European Banking Authority could risk financial stability with bonus cap

But the bonus cap itself will not lower overall bank risk as this is set at the whole bank level to marry up the risk and returns the CEO thinks he or she needs to deliver to the capital markets. Even if a bank used no bonuses at all it could still be made very risky if that is what the bank’s leaders wanted. They would target the bank at risky products, demand their bankers take risk, and promote those that do.

Furthermore, capping in its present form is not without its problems according to Professor Thanassoulis. The most challenging issue is the inevitable rise in fixed pay to compensate for any reduction in bonuses.

The problem of the bonus cap is that banks need to pay at market levels to keep the bankers they need. My research has shown banks, such as RBS and Barclays, are right when they say they are victims of a system in which rivals target others’ staff relentlessly, driving pay up.

But by capping bonuses and having the EBA enforce that cap, banks will be forced to actually raise fixed pay to stop poaching banks taking their staff.

Professor Thanassoulis believes this higher fixed pay figure, when multiplied across a large part of their workforce, will represent a "crippling bill for banks in times of stress" and make banks riskier as it pushes up their fixed costs.

If a bank does not have the profits and ultimately the balance sheet to shoulder those remuneration costs comfortably, then the bank itself is put at risk.

But with a few tweaks the cap legislation could be much more effective in delivering safer banks and lower pay claims Professor Thanassoulis.

The cap on the bonus should be applied at the aggregate bank level. If total bonus payments to bankers had to be less than a given proportion of the bank’s risk-weighted assets then the European Union would win and see lower pay levels; and banks would win as they would be safer, while being able to retain the key people they think they need.

Such a cap would impact on the poachers bemoaned by the likes of RBS and Barclays most forcefully and so damp down the aggressive poaching market. The cap would stop weak banks overstretching themselves to offer eye-watering sums to tempt bankers to join them. This aggregate bonus cap would reduce bankers’ pay levels. By doing this the banks would gain in value and in safety.

This improvement in financial security would have been worth as much as 150 basis points of extra Tier-1, the core measure of a bank’s financial strength from the viewpoint of regulators, and could be achieved without any risk to lending to the real economy.