Bonus regulation — a terrible idea whose time has come?

Finally, it appears that the investment banking industry (in Europe at least) has got the kind of regulation it deserves. Which is to say, capricious, wrongheaded, arrogant and systematically destructive. As someone who worked in this industry until about three months ago, all I can say is that I feel for my ex-colleagues, but that this was not a disaster which fell on the industry like a Black Swan from a blue sky — it was more like the kind of injuries that you get if you climb into the lion enclosure at the zoo, and repeatedly kick a sleeping lion up the bum to see if it will wake up.

I could be talking about any one of a number of regulatory initiatives, from leverage ratio regulation to “ring fencing”, but actually I’m talking about the controls on variable remuneration (or “bonuses” to hoi polloi). Regulating variable pay is a world beater of a terrible idea, because it basically rules out all business models from the industry other than those which cause the biggest conflict-of-interest problems.

All of my very best times in the industry were spent at scrappy, research-oriented brokerage firms, which provided trading services to institutional investors, and which lived and died by the quality of advice and execution we provided. If our clients didn’t eat, we didn’t eat. This is a totally viable business model — in fact, it’s pretty much the only part of the investment banking industry where anyone has ever set up a new business with their own money — but it depends on a particular kind of cost structure.

That cost structure is that you jack down fixed salaries to the lowest level possible — in my day, this meant £100,000 for Directors and about half that for junior ranks — and benefits, including pension entitlements, to the bare legal minimum. Then you went out and did business for a year, and you calculated the pre-bonus profit, and you divided that up fifty-fifty between employees and shareholders. Often, in this model, the actual bonus day announcement was communicated to you in “points”, each point being equal to roughly 0.02% of the pre-bonus profit when it was audited.

But this model regularly delivered, in good times, variable/fixed compensation ratios above 200%, which would be totally illegal under the recent Capital Requirements Directive (CRD4, there have been three previous ones). Which could mean that it’s going to become more and more unviable these days — I suspect that the very small brokerages, where the shareholders and the employees are more or less identically the same people, might be able to get round it, but there is no way that anything regulated as a division of a bank will be able to do business this way.

And that means that the industry could be dominated by big banks paying big fixed salaries. Which is a problem, because everyone knows that there is only one way to remunerate a big fixed cost base, and that is to do deals — IPOs and rights issues. The economics of a bulge bracket bank are very different from a small operation — the way you make money at big scale is to expand your brokerage operations until they either break even, or are slightly loss-making, and then you have effectively got a distribution network for your deals, for free.

So, the regulation of compensation levels has obvious costs. The intended benefits are that it will “reduce risk taking incentives”. As I’ve mentioned earlier, I did some of the original regulatory economics work on this subject, and it was, largely, wrong. Or at least, it was based very heavily on one particular case (Nick Leeson at Barings Futures Singapore), which extrapolates reasonably well to a few similar incidents (Jerome Kerviel at SocGen and Kweku Adoboli at UBS also seemed to have been motivated by bonus upside potential), but not to any of the big failures that really caused the problems — recall that the subprime CDO crisis in the investment banks was not related to risky instruments, far from it. It was caused by AAA and super-senior tranches of CDOs, instruments which were believed by everyone who held them to be very very safe indeed. Also, looking back even at the Leeson and Kerviel cases, the real damage wasn’t done by people speculating on the upside — it was done when the rogue traders tried to cover up their mistakes and nobody detected what they were doing until it was too late. Basically, bonus regulation is the answer to a question that nobody asked.

In fact, no bank regulator did actually ask this question and a number of them (including the Prudential Regulation Authority (PRA) of the Bank of England) actually oppose it and are not shy about saying so. The bonus cap made it into the regulations thanks to a last minute push by the European Parliament, specifically insisted on by a very impressively organised group led by the Belgian Greens. It is purely and simply a piece of populist banker-bashing.

But, but, but … whether it’s a good or bad idea, it’s now the law in Europe. And whether you believe that there’s any rational basis to the law or not, that doesn’t mean that you get to disobey it, any more than you can crack open a six pack of Fosters’ Lager and take a few swigs while walking down the high street in Riyadh during Ramadan. And this is the context to the EBA’s latest official document.

A lot of banks had, on the basis of what frankly seems to me to have been legal advice motivated more by optimism than accuracy, introduced a system of “role based allowances” for their employees, which varied their “fixed” pay every year, with some vague idea that in good years the employees would be compensated for the extra time and effort required to do all that much more business. These things looked like bonuses, quacked like bonuses, but various people in the European investment banking industry had convinced themselves that they were part of fixed compensation rather than variable.

And this is what I mean by saying that this is a bad idea whose time has come, and that the banking industry is the author of its own misfortunes. Playing fussy little games like this with the letter and spirit of the law is the definition of what it means to treat your regulator like a punk. It’s at the heart of what was wrong with the supervisory culture that gave us the crisis. And so, even though I know in my heart that it’s absolutely the wrong decision, I can’t help feeling an instinctive “good on yer” toward the EBA, for putting out a document yesterday saying, in the immortal words of the New York Post front page from 2009, “NOT SO FAST YOU GREEDY BASTARDS”. They’ve published an Opinion, in which they attempt to crack down, and hard, on the definition of fixed pay, and make it very clear that role-based allowances, except in the very small minority of cases where they are needed to compensate employees making (eg) geographical moves, are not going to be counted as fixed.

As substantive regulatory policy, it’s a terrible idea. As a rare example of a major regulator refusing to be treated like a doormat, it’s fantastic. Hopefully, the genuinely terrible system of bonus regulation in European investment banking will be chucked away with the next round of legislation (and hopefully, this will happen at roughly the same time that industry profits recover to the extent that bonuses above 200% of salary will be economically viable). But until it does, then the banks need to obey the law as it’s written, and to send all of their negative energy in the direction of the (mainly American) bastards who caused this problem for the industry in the first place.