“I think it will really hit them.”
Posted by Marc Hodak on February 28, 2013 under Executive compensation, Unintended consequences | 
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That was the comment of a Green Party member of the EU Parliament regarding the sweeping compensation restrictions on banker’s pay in Europe. The measure would limit bonuses to the level of salary without explicit approval of a supermajority of shareholders, and up to two times salary with such approval. This is part of a package of reforms intended to reduce banking risk on the theory that highly leveraged pay structures encourage the kinds of risk that got the world into the financial mess of 2008-2009. This theory has no empirical support, but that’s never stopped the social engineers and the occasional filmmaker who know better.
The UK is in a fit about this since they understand that this measure threatens the competitiveness of European banks, and London is the center of European banking. “People will wonder why we stay in the EU if it persists in such transparently self-defeating policies,” said Boris Johnson, no stranger to populism but, alas, the Mayor of London.
Boris need not fret. Unlike the Greenies and socialists, London bankers understand exactly how liquid money can be, and will easily figure out a way to keep control of it. For example, say they have a star investment banker who has proven himself capable of bringing in $30 or $50 million worth of fees. The new law will nominally prohibit his bank employer from paying him $200,000 salary plus a bonus based on, say, 20 percent of the fees he brings in. The bank will, instead, raise his salary to $5 million, with the possibility of a $5 million bonus. This would keep the banker whole, more or less. But it can’t stop there.
Consider for a moment what an investment banker (or fixed income trader, or M&A adviser, etc.) must do to bring in $50 million in fees. They must plan and continually adapt an aggressive and creative strategy to thwart their global competitors in getting those fees first. They must then execute that strategy by waking up in a different city nearly every other day, working 60 to 90 hours a week, driving their teams crazy, then calming them again or hiring their replacements in order to maximize their productivity, and continually wondering if they might miss the next deal by days or hours because their competitors are chasing them that much faster, all the while leaving behind their families time and again because a real or potential client needs to see the analysis or the man the next day. And they must hope the global economy is good this year, or it’s all for naught. They work that hard because (a) every incremental hour on the job is potentially worth over $1,000 and (b) they won’t be young forever.
Now, if a banker had to work about 3,500 hours to earn their $10 million bonus under the old compensation program, they might get away with working much more normal hours, including watching their kids grow up, to make, say 35 to 40 percent of their new bonus opportunity. Under the new compensation structure, that would mean getting their $5 million in salary, and about $3 million in bonus. (Go ahead, check the math.) Experienced bankers know the 80-20 rule better than most, and if they can make 80 percent of their previous pay with about half the flights and half of the evenings and weekends sacrificed to the job, more than a few will try that, especially the older, more experienced ones with fewer years left before they call it quits and open their hedge fund out of the public eye.
Well, their banks can’t let that happen. Neither can they allow their fixed costs to jump that high, and they certainly can’t allow their top talent in New York or Hong Kong to go across the street to their competitors. So they will do something else. They will enact the kind of strict clawback regime that everyone has been waiting for. Eighty percent of the new, $5 million salary would be placed in escrow, and at risk of forfeiture. To the extent that the banker fails to achieve, say, $30 million in fees, his salary (in escrow) will be docked by twenty percent. If he brings in at least $50 million in fees, he will get his full $5 million salary plus $5 million bonus. That way, if the banker does pretty much what he does now, the bank can pay him pretty much the way they pay him now.
When the Greenies and other socialists in Brussels catch on to this, they will no doubt enact additional laws preventing this particular work-around. We compensation advisers will then develop others. To the extent that the Greenies and socialists tighten the screws to the point where workarounds become too difficult or costly, then the City of London will fade as a global banking center, while the diehard, remaining European banks see their fixed costs as a proportion to their revenues move sharply higher. The net effect of higher fixed costs, of course, is higher risk to the company. I know, I know; the whole purpose of this regulation was to reduce bank risk, but that’s what happens when financial illiterates make financial rules. It’s a bit like watching novice campers trying to cut down trees with blowtorches.
As with all pay rules, the people living under the evolving EU rules will have their choice of unintended consequences:
1) Encourage endless additional complexity by creating new rules to stop the workaround of the old rules;
2) Increase banking risk by forcing banks to accept a higher fixed-cost structure (more than offsetting any benefits of new capital requirements that are driving this whole process);
3) Push their banking centers to other nations, further lifting the property values of New York, Hong Kong, and Singapore.
One way or another, the Greenie who commented “I think it will really hit them” will prove correct. But like the hapless shooters that lawmakers often are, they will hit the wrong target.