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Economic HR – If the cap fits, enforce it

The news that Barclays wants to increase the size of its bonus pool, and that RBS wants agreement for bonuses up to 200 percent of salary, was met with some incredulity. John Thanassoulis, Professor of Financial Economics at Warwick Business School, weighs up whether banks could possibly remain competitive without the bonus culture, as it currently exists. 

After bailing out the banks and enduring close to a decade of austerity, how the bailed-out bankers pay themselves is a subject of great public interest. Especially if the pay the bankers reward themselves might lead to a weakening of the health of the bank, or create risks for the future. Research I have led at Warwick Business School highlights four important points about bankers’ pay. The first is that both banks are right when they say they are victims of a system in which rivals target others’ staff relentlessly, driving pay up. The market rate of pay in Britain cannot be set independently of the rate of pay in Frankfurt or New York. It is this poaching market which sets bankers’ pay levels. That is why the chairman of Barclays, Sir David Walker, noted at the AGM that Barclays had to respond to aggressive competitors, keen to poach Barclays’ best staff.

So where is the problem? The second insight is that when multiplied across the bankers the total pay and bonus pool can get so high, that it damages the financial stability of the bank. 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. Hence the news that Barclays was simultaneously announcing losses and increasing its total bonus pool is noteworthy. The new bonus pool announced at Barclays, most of which is earmarked for investment bankers, is equivalent to 1.7 percent of the investment bank’s Risk-Weighted Assets, which is a significant amount. To put this into perspective the global response to the financial crisis has been to increase the proportion of Risk-Weighted Assets funded by safe equity capital by a similar proportion.

Shortly after that news broke, Barclays announced that it intends to reduce the size of its investment banking division drastically. It will be important for Barclays to be sure that the remuneration costs of the staff that remain can be well covered by the money they will have left to manage – even if investments underperform. The problem of total pay being so high it can threaten the whole bank is not unique to Britain, with Basel III already considering pay a risk factor. The third research insight is that a simple tweak of those rules can make the financial system a lot safer: a cap on total remuneration for investment bankers in proportion to Risk-Weighted Assets. Not allowing banks to over-reach themselves through very high pay might seem like common sense for the sake of the wider economy. Research has shown that the benefits of this intervention go further, as such a cap would impact poachers most forcefully, and so damp down the aggressive poaching market. This would reduce bankers’ pay levels enabling to banks to 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, achieved without any risk to lending to the real economy. By adjusting the cap rate during the cycle, a regulator can encourage money into retail banking and out of investment banking at key points of the cycle. Finally, my research demonstrates that bonuses themselves need not be problematic, they reflect the correct risk awareness of the bank, balanced against the typical profile of a risk-loving banker. Banks which do not make use of bonuses have to pay higher base salaries, as RBS will discover. This increases the cost base and can create a vulnerability for the bank. The pay revolt at Barclays highlights that the unfettered system of pay competition is bad for shareholders and is bad for financial stability. There are solutions that should explore.


www.wbs.ac.uk

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