influence on banker pay.
These alternative investment fund managers (AIFMs) are not subject to the same shareholder and regulatory pressures, they are answerable only to their investors and there is no limit on their pay once their performance hurdle is reached.
Some argue that high pay in the private equity sector comes largely at the expense of Limited Partners (per Peter Morris) and other stakeholders in investee companies (per Josh Kosman). Some argue that a good portion of hedge fund earnings come from fees or are transferred from more patient capital via arbitrage and volatility strategies (Paul Woolley).
If these markets were efficient, investors should notice this and either disinvest or demand lower fees. But they don't because (i) there are too many informational barriers for the market to 'clear', eg poor disclosure means investors struggle to attribute IRR at PE funds, or the market makes it impossible to work out how an investor's allocation of funds to HFs might increase volatility and lower returns on the rest of their portfolio, and (ii) many AIFMs have delivered strong performance despite the crisis, and (iii) AIFMs give the appearance of portfolio diversification.
As a result there is little downward pressure on hedge fund and private equity pay. Tackling bank pay on its own will drive more people into the shadows of AIFMs, where tackling pay via regulation will be much tougher thanks to the common view that AIFMs did not contribute to the crisis.
Other measures
Luckily, Walker's disclosure of bank pay is not the only tool in the box. Others include absolute bonus caps, the raft of measures proposed by the G20 and FSA (such as clawbacks, paying in equity and spreading payments over time), breaking the link between pay and return on equity, and eradicating monopoly profits.
Taking these in turn, the most radical is absolute pay caps, which would pose an almost existential threat to much of modern finance. With disclosure off the table for now, caps are the nuclear option that cannot be ignored. But they are hard to calibrate, they undermine freedom of contract and invite avoidance, especially as Wall Street will never adopt them. They have high campaigning value in raising deeper questions about finance and making other reforms palatable by comparison but have little regulatory support so far.
The G20 measures can mostly be dismissed as “something-must-be-dones”. Equity and staggered pay were already in place at Lehman Brothers, JP Morgan before the crisis, while clawbacks have limited deterrent effect as they affect only bad trades by known culprits.
Attacking the link between pay and ROE may be more fertile ground. Remuneration consultants say that in the end the different bonus measures at the top all boil down to returns on equity, an internal accounting measure. Perhaps shareholders should demand that pay be linked to better measures of shareholder return, such as long-term dividend and share price performance.
Banking profits (before leverage) are driven mainly by lending margins, trading profits and advisory fees. Since each of these markets suffers deep inefficiencies, reducing the monopoly profits would also lower ROE, and therefore bonuses.
In lending, the current fractional reserve banking model gives banks a high degree of control over where credit is created, encouraging them to push credit to parts of the economy where bank ROE can be maximized even when lending has little economic benefit, as with some securitised real estate lending. Basel capital rules exacerbate this through risk weightings, while allowing banks to gear up and turn relatively modest interest spreads into fat ROEs of 20-30%, even during historically low interest rate periods.
As the crisis showed, neither of these is particularly good for banks or the economy, although they are excellent for bonuses. If wider bank reforms address these, they will help reduce bank pay.
It's not all about lending, however, and trading and advisory profits are also part of the equation. Trading profits have soared in recent years on volatility, complexity and volume (Paul Woolley again), while advisory margins are protected by a double layer of agents in the form of executives and shareholders and no disclosure rules. To the extent that these feed into ROE, capital market and advisory reforms will also help bring down financial pay.
Plenty of other policies might be worth considering too, from clamping down on the use of tax havens to mask pay levels, to monitoring pay ratios in non-financial sectors in order to compare them with finance. Others might include cultural measures to replace the role that bonuses play in motivating financial workers, reversing the “headhunter ratchet” by requiring recruitment agents to be paid by shareholders instead of executives, and reforming nomination committees to include workers and shareholders as is common elsewhere in Europe.
UPDATE 30 Jan 2011: It's catching. A PwC survey has found that asset managers are demanding higher pay because banks have increased salaries to avoid bonus taxes:
Many banks are reported to have sharply increased base salaries to limit the effect of higher taxes on bonus payments and restrictions on the proportion that can be paid in cash.
This has forced asset managers to follow suit, according to a survey of 22 houses conducted by PwC. "Ultimately asset management and banking share much of the same talent pool and new hires expect base salaries to be aligned".
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